Front page of “The Economist” (August 11th-17th, 2012)
In its edition of August 11th-17th, The Economist assesses the costs and benefits of a partial break-up of the euro area, with five exits – Greece and the “PICS” countries (Portugal, Ireland, Cyprus and Spain) who all share the characteristic of having already asked for a bail-out –, in a fictitious memorandum addressed to Angela Merkel by its advisors.
The idea of simulating a plan B within the “Merkel memorandum” was extremely interesting. However, I believe that despite the caution of the “advisers”, the real costs of a partial break-up of the euro area are undervalued.
The risks and costs for Greece and other expelled countries
First, the risks for Greece do not seem so easy to solve. For instance, the idea of using electronic payments while waiting for the emission of a new currency requires technical support and trust from the people, and I doubt both conditions are met in Greece. Regarding the extended bank holiday and the capital controls, they would not necessarily avoid a bank run. Indeed, people could still draw out some money at cash dispensers (except if these are emptied before). Moreover, capital controls are useful only if people wish to move their money abroad. But they could decide to keep their euros at home, waiting for better times to move them abroad. Finally, could customers not institute legal proceedings against banks that refuse to let any money be drawn out, especially money that is on current accounts (which is deemed to be available at all times)?
Second, with their banks and country being bankrupt, a vast majority of the Greek people would suffer from a much more dramatic misery than now. Indeed, the businesses and the people would lose a part of their possessions, while the rest would be so devaluated that it would be worth nearly nothing. If the drachma lost 50% of its value (as assumed in the “memorandum”), the minimum wage in Greece would become worth the one in Slovakia (but prices are 30% higher in Greece than in Slovakia – see this link). Furthermore, the costs of imports (especially) would be prohibitive. So, departing from the euro area would only accelerate and intensify the economic and social disaster.
Third, I am almost sure that the vulnerability to foreign capital flight would worsen at first, if these countries left the euro area, as their new currencies would have a very low value.
Finally, the fictitious memorandum highlights the risks of hyperinflation and insists on the need to implement credible policies. The problem is that not all central banks are known for their credibility…
The costs for Germany and the other remaining countries in the euro area
There would be also high costs for the remaining members of the euro area. Indeed, after having expelled the “sinners”, the euro area may become more viable, but its remaining members would face higher export costs (due e.g. to foreign exchange costs) and a lower competitiveness, as the euro would appreciate while the newly created currencies would depreciate. German exports alone would decrease by 10-20 billion euros (at least), as expelled countries could nearly not afford anymore German products.
Additionally, if the expelled countries were to remain within the EU, the memorandum also forgets costs such as the reallocation of EU funds. Indeed, several regions or even entire countries would become some of the poorest areas of the EU. Thus, they would benefit most from EU (cohesion, etc.) funds, at the cost of other regions/countries such as Eastern Germany.
Furthermore, a third bail-out of Greece would be necessary anyway, let alone potential additional bail-outs of other expelled countries. So, in the short term, a partial break-up of the euro area brings no advantage.
The political costs
Finally, the memorandum does not mention the political costs for Germany and the EU. This includes the rise of political extremes, which is already under way in several countries and needs to be watched carefully. It also entails the risk of an anti-German mood across Europe (with political and economic consequences).
Breaking up the euro area would also be a blow to the “European dream” of unity, peace and prosperity all across the continent. It would show a divided Europe. This could lead to distrust among Member States and a potential EU break-up with potentially disastrous and dramatic consequences.
Some thoughts on the current situation and how it might be improved…
I will only mention two points, related to my reading of the “memorandum”.
First, one of the problems pointed out by the fictitious advisors of Angela Merkel is the inefficiency of monetary policy (despite two rounds of long term refinancing operations (LTRO) which led the ECB to lend a total of around 1 trillion euros to the banks during 3 years). As mentioned in the memorandum: “that makes banks worryingly beholden to the ECB, causing them to clamp down on their lending to firms and households. This squeezes the economy even more tightly and makes it harder to get public finances in order”. One solution to force the banks to lend money to the “real economy” would be that the ECB puts a condition to refinancing: a high percentage (to be determined) of the previous refinancing operation would need to have been lent within the country if the bank wants to have access to new funds.
My second (and final) thought is that if Germany wants to keep its current competitive advantage within the EU, I am afraid we will need a system of permanent transfers (preferably through an adapted EU budget) in order to make off the costs borne by other countries, such as unemployment benefits. Indeed, if the other countries implement deep structural reforms (and some should urgently do so), Germany will lose competitiveness (relatively speaking). And just as there is a limit to running ever-faster the 100 meters race at the Olympics, there is also a limit to ever-more competitiveness…