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There has been little love by financial markets for European leaders these days. But one has to wonder about the level of disdain reflected in recent surveys of City of London economists1 and global investors showing agreement about the likelihood of a breakup of the eurozone. How can a majority of 25 City of London economists conclude that "a euro breakup of greater or lesser proportions will occur during the next Parliamentary term"—within five years, in other words—a view supported by 40 percent of global investors polled by Bloomberg?
Not the economic and political facts, it would seem.
A currency union in Europe was always destined to suffer problems. Because it lacks a fiscal as well as monetary component, the eurozone does not possess a central mechanism to overcome future geographically concentrated "asymmetric shocks," in which some countries suffer downturns and need fiscal help while other countries do not. Without adequate labor mobility across member state borders (or often even within them), the European institutional framework is further hampered as workers find it difficult to move in search of jobs because of language and other barriers. These handicaps rob the eurozone of several basic tenets of an "optimal currency area" (OCA).2
Despite these problems, however, it is worth remembering that OCA theory predicted in the first place that the euro would never happen. The same theory suggests that the euro is now bound to fail. Such predictions, though, are overwrought. Just because something doesn't operate optimally in an economic sense does not mean that it will fail once in existence.
In reality, there is next to no chance that the eurozone will break up as a result of the current economic crisis in Europe or as a result of a probable Greek sovereign default. There are several reasons why.
First, leaving the euro would impose a catastrophic cost on any nation that tries to do so out of economic weakness. Even eurozone countries that default on their debts would be far better off inside the eurozone than outside (eurozone members cannot be kicked out) because in the longer term they would still have access to the deep liquid eurozone financial markets. Any euro-denominated interest rate imposed by financial markets, even after a default, would be a lot lower than interest rates on, say, new drachma-denominated bonds.3
Moreover, under the Lisbon Treaty (which will not be revised in even the medium term) leaving the eurozone cannot be done without quitting the European Union entirely. Such a move would entail a nearly complete regional political isolation and probably exposure to the European Union's external trade barriers as well.
It is important to note that ditching a physical currency that remains the legal tender in other countries is very different from simply breaking a currency peg, as Argentina did in 2001. As the introduction of euro notes and coins showed in 2002, a new physical currency would entail a lengthy logistical operation. A process of many months of emptying and refilling ATMs, etc. can hardly be kept secret. While the mechanics are undertaken, a country wishing to leave the euro and reintroduce a new weaker national currency would experience a devastating capital flight, as private residents transfer their money out of the country.4
It can be argued that quitting the euro after a sovereign default resulting from a collapse of the domestic banking system would not add that much more economic chaos to the mix.5 But that view ignores several issues.
There is a lot more to an economy than the banking system, for one thing. Leaving the euro for a weaker currency would essentially cast private contracts denominated in euros into default, or subject such contracts to rapidly rising liabilities through a depreciating "new drachma." In addition, countries that seek to reintroduce a new national currency must have reasonable expectations of large export gains from a competitive devaluation. In the case of Greece and most other Mediterranean eurozone members (with Italy as the partial exception) large export gains from even a large competitive devaluation look very unlikely.
As described here on RealTime earlier, Greece with a total "goods-export intensity" worth just 7 percent of GDP in 2008 is by far the least goods export–oriented country in the eurozone.6 The country fundamentally makes too little that the rest of the world wants to benefit much from the short-term pricing advantages of reintroducing its own currency. Moreover, Greece's two large services sector export articles—tourism and shipping—would find it difficult to gain from depreciation. Tourism is highly sensitive to social unrest, which would be all but guaranteed with the introduction of a "new drachma." Shipping is conducted almost wholly in US dollars for both revenues and costs, and is thus unlikely to benefit much from a competitive Greek devaluation. The economic gains for Greece associated with leaving the eurozone thus are like the Sirens—seductive, but mythical and dangerous.
What if a strong country like Germany were to leave the eurozone? Similar misconceptions exist about the willingness and possibility of such a move. Despite some talk about this prospect in Europe, the case for a German departure from the eurozone is simply nonexistent.
It is politically unthinkable that Germany would undermine 60 years of pro-European policies by leaving the eurozone and thereby destroying the entire European Union, which has anchored its identity and powered its postwar authority. Recall that the German parliament drew broad political support for the recent €750 billion European Financial Stability Facility (EFSF) from both the governing Christian Democratic Union-Free Democratic Party (CDU-FDP) coalition and the main opposition parties Social Democratic Party (SPD)/Green party. That backing came despite the potential price tag of €150 billion or more for Germany. The SPD/Green Party abstained in the vote only because of opposition to the lack of "private sector involvement" (i.e., pain for the banks) in the package. In other words, only a Germany ruled solely by the far left party, Die Linke, which received just 11.9 percent of the vote in the 2009 national German elections, would conceivably oppose current policies.
This broad political support among the German political parties matters. German politicians are elected by proportional representation, a system that awards power to smaller and bigger political parties. Financial markets fearing a departure from the euro by Germany, where the euro is admittedly more and more unpopular, still attach far too much importance to single-issue polls on this issue.
The experience of European countries7 that have undergone popular referenda on EU-related issues is that whereas voters reject the recommendations of their elected politicians on such matters, there is next to no impact on how they vote in the next general election. There is no reason to believe that the German electorate is different. Polls showing public dissatisfaction with the euro will not likely lead to a massive swing of voters to Die Linke or a new "anti-EU protest party" in the next German election. The polls can therefore be largely ignored.
There is a striking contrast between the power of populist fringe groups in the United States and Europe. Many American commentators accustomed to the ability of extremist groups to win in closed winner-take-all primaries—as the Tea Party candidates have done this year—underestimate the stabilizing political effect of proportional representation in Europe. Commentators also underestimate the electorate's and the government's deeply institutionalized attachment to the European Union, which will make it harder to attract the popular majority required in proportional representation systems in support of an EU pullout.
As argued forcefully by Adam Posen, Germany retains huge economic advantages from being in the eurozone in the form of seigniorage, deeper bond markets, and the inability of close trading partners/competitors in France, Italy, and elsewhere to devalue. Add to this the €972 billion (data from end Q1 2010) in German bank exposure to other eurozone countries, of which €355 billion pertains to Greece, Italy, Spain, and Portugal, as of end-March 2010.8 All of these claims—currently denominated in Germany's own national currency—would be severely impaired, were the other eurozone countries to reintroduce their own weaker national currencies, adding an intolerable strain to an already weak German banking system. Destroying the eurozone by leaving it would therefore completely destroy the German banking system far more completely than any Greek default could.
Yet while the eurozone won't break under the strain of the current crisis, it will nonetheless be a very different eurozone after the current crisis, especially in its southern part. Originally designed as the ultimate symbol of European monetary integration and the firm foundation of the rapid economic growth in the southern peripheral members—with the hope of delivering convergence in living standards to the richer northern parts of Europe—the euro from now on will convey no such positive vision.
Rather than economic growth and rising living standards, the euro will now entail a damp deflationary—potentially even Thatcherite—embrace of its Mediterranean members. Its power is certain to force European leaders to legislate lower public wages and overhaul their social and economic models to avoid the catastrophic Greek-like debt death spiral. Just as German politicians have swallowed the bitter medicine of a €150 billion bailout of the eurozone (on top of the previous Greek bailout), so too will the eurozone's Mediterranean leaders drink from the same cup.
In spite of all these dark forebodings, the eurozone will hold together. It will do so not by a positive vision of the common future, but by the painful recognition of the staggering cost of leaving.
As Machiavelli wrote concerning whether it is better for a ruler to be loved than feared:
"It may be answered that it…is much safer to be feared than loved…because friendships that are obtained by payments…are not secured, and in time of need cannot be relied upon…but fear preserves you by a dread of punishment which never fails."9
As with princes, so too with currency unions of democratic nations.
Europe can be consoled by the understanding that it will prove safer for the euro to be held together by elected governments fearful of the cost of leaving than by the mirage of an excessively low cost of capital, a spurious convergence of government bond yields, and unsustainable bursts of growth in the periphery.
Let the financial markets and the doomsayers wail that the end is nigh for the euro. The performance of Germany and the weaker eurozone states demonstrate that, on the contrary, the euro is safer today than ever. Instead of a breakup, look for expansion, starting with Estonia in 2011.10
Notes
1. Admittedly, The Sunday Telegraph (or Tory-Graph) is a rabidly anti-EU newspaper, which may have skewed its survey of pooled economists in favor of Euroskeptics.
2. See Mundell (1961) for the original description of the optimal currency area theory.
3. See also Buiter (2010) for an in-depth discussion of the preference for a Greek default within the eurozone.
4. See Eichengreen (2007) for the original formulation of this argument.
5. See for instance Paul Krugman.
6. Greece exported for more than €500mn in just four HS six-digit categories in 2008; light petroleum distillates (HS271019), bulk medical supplies (HS300490), fresh fish (HS030269), and "other (HS999999). Data from UN Comtrade Data.
7. Denmark, Sweden, Ireland, France, and the Netherlands.
8. Data from the Deutsche Bundesbank.
9. Nicolo Machiavelli, The Prince, Chapter XVII: Concerning Cruelty And Clemency, And Whether It Is Better To Be Loved Than Feared.
10. See the European Commission (2010a) for its recommendation for Estonian euro membership starting from 2011.
