Euro exit and depreciation would bring economic gains

In an exclusive extract from his updated book, Roger Bootle explains why allowing a country such as Greece to leave the euro is not as hard as critics think.

Austerity has provoked protests in Greece Photo: AP

By Roger Bootle

10:00PM BST 21 Jul 2012

'Many of the issues bedevilling the world economy have coalesced into a new and extremely serious problem – the crisis of the euro. This threatens to shake the world to its foundations.

How it pans out will be the critical determinant of whether the world manages to stage a reasonable economic recovery or plays out an extended rerun of the Great Depression.

The eurozone’s predicament is both financial and economic. The financial element centres on debt. Several countries have public debt burdens that are unsustainable. In some cases, private debt is also overwhelming. Meanwhile, this excessive debt in the public and/or private sectors, which can barely be serviced never mind repaid, threatens the stability of the banking system, which owns large amounts of it.

The economic problem concerns cost and prices. Monetary union was supposed to bring convergence between member countries with regard to costs, prices and, indeed, just about everything else. In fact, after the monetary union was formed, in the now troubled peripheral countries of the eurozone – Portugal, Italy, Ireland, Greece and Spain – costs and prices continued to rise rapidly relative to other members of the union. This caused a loss of competitiveness vis-à-vis the German-led core of between 20pc and 40pc, resulting in large current account deficits (i.e. an excess of imports over exports) and the build-up of substantial net international indebtedness.

To return to prosperity, these countries clearly need a depreciation of what economists call the real exchange rate; that is, the level of their prices and costs compared to other countries’, as translated through the exchange rate ruling between their currencies. Clearly, the financial and economic aspects of the crisis are closely intertwined.

For countries afflicted by the twin problems of excessive debt and uncompetitiveness, leaving the euro and letting their new currency fall potentially offers not just a feasible but even an attractive way out. If successful, it would help support an economic recovery through increased net exports, while not increasing the burden of debt as a share of GDP through domestic deflation.

Indeed, the higher inflation unleashed by devaluation would reduce real interest rates and thereby tend to boost spending. Moreover, outside the euro there would be some scope to operate a policy of quantitative easing. This might also help to boost domestic demand. If the troubled peripheral eurozone economies were able successfully to deploy this adjustment mechanism, then they would not only improve their own GDP outlook, but also help to allay concerns about the long-term sustainability of their debt situation and, thus, bolster the long-term stability of the “core” countries, too.

From a purely economic standpoint, the optimal reconfiguration of the eurozone would probably be the retention of a core northern eurozone centred on Germany, in which it seems clear that Austria, the Netherlands, and Luxembourg could remain. Finland and Belgium could also fit in tolerably well.

Perhaps the most intriguing issue is the potential position of France. It has been Germany’s close economic ally and partner, but France’s recent economic and fiscal performance has in some ways more closely resembled that of the peripheral economies. It has a current account deficit as opposed to Germany’s surplus and its primary budget deficit is close to that of Greece. It also has strong banking and financial links to Greece and the other peripheral economies.

Given these points, there would be a strong economic case for France to stay out of a northern euro. Indeed, there would be attractions for it in joining – and indeed leading – a southern euro, if one existed, or, more informally, a grouping of former euro members. A French-led bloc of former euro members would split the eurozone into two roughly equal parts, with the southern bloc slightly larger. Yet this would amount to a complete overturning of post-war French economic and political strategy. I suspect the French establishment would choose to stick with Germany without even thinking about it. If so, France could end up paying a heavy price.

The question is, could a break- up of the euro be achieved? There does not appear to be any insurmountable legal barrier to a country leaving the euro and remaining within the EU, even without the prior agreement of other member states.

A bigger issue is the legal status of any new currency and its impact on contracts specified in euros. While this threatens to be a legal nightmare, there is a way forward. In what follows, to keep matters simple, I assume that Greece is the first to leave, and that its new currency is called the drachma. But when I refer to Greece this should be taken as shorthand for any, or all, of the peripheral countries.

The principle of “Lex Monetae” states that everything that governs the currency of a country can legally be determined by the national government concerned. Major legal problems arise, however, because the euro is both the national currency of Greece, for now at least, and the common international currency of the EU as a whole. Hence, there may be uncertainty whether any reference to the euro in a contract should be interpreted as the national currency of Greece at the time payment is due, and hence the new drachma, or the common international currency of the EU as a whole, in which case it would remain the euro.

As it happens, most sovereign debt is issued under local laws. In this case, an exiting government could simply redenominate its debt into the new currency at the official conversion rate, applying Lex Monetae.

At the point of departure, the Greek government would need to declare a conversion rate from euros into drachmas. What should it be? I suggest the new currency should be introduced at parity with the euro. Where an item used to sell at €1.35, it would now simply sell at 1.35 drachmas. This would promote acceptance and understanding throughout the economy.

In the run-up to exit, controls would be required to prevent capital flight and a banking collapse in Greece – this is not some hypothetical problem. Greece and Ireland are already seeing huge contractions in their money supply as a result of deposit withdrawals. Accordingly – and in particular, from the announcement of the redenomination until banks were able to distinguish between euro and drachma withdrawals – banks and cash machines would need to be shut down.

Because euro exit and depreciation would bring considerable economic gains, which would both reduce deficits (and therefore the rate of growth of debt) and increase GDP, the scale of any implicit and explicit default following a euro exit is likely to be smaller than if the country had stayed in the euro.

After leaving the eurozone, it is inevitable, and necessary, that the new currency fall sharply to restore the competitiveness that has been lost over the past decade or more. Greece and Portugal require a depreciation of their real exchange rate of about 40pc, Italy and Spain about 30pc and Ireland about 15pc.

It is likely that the exchange rate depreciation would raise the price level by about 15pc in Portugal, 13pc in Greece, and 10pc in Italy, Spain, and Ireland.

Assuming that this adjustment takes place over a two-year period, the effect would be to raise the annual inflation rate by about 7pc per year in Greece, about 6pc in Portugal, and 5pc in Italy, Spain, and Ireland. The historical experience from Argentina in 2002 and Iceland in 2008 is that inflation is then likely to fall back sharply. Of course it needs to, if any real depreciation is to be secured from the large nominal depreciations.

A key determinant of the degree of impact of a eurozone exit on those countries remaining within the currency union would be the extent of “contagion effects”. These might result from the direct adverse economic and financial effects of an exit, but also from the increased perception that other countries might leave the euro. Accordingly, decisive measures to limit such effects would be vital.

The first and most immediate would probably be substantial measures to support the banks of the remaining members, to prevent bank runs in the potentially exiting countries. This would probably involve large injections of liquidity by the ECB. There would also need to be a substantial increase in the firepower of the bail-out funds, probably supplemented by additional support from international organisations such as the IMF.

It seems likely that the remainder of the eurozone would need to take much more decisive steps toward some form of economic and political union. This might involve the implementation of commonly issued eurozone-wide bonds – “eurobonds” – which would effectively allow the troubled peripheral economies to borrow at something close to the eurozone’s average interest rate. However, more direct forms of fiscal transfers from the core economies to the periphery might also be needed.

Suppose that Greece made a success of its euro exit, with growth surging and unemployment falling. It would then surely be impossible for politicians in the peripheral countries to argue that there was no alternative to never-ending austerity within the euro. Parties advocating euro exit would gain in popularity and the market would react by pushing up peripheral countries’ bond yields. At that point, contagion from Greece’s exit could well prompt the departure of other countries.

If any country leaves the euro there are bound to be winners and losers. For Greece, devaluation and default would produce two sorts of loser: those whose capital is reduced by redenomination or default, and those whose real incomes are reduced by the higher inflation unleashed by the devaluation. The most important beneficiaries of all would be currently unemployed Greek workers. Their gains consist of the prospect of future income, in contrast to a presumed near-zero income if the present path continues.

The break-up of the euro would be an event of such political and economic import that everyone, including financial markets, should be awed by it. And the immediate results could be truly awful, involving banking collapses and heaven knows what. However, I suspect that both businesses and the authorities are much better prepared for the euro’s demise than they were for the Lehmans crisis. Indeed, future historians may come to regard the latter as a lucky break, because it alerted people to the dangers of financial instability and encouraged them to put in place arrangements to deal with the really big crisis that was yet to come.

Moreover, the resolution of the euro crisis promises relief from some of our acute economic pressures. I have highlighted the contrast between deficit and surplus countries. The attitude of the latter seems to have been: “Thank goodness the leak isn’t in our part of the boat.” Yet getting out of the current depression will require the surplus countries to spend more.

The euro has enabled Germany to continue its oversaving, in a way that could never have happened with the deutschmark, which would have risen strongly on the exchanges and thereby counteracted the effects of Germany’s slow growth of costs. The demise of the euro would release us from this straitjacket. The peripheral countries – whose economies are collectively slightly larger than Germany’s – would be able to grow again, and in Germany and the other northern core countries the pressure would be on to boost domestic demand to offset loss of demand caused by lower net exports. In short, the demise of the euro is part of the solution.

The crisis happened as a result of the phenomenal arrogance and incompetence of the European political elites. It is more a failure of government than of markets. However, the mechanism that brought the system to its nemesis was fully in line with the market defects that I analyse in my book. What undermined Spain and Ireland was a purely speculative boom centred on real estate that came straight out of the textbook of financial bubbles; bubbles that modern markets, central banks, regulators, and economists confidently believed no longer existed.

It is the expression of the belief that sheer political will can overcome market forces – and the living proof that it cannot.

So the euro crisis is really another expression of the forces that brought us so close to financial and economic disaster in 2008-09. It is the second shoe to drop. Having played a major role in getting us into this mess, once exchange rates are unshackled and are allowed to do their work, markets can also play a major role in getting us out of it.”

Europe will thrive. But we could be doomed to a life on the fringes

There is a Little England-ism that would have us leave the EU fold. It would be a disaster

• 
• • Will Hutton
  • The Observer, Sunday 10 June 2012
  •  

Santander: familiar on our high streets and part of the Spanish banking system that needs bailing out Photograph: Kumar Sriskandan / Alamy/Alamy

Taxi drivers and eminent commentators are agreed. The euro is an unmitigated disaster. It should never have been launched. Europe's elites over-reached themselves, locking the proud peoples of Europe in a disastrous straitjacket without any democratic mandate or ongoing accountability. This is payback time. Its collapse won't be pleasant, but the sooner the whole experiment is ended and Europe becomes no more than a loose association of free-trading nations with freely floating exchange rates the better. Eurosceptics have been vindicated.

This has become a settled British media and political consensus and now hardly seems the moment to challenge it. After all, Spain needs a massive bailout of its tottering banking system, including Santander, so familiar on every British high street, before the Greek election next Sunday. This appears to have been agreed yesterday. If Greece were to leave the euro before the bailout is complete, the bank run would overwhelm Spain and spread elsewhere. The EU and the IMF have only days to avoid a calamity. Southern Europe would confront run-away inflation and slump.
Nobody knows what will happen. Now Spain has got its bailout, Germany will agree to a fully fledged European banking union before the end of June, in which all eurozone countries guarantee each other's bank deposits and bank debt, agree common banking supervision and joint means to ensure every eurozone bank has sufficient capital. This should cut the poisonous link between the banking crisis and the public debt crisis. I also bet that the next Greek government will cut a deal to allow it to stay in the euro with less austerity.

In addition, a combination of ultra-cheap money and big infrastructure spending, again agreed reluctantly by Germany, across the continent will start to lift the European economy. The EU will have muddled through and the system held, because in the end the costs of break-up or for any one country exiting were just too prohibitive.

But the situation is dangerously volatile and the Germans may be too slow to act. It may be that we face months of bank runs and pandemonium and that the euro is reduced in essence to a north European euro bloc, including France and Germany but not most of southern Europe. But the big point is that one way or another the euro will have survived in some form because the member countries will have pulled together. And what will remain will be immeasurably stronger and more integrated – a euro area with a banking union, common governance of fiscal policy and political structures to match. Not a federal superstate but a new amalgam of nation states within a new international architecture – and with a newly forged European identity.

One of the byproducts of the crisis is that every European has become aware of the continent's interdependence. What happens in Greece, Spain, Ireland, France or Germany affects everyone else. Like it or not, we have to co-exist. In which case, this becomes a moment of existential choice for Britain. Eurozone members are not only fighting for the euro because the costs of collapse are so awesome. Europe must have a monetary order to underpin its ambitions to be a single market.

Devaluation, touted as a panacea across the British economic and political spectrum, certainly works for an individual country if it can devalue against others that hold their currencies stable. But as Keynes argued so effectively, if devaluation becomes the default policy for the entire system – the temptation in a world of floating exchange rates – then the consequence is disaster. It is an invitation for everyone to engage in beggar-my-neighbour economic policies by trying to rig their currency to boost their exports and minimise their imports, just as China has been doing for 30 years. A single market needs an accompanying monetary order – a heartland Keynesian proposition. This is not a doctrine of euro elites. It is how a single market can be made to work for all its peoples.

Which is why post-crisis Europe will be so tough for Britain. The EU that survives with its euro will be the centre of the European order. It will set interest rates and fiscal policy that will become the benchmark for every other European country. It will be the biggest and most desirable market in Europe and it will set the rules for how trade is conducted within its jurisdiction. Already it is happening. Senior ministers and officials have recognised that Britain had to agree to the banking union – with incalculable consequences for the City – but could do little or nothing to shape it. Financial regulation will be organised in Brussels for the benefit of euro member states. If we don't like, we can lump it. It will be across the board, from economics to climate change.

There is general delight that we are not part of this emerging superstate – a language that misrepresents what Europe is becoming. A referendum will cement our detachment or even lead to exit. Sceptics say the model for us to follow is Switzerland. The truth is that we would be a sort of Greater Guernsey, suffering an accelerated economic rundown. We will proudly float the pound, despite evidence that what floating means in practice – for a country with a huge international financial sector such as ours that sucks in capital from abroad – is systemic overvaluation and the evisceration of our traded goods sector: an economic doomsday machine.

Our foreign-owned car industry, dependent upon exports to the EU single market, will gradually migrate back to Europe or low-cost Asia. On a range of key strategic interests – finance, agriculture, fishing, transport, energy, IT and data security – benchmark policy will be made in Brussels, Paris and Berlin. They will have brought the EU through the crisis; their debts will be to each other, not us.

For the British Eurosceptic none of this counts. The vision is of endless austerity, prioritising deficit reduction above all else and evisceration of the social contract at home, and a refusal to recognise interdependence abroad or that there is any need constructively to create rules and an international order, especially in Europe. We should all resolutely tighten our belts and export our unemployment to others in a world of floating exchange rates and nonexistent international rules. It is a doctrine of arid meanness and nationalistic jingoism, an appropriate editorial line for populist centre-right newspapers, but nonsensical for a state with real interests to protect and advance. Britain stood aside from the euro crisis. It will stand even more aside from what follows, leaving us not just economically diminished but culturally shrunken.