Breaking up is hard to do: consequences of a disintegrated euro zone

Deutsche marks, French francs, Dutch guilders and Greek drachmas are still floating around, and Europe and the world economy are not in this mess. The US economic collapse of 2008-09 has perhaps led to a contagious slowdown in the global economy, but countries with strong fundamentals have regained their competitiveness once the dust settled. Countries with serious fundamental problems, like Iceland and Greece, may have suffered a larger slump, but the depreciation of their currency has boosted their exports and revived their economic growth.

But the euro exists, and country after country is suffering longer and larger effects of the European financial-fiscal mess than they should be. This is because their currency cannot be used as an adjustment tool for each individual economy. Billions of euros has been disbursed to bail out these troubled states. Jobs have been slashed, salaries cut, not to mention the continuous turmoil in the global financial markets these last two years. 

One cannot help but think the world would be better off without the euro. At very least, one of the more troubled countries would surely be better off had it been allowed to leave the currency union. 

But is it so?

Despite European policymakers’ insistence, many in the financial markets expect euro-zone membership to shrink in the next five years. Some research houses have gone so far as to say that the shrinkage will occur as soon as this month. But before we get into that, it’s worth clarifying the three scenarios for the euro zone’s break-up:

1) The exit of the weakest link, ie Greece (the so-called Grexit); 

2) The exit of Greece, along with Portugal, Ireland, Spain and Cyprus; and 

3) The abolition of the euro and the return of countries’ national currencies.

To analyse the possibility as well as the consequence of a euro break-up, there are three frameworks at play. 

The first framework emphasises the legal versus practical aspect of disintegration. Strictly speaking, there is no legal specification on how a country can leave the euro zone. That means that if a country wants to exit, it might have to leave the European Union (EU) as well. That option has drastic economic consequences, since the departing country will be forbidden from free movement of goods, services, capital and labour to and from the rest of the EU.

In practice, however, countries might be able to leave without incurring such a penalty. If all members forged a new agreement, a country – say Greece – could be allowed to convert its currency back to the drachma without forfeiting its EU status. 

Furthermore, practically speaking, Greece could be expelled if the creditor nations view that step as more beneficial to all. This month the Troika of creditors – the European Commission, European Central Bank (ECB) and IMF – is scheduled to disburse the next rescue fund of ¤31.5 billion to Greece. In exchange, Greece will have to slash its budget deficit by ¤11.5 billion in the next two years, which is unlikely to happen given the current pace of deficit reduction. 

However, if the Troika agrees to let Greece go, they can just simply cancel the transfer of funds. Then the Greek government will have no other option but to issue IOU notes as a parallel currency. This note will, in effect, be Greece’s new currency, and is expected to depreciate massively.

The second framework to be considered encompasses past international experience. There are three recent experiences of currency union break-up worth studying: the Pound Sterling crisis in 1992, the Thai baht crisis in 1997 and the Argentine Peso crisis in 2001. 

The first crisis has broad similarities to that of today. Facing a recession in the early 1990s, the British economy was in desperate need of monetary stimulus. But the Bank of England (BoE) had to sacrifice its monetary tools for the sake of euro-zone convergence. Spotting this opportunity, currency speculators led by George Soros attacked the Pound. The BoE fought back, and suffered a single-day loss of £1 billion. 

Defeated, the BoE decided to take the Pound out of the pact. It significantly depreciated against the deutsche mark (approximately 11.3 per cent within a year). But after that, the economy improved significantly. GDP growth increased around 3.4 per cent within two years of the break-up as exports regained competitiveness and monetary policy loosened. 

By contrast, the latter two break-ups were less successful. After their peg with the US dollar was abandoned, the baht and peso plummeted – 38 per cent and 73 per cent respectively in two years. GDP growth also dropped by around 14-15 percentage points compared to the peak prior to the crises. 

The differences between the first and the later two cases may have been due to the BoE’s timely and decisive action in “biting the currency bullet”.

The third framework that aids analysis focuses on the cost of each break-up option compared with the cost of strengthening the union. 

The first break-up option, a “Grexit”, would cost creditors around ¤320 billion, according to analysis by the Economist magazine. This figure comes with the assumption of a write-off for 1) all Greek bonds held by the ECB, 2) all disbursement of the previous bail-out, 3) the Greek temporary debt currently in the ECB’s payment system, and 4) the projected one-off Trioka grant to facilitate the Grexit. This is because the new drachma would massively depreciate until Greece could not repay its debt. 

For the second alternative, given the same assumptions, the cost of a southern European departure will be in the ballpark of ¤1.16 trillion. 

As for the third scenario, since the probability of a total euro break-up is close to zero, no one has put a price on this “nuclear option” just yet.

By contrast, the cost of making the pact stronger is hard to calculate. By nature, the euro zone is a monetary and currency union, meaning that members share the same currency and central bank. To make a stronger union, it needs a “banking union” and a “fiscal union”. The first one can be achieved by creating a pan-European deposit-guarantee scheme to re-capitalise weak banks, and then creating a single European banking authority to regulate them, which would cost around ¤375 billion euro, according to one estimate. The fiscal union, on the other hand, needs no extra cost right now since it only requires the European countries to issue a joint bond underwritten by all members.

Although a Greek exit might cost less than the rescue plan, it is highly unlikely that if Greece were allowed (or forced) to exit, the process would be smooth and orderly. Panic would strike bondholders of other southern European countries, triggering soaring yields. Domestic savers would fear a massive loss of value for money in their bank accounts, sparking a run on the banks. The contagion would spread to northern European countries, since their banks lend massively to their southern peers. The newly depreciated currency (or currencies) would lead to skyrocketing prices for imports, causing hyperinflation. Financial and political crisis would be hard to avoid. Given that circumstance, it is much safer for the creditor nations to choose the “stronger pact” option. 

In sum, a euro zone break-up would be costlier and riskier than a stronger union. But if enough people believe in the end of euro, it will eventually come true, and with disastrous consequences. Only with strong determination and a sense of unity among European policymakers will the euro and the world economy remain safe. 

 

Piyask Manason is vice president for research and planning at Kiatnakin Bank.