The current hot topic in the market isthe EMU breakup. Similar fears already spread across the markets in 2003 and 2004 when France and Germany paved the way to a “more flexible” SGP, and Italy’s Maroni said that he was thinking of calling a referendum to allow Italy to leave the single-currency area blaming the euro for the rise in the general level of prices and the loss of competitiveness. Last week, Standard & Poor’s put Ireland, Spain, and Portugal “on negative watch” and downgraded Greece by one notch. Consequently, peripherals sovereign cash and CDS spreads have widened further and betting websites now assign about 30% probability to the scenario of one country dropping the euro.
First, our bottom line, and then a bit of our rationale.
- We regardsuch a scenario as highly unlikely, since we deem the exit costs almost unbearable compared to the few (thin and temporary) advantages. Moreover, as we argue below, technicalities make the euro abandonment almost an impossible scenario.
- We definitely welcome at least part of the recent spread widening because it will enforce in the medium-term fiscal discipline and it embeds a sort of normalization in a 16-country area with wide differentials in terms of, growth, inflation total deficit (fiscal and current account) and productivity trends.A certain degree of market penalization for underachievers is always a welcome outcome. We totally agree with those arguing that spread widening is a sign of good functioning of the area rather than, the first signal of an upcoming breakup.
An outstanding recent NBER working paper by Barry Eichengreen (http://www.nber.org/papers/w13393.pdf) explains amazingly well why it is unlikely that in the next ten years a single country will leave the euro area and why it is even less likely that the single-currency area will implode. In a nutshell the author argues that
1) although in the past there have been relevant example of monetary unions members unilaterally introducing a new domestic currency, overcoming apparently insurmountable legal problems (Germany in 1924), modern technological and financial integration make things much more complicated nowadays;
2) The passage of the law will probably require an extended period of time, exploited by agents to run on the financial system of the country in anticipation of the future new currency devaluation. Rating agencies would compare the change in the unit as a technical default;
3) in the case of an “underperforming” country leaving the area, the increase in debt-servicing costs will be one of the most important hurdles. Knocking at the IMF’s door would be one of the few options on the table. Keep in mind that, notwithstanding the spread enlargement, the debt-servicing cost for Italy, Greece, Portugal and the likes is much lower today than last summer when the ECB raised rates to 4.25%;
4) the political costs are particularly serious. The Maastricht Treaty provides no provisions for exit. If investors, as a consequence of a single opt-out, start doubting on the future of the EMU thus shifting out of euro-denominated assets, there might be the case other incumbent countries may pursue legal action against the leaving country.
True,we cannot say that the potential exit of a single country is a mere hypothetical issue, especially if it boils down to a strong overachieving country deciding to leave because, say, of the lack of fiscal discipline by most other members and/or of a relaxation in the anti-inflation stance on the part of the ECB. In this case, the economic costs would probably be lower as long as credible alternatives to the SGP are established, central bank independence is reinforced, and alternative fiscal and structural reforms are put in place. But let’s make the issue a bit more practical. If Germany, the only country that in the current juncture may meet the above conditions, decides to drop the euro it would face, in our view, unpleasant consequences. Without the euro, the new German currency would significantly appreciate and Germany would face a competitive devaluation, similar to the one that, back in 1992, almost destroyed its competitiveness. In the present macroeconomic circumstances, Germany would experience a textbook Fischer debt deflation and the German banking sector would be in a much worse position. Over the last decade, thanks mainly to a subdued unit labor cost dynamics, Germany has achieved a great competitiveness mainly at the expense of its area peers. A large portion of German GDP growth is generated by intra-EMU exports.
Hence,we think that the euro is a one-way door both for the good guys and the bad guys. Clearly, in the long-term a single abandonment or a breakup cannot be excluded but we are rather confident that this is not an option for the short- or the medium term. Apocalyptic scenarios may even present great trading opportunities. The current crisis brings about a unique chance to implement significant reforms that will improve the public finance outlook and the single-country competitiveness. The European Commission and national governments should push for more cooperation by spreading the message that we share a common fate.The balance of cost and benefits is still heavily skewed in favour of staying within the EMU and basic game theory teaches us that cooperation is always a superior equilibrium on competition.