European monetary and fiscal authorities are determined to safeguard the Euro at all costs, and European government bond markets are currently waiting on the implementation of the Outright Monetary Transactions (OMT) and the European Stability Mechanism (ESM) operations. With the hastening of stabilization and liquidity actions, the economic situation within the Eurozone (EZ) appears increasingly dire. Years of futile crisis management have demonstrated that a deficiency in any one of a number of key institutions could doom the entire European common currency adventure to failure. According to Clausewitz, an orderly retreat from an untenable position is the most difficult of all maneuvers As fundamental changes occur, however, EZ members may find channels through which to withdraw themselves from the untenable position. The dynamics of a potential EZ disintegration is likely to alter European political-economic conditions in a way that allows EZ members to exit the Euro without leaving scorched earth.
The EZ currently comprises seventeen sovereign members locked into a dysfunctional institutional setup. The European Central Bank (ECB) has introduced a legal tender among constituent nations that has halted national note-issuing power. Combining the right to issue notes with the sovereign’s tax-raising power provides the most reliable assurance that any financial claims that stretch out beyond concurrent delivery and payment can finally be paid in full (having mopped up the Knightian uncertainty, whether a financial investor receives full compensation is then a matter of risk). Regarding the ultimate (real) settle-up of a financial claim, a sovereign note-issuer warrants future real production, which such authority may seize by enacting taxes, for example. In this regard, the sovereign acts as a guarantor of last resort for all contracted financial obligations. Such an institutional prerequisite encourages the private sector to use and hold a conventional currency, which supports savings and investments.
Such a close nexus between note issuance and tax-raising power, however, does not exist within the context of the EZ’s monetary setup. Instead, the Euro represents a foreign currency from the viewpoint of each individual EZ member. This leads to greater uncertainty, from the perspective of financial investors, with regards to financial contracts denominated in Euro. Such concerns center around contracted financial obligations and whether commitments can be fulfilled as originally envisioned by the contracting parties. With the Euro akin to a foreign currency, the sovereign latent right of EZ members to note issue poses a particular problem. That is to say that any kind of financial contract in Euros is generally subject to a redenomination risk.
With the Euro proving to be a uniquely fickle currency, further drawbacks—stemming from a mal-designed institutional setup of the EZ—pave the way for a self-enforcing monetary disintegration. In particular, politics has exacerbated matters by requiring that EZ membership be irrevocable. This is equivalent to an implicit guarantee that the EZ members will support one another to preserve the irreversibility of the Euro, whatever the circumstances (Fahrholz and Wòjcik, 2012). In the current absence of a debt restructuring regime—unlike, for instance, US states—moral hazard behavior has evolved and has prompted a credit boom. Moral hazard has allowed for the front-loaded benefits of EZ integration to be enjoyed at considerably delayed costs.
At the outset of the current crisis, financial investors realized that the level of indebtedness of some EZ members might be unsustainable. Their trigger might have been an announcement by Greek authorities in late 2009; when the Greek central bank declared that government bonds should no longer be emitted toward local Greek commercial banks but rather be purchased by foreign investors (Fahrholz and Kern 2009). Fiscal authorities within the EZ, at that stage, did not opt to expedite the recapitalization of struggling financial sectors that were suffering from the erosion of their assets from holding of government debt. Furthermore, European governments did not take the opportunity to initiate a reform of the EZ institutional setup. Instead, consolidation was eventually forced upon private sectors of bailed-out periphery economies within the EZ, and this prompted a debt-deflation process. The generally declining output and falling prices—which, in turn, increase the real debt burden—increase the risks to the lenders in the financial sector of net creditor EZ members. The most obvious policy alternative has thus been to provide increasing monetary and fiscal assistance to keep financial sectors afloat. In doing so, however, immediate economic devastation has been avoided at the expense of what may prove to be a harsher EZ disintegration process in the future.
The incipient redenomination risks within the EZ cannot be effectively curtailed because of a flawed institutional setup. As a result, there currently exists a sort of rational muddling through the current crisis as European governments delay costly short-run debt rescheduling (i.e., the default risk). Incurring ever more debt, however, decreases the probability of governments being able to eventually guarantee all kinds of contracted financial obligations within their economies. Pledging and paying-out more monetary and fiscal assistance effectively mitigates short-run liquidity risks. The increasing level of over-indebtedness, however, increases default risks. Most notably, by eroding the basic principles for using and holding the Euro, the economies will be in a protracted slump as financial investors further refrain from taking long-term financial risks denominated in Euro. The consequent sliding debt-deflation spiral will incrementally increase the incipient redenomination risks. European monetary and fiscal authorities are seemingly stuck between a rock and a hard place. As the monetary setup of the EZ tears itself to shreds, the implementation of the OMT and the ESM operations are signs of desperation.
As a result of a dysfunctional EZ, the Euro has no reasonable chance to weather the current crisis. Nevertheless, the dynamics of the EZ disintegration process may alter the political-economic conditions as both monetary and fiscal assistance will eventually come into conflict with electoral interests, particularly within the EZ core (Fahrholz and Pehnelt 2012). Once the EZ core confronts the adversities of futile EZ crisis management, policy-makers are likely to change their mood, and a revaluation may become a politically feasible option for EZ core members. When exiting from the EZ by introducing a new legal tender, the new currency within Europe (either unilaterally issued or jointly by some faction of the EZ) will most probably considerably revalue against the Euro—though the scope for revaluation depends upon the new institutional monetary design. Such revaluation may particularly help the EZ core to detach from rising unemployment and inflation within the EZ. If the real appreciation is sophistically managed and channeled into productivity-enhancing investments, a new window of opportunity will possibly open up. Incentives will crop up, which will allow the revaluing EZ core to take the lead in Europe by drawing on non-EZ financial investor resources. In doing so, the EZ core economies may help dismantle the EZ, help put the achieved level of real economic integration at safe, and stave off political disaster within Europe.
The Euro is a currency sui generis. A deficiency in the monetary setup of the EZ dooms the entire Euro endeavor to failure. Ever more monetary and fiscal assistance in the course of the OMT and the ESM operations is the result of rational political decision-making. Without fundamental reforms of the EZ institutional setup, however, these policies will eventually only serve to increase the probability of an exit from the EZ core. In the run-up to the Euro resolution, there will be an opportunity for EZ members to extricate from the untenable position in EZ crisis management. This applies, first and foremost, to the EZ core. Economic slack and a deferred inflationary impulse may alter political-economic conditions within the EZ core. An orderly retreat from the Euro, initiated by the EZ core, would come along with a considerable revaluation of probably resurrected national currencies. While relying on attracted real resources from third countries (i.e., the real appreciation), this may provide ample leeway for averting a messy EZ disintegration.
Fahrholz, Christian and Andreas Kern. 2009. “A Big Fat Greek Financial Wedding”, Berlin and Washington D.C., Atlantic Community, 8 December 2009. URL: http://www.atlantic-community.org/index/Open_Think_Tank_Article/A_Big_Fat_Greek_Financial_Wedding.
Fahrholz, Christian and Gernot Pehnelt. 2012. “Mid- and long-term risks of German Bonds”, Jena, GlobEcon Policy Brief 01-2012. URL: http://www.globecon.org/fileadmin/template/userfiles/Research/GlobEcon_Policy_Brief_01-2012_Oct_2012.pdf.
Fahrholz, Christian and Cezary Wójcik. 2012. “The Eurozone needs exit rules”, Jena and Warsaw, CESifo Working Paper, No. 3845. URL: http://www.cesifo-group.de/portal/pls/portal/docs/1/1217000.pdf.