Monday, August 20, 2012

Divorcing Europe - How Hard Can It Be?

A recently published paper entitled "Leaving the euro: A practical guide" by Roger Bootle, an economist with Capital Economics answers the following question:

"If member states leave the Economic and Monetary Union (i.e. leaving the euro), what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?"

I realize that this is a rather lengthy posting, however, it is an issue that one way or another will impact all of us.  In light of that, let's open by looking at the debt-to-GDP levels for Europe's Member States to the end of 2011 to put the issue into perspective: 

In order to answer Mr. Bootle's question, we must first look at the economic problems facing the Member States and how these problems could be tackled by breaking up the eurozone.  Once departed, the former Member State must adopt a new currency, re-denominate wages and prices and then rely on the world's currency markets to set the value of the new currency which would most likely result in a substantial devaluation. Mr. Bootle suggests that there could be more than one scenario; first, the eurozone could break up because of the departure of one or more strong economies, second, there could be a division of the eurozone into a "hard" and "soft" euro and third, there could be the departure of at least one weak country.  No matter which scenario occurs, the countries that remain under the euro umbrella will find themselves weaker with a less valuable currency, higher inflation and a weakened banking system.

Mr. Bootle examines in some detail the scenario where a weak country leaves the euro and makes the assumption that Greece is the first to leave and that its new currency is called the drachma.  That said, he notes that any of the other so-called PIIGS debtor nations could also be vulnerable and that any of them could well be the first nation to leave.

As we know too well, the biggest problem facing the eurozone is the over-indebtedness of some Member States which have unsustainably high public and private debt levels as you could see in the graph above.  Many of these nations have costs and prices that are high relative to other nations in the EU, resulting in a loss of competitiveness.   This results in a shortage of demand which results in high levels of unemployment which worsens the debt situation.  Unfortunately, austerity through the cutting of deficits alone will not work because it will result in reduced demand which again, will worsen the problem.  Price deflation will not work since it will increase the real value of the debt, adding to the nation's debt burden.  Basically, it's a "damned if you do, damned if you don't scenario".

Leaving the euro and letting the value of a new currency fall (i.e. devaluation) would be a solution that would result in increased net exports (because the price of the exports would be more competitive)  without increasing the debt-to-GDP level.  That said, history is rife with examples of devaluations that failed; Argentina in 1955, 1959, 1962 and 1970, Israel in 1971 and Brazil in 1967.  The author suggests that the following devaluations may be required in new currencies:

Greece and Portugal - 40 to 50 percent drop in exchange rate
Italy and Spain - 30 to 40 percent drop in exchange rate
Ireland - 15 to 25 percent drop in exchange rate

The biggest problem with devaluation lies in the fact that because of the current multi-state monetary union, the exiting country's debt is denominated in euros and, if the new currency devalued, the debt problem would worsen, likely resulting in a default.  While this would be quite painful over the short-term, it may, in reality, be no worse than if the debt transgressing nation stayed within the euro.  Over the long haul, the remaining Member States may find that their combined economies are stronger with the departure of their weaker counterparts.

Which European countries would form the core of the "new euro"?  Mr. Bootle suggests that economically, it is important to retain a core of northern European countries including Germany, Austria, the Netherlands, Finland and Belgium and possibly France.  The remaining southern European nations would not form a "southern euro" since they have relatively little trade with each other, rather, they would develop their own independent currencies and economic policies.  Mr. Bootle notes that it is interesting to see that nations like Spain, Portugal and Italy are attempting to make it clear to the world that they are NOT another Greece.  So much for "union"!

The formation of a "new euro" by the stronger northern Member States could result in a flight of capital from the weaker, departing southern Member States.  Departure could also result in a run on banks, plummeting asset values (i.e. real estate), large rises in interest rates on bonds and negative impacts on consumer and business confidence.  These issues would most likely rise if the departure were planned in secret rather than involving the public in a democratic decision-making process, however, even if a departure was well known by the voting public, there is no guarantee that there would not be mass bank withdrawals for example.  Here is a graph showing dropping deposit levels for the PIIGS nations between 2007 and 2012, suggesting that the problem of a run on banks is far from remote, particularly for Greece and Ireland who have already suffered from a major drop in bank deposits:

Mr. Bootle makes the following very interesting suggestion about the departing nation:

"...leave quickly. Once it has become clear that a country needs to leave the euro-zone, it should waste no time doing so. Accepting more and more bail-outs before finally deciding that membership is impossible, then leaving and defaulting, could be far more damaging than simply leaving immediately. So far, best practice has certainly not been followed on this front. There is already clear evidence that the core euro-zone governments are tiring of Greece‘s financial requirements and would perhaps prefer a speedy exit."

He notes that the shock of a sudden euro departure announcement is probably less damaging to a nation's reputation and international standing than the financial cost of bailouts in a long-winded exit.  

With all of that in mind, here are his seven recommendations for exiting nations:

1.) Honour official debts (as far as possible).

2.) Pre-warn other governments.

3.) Co-ordinate planning with other eurozone and EU Member States.

4.) Stay within the European Union, even if it is only for the short-term.

5.) Leave quickly (as noted above).

6.) Stay within existing EU laws and treaties.

7.) Manage the media by stressing that the departure was amicable.  Basically, even though we're now estranged from the EU, we're still best of pals.

One of the issues facing Greece (or whoever) would be printing up a new currency and establishing a value.  Mr. Bootle notes that physical coins and notes are not as essential to an economy as they once were, however, small transactions by private citizens are frequently consummated using physical currency.  If new notes and coins are not immediately available, this could be overcome by using a dual-pricing system where items would be priced in both the new currency and in euros.  The only negative issue with this scheme is that if the new currency is devalued and people are allowed to pay a lower price using euros, the system could be drained of euros very quickly since that would be the preferred means of completing a transaction.

In closing, let's look at one of the big issues that will face the departing country; the collapse of the banking sector.  As I showed in the graph above, both Greece and Ireland saw a collapse in the funds on deposit in their domestic banking system as their debt crises deepened.  Right now, the ECB is providing liquidity to these banks so that they can keep functioning, however, this may not go on forever.  Here's where the author gets into a rather frightening scenario:

"Accordingly, it would be advisable to prevent people from withdrawing more money from the country in the run-up to exit by effectively bottling it up within the domestic economy. In particular, when the redenomination was announced but before notes were available, cash machines, or ̳ATMs‘, would need to be shut down. Otherwise, realising that the euro would become more valuable than the drachma, most Greek residents would attempt to withdraw as many euros as possible from their bank accounts. The maximum daily withdrawal at ATMs in Europe is typically around 300 euros. If every Greek citizen of working age withdrew that amount, this would amount to 2.3bn euros per day, or a reduction in banks‘ assets of 3.5% per week. In practice, banks would soon run out of notes."

Mr. Bootle suggests the imposition of a bank holiday in which all banking transactions were prevented and all ATMs were shut down. I don't know about you, but I can't imagine that this would make any citizen of any country very happy and, once the banks reopen for business, a delayed bank run could still occur.

As you can see, the issue of a European state divorce is extremely complex.  There is really no way of foreseeing the repercussions of an unprecedented departure from what appeared to be such a strong economic union just 10 short years ago.  I can remember much discussion about the euro replacing the United States dollar as the world's reserve currency; no one foresaw the collapse in the value of one of the world's key currencies and certainly no one was discussing the demise of Europe as a union.

As Star Trek's Spock once said "...logic dictates that the needs of the many outweigh the needs of the few".  Apparently, the writers of the Wrath of Khan were way ahead of their time.  Perhaps a European divorce is the answer to one of the 21st century's great dilemmas even though the impact of such an event is far from clear and the issue is extremely complex with many unforeseen consequences.


  1. Europeans might find searching for income protection a wise thing to do in such an unstable economy.

  2. How does sequestering the bank deposits of the many assist in their needs, Mr. Spock? Letting the Greeks return to the "good old days" of the Government dishing out favors without the surly Uncle Euro looking over their shoulders wold not appear to be to anyone's benefit. Decades of mismanagement cannot be overcome by separating from the Euro, especially if the goal is to return to that mismanagement. I envision a time when productive people live in North Europe and retire to the Club Med Countries. Kind of like the US where people retire to Arizona and Florida.