If the Euro Crashes, so will the European Union!

Eurozone map in 2009 Category:Maps of the EurozoneImage via Wikipedia
The British and other European Union members who don't belong to the Euro-zone are gloating these days: they've escaped the fate of the silly Euro! Little do they realize that if the Euro crashes, so will the European Union, including Britain and all the other gloaters...

The Euro is the end product of the European Union dream: if it goes down, so will the rest. And Britain will find itself belonging to a Europe that is likely to be run-down and depressed for a very long time: hardly a good platform to work from on the international scene!

If you don't believe me, read Krugman's major magazine article in the New York Times on the subject: he's just come out with an extraordinarily clear and pointed analysis of the Euro - a must read! Here's the link:
Krugman: CAN EUROPE BE SAVED?

He makes several major points (many of which for those of us who live in Europe are quite familiar):

- the Eurozone is an INCOMPLETE monetary union (read: no fiscal integration, no over-riding Federal structures like those that govern the dollar zone: the Federal Reserve system and the US Treasury); as a consequence, there is NO TRANSFER of shock waves across the union. To put it more clearly as Krugman did in his example comparing Nevada and Ireland (two states with similar problems): Nevada will recover sooner and with less trauma than Ireland precisely because it doesn't have to save its banking system like the Irish do, or cut back on its pensions. Washington will see to that. As to labour moving out in search of jobs elsewhere in the union, that is the one thing the two states have in common. And a lot of Irish are emigrating while many of those who had come to Ireland during the good times have already left.

- internal deflation is the only way Euro zone members can tackle their deficit: that is the policy currently pursued in Greece, Ireland, Portugal and Spain. And it is something that entails tremendous sacrifices and costs to the citizens.

- currency devaluation is not an option for Euro-zone members; but as the amount of the public debt cannot be devalued/deflated, it means that the deficit problem remains whole, no matter how much you tighten your belt.

Krugman offers four possible scenarios for the future: toughing it out; debt restructuring; full Argentina; and revived Europeanism.  Here they are in his own words (in italics):

(1) Toughing it out: Troubled European economies could, conceivably, reassure creditors by showing sufficient willingness to endure pain and thereby avoid either default or devaluation. The role models here are the Baltic nations: Estonia, Lithuania and Latvia. These countries are small and poor by European standards; they want very badly to gain the long-term advantages they believe will accrue from joining the euro and becoming part of a greater Europe. And so they have been willing to endure very harsh fiscal austerity while wages gradually come down in the hope of restoring competitiveness — a process known in Eurospeak as “internal devaluation.” 

Does it work? Yes, but at a very high cost, both economic and political. I don't think other European countries, such as Greece, will endure it.

(2) Debt restructuring: At the time of writing, Irish 10-year bonds were yielding about 9 percent, while Greek 10-years were yielding 12½ percent. At the same time, German 10-years — which, like Irish and Greek bonds, are denominated in euros — were yielding less than 3 percent. The message from the markets was clear: investors don’t expect Greece and Ireland to pay their debts in full. They are, in other words, expecting some kind of debt restructuring, like the restructuring that reduced Argentina’s debt by two-thirds.
   
In Krugman's view, this would work - and is probably inevitable in the case of Greece and Ireland - but it wouldn't avoid the pains of deflation but, as he put it:  debt restructuring could bring the vicious circle of falling confidence and rising interest costs to an end, potentially making internal devaluation a workable if brutal strategy. 

(3) Full Argentina: Argentina didn’t simply default on its foreign debt; it also abandoned its link to the dollar, allowing the peso’s value to fall by more than two-thirds. And this devaluation worked: from 2003 onward, Argentina experienced a rapid export-led economic rebound. 

As Krugman points out, the one European country that was able to pull it off successfully was Iceland - but then, it could devalue since it isn't part of the Euro-zone. Can a Euro-zone member do it? No. As Krugman put it: any euro-zone country that even hinted at leaving the currency would trigger a devastating run on its banks, as depositors rushed to move their funds to safer locales. In short, in the words of Professor Eichengreen,  this “procedural” obstacle to exit made the euro irreversible. But, argues Krugman, Argentina's link to the dollar was also supposed to be irreversible, yet it did it.

Frankly, I think that is Krugman's weakest argument. The fact that it is theoretically possible - anything is - doesn't mean it will happen. There is simpy NO WAY Euro-zone members can pull out and return to their national currencies: the disruption to the national banking and commercial system would be so catastrophic that it is unthinkable. And this is an important point: Germany, Europe's locomotive, the one that has seen its GDP grow last year and a recovery in employment thanks to stellar exports, would be the nation that would suffer the most: after all, the Euro was modelled after the Deutsche Mark and Germany gained from the Euro more than anyone else. It also stands to lose more than anyone else.

(4) Revived Europeanism: The preceding three scenarios were grim. Is there any hope of an outcome less grim? To the extent that there is, it would have to involve taking further major steps toward that “European federation” Robert Schuman wanted 60 years ago.

And Krugman recalls here the suggestion made last month by Juncker and Tremonti to float Euro-bonds. It would indeed be a "step in the right direction" but Germany is having none of it. As Krugman put it: the Germans are adamant that Europe must not become a “transfer union,” in which stronger governments and nations routinely provide aid to weaker. Indeed, Germany, of late, has gone into a Deutschland Uber Alles mode and they don't want to give up any bit of their fiscal and other sovereignty in the name of Europe. Of course, joint European bonds would require a management structure and that would mean coming too close for comfort to the concept of a federal treasury.

The way out? None for the moment. Scenario n. 1 is the on-going one, and moving to scenario n.4 seems, for the time being, highly unlikely.

But let's try to gaze into the future using Krugman's plotlines. Scenario n. 2 - debt restructuring - is in the cards: it is the natural outcome of scenatio n. 1 - toughing it out -. Sooner or later, countries living through bouts of high social tension as disgruntled citizens take to the streets, will have to bend back and restructure their debt.

Once that happens, will anybody move out of the Euro? No, too disruptive.

So what will happen? I would bet on devaluation. There is no escaping it: if the sovereign debt of several Euro-zone members is restructured, then the Euro will necessarily lose value. Not perhaps a lot, particularly if the stronger Euro-zone members pull their act together (read: France and Germany) and realize that it is in their interest to guide the Euro towards a soft landing.

But a devalued Euro it will be. In spite of what anyone says about the joys of having a strong currency, in this case it would be a manna: it would help exports and revive employment. Germany would of course stand to gain most since it is the biggest exporter (50 percent of its exports go outside the Euro-zone). And surely it could afford the "transfer" aspects of a full monetary union.

But when will the Germans ever understand that it is in their interest? Soon, I hope... 


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