Sunday, November 13, 2011
Breaking up the eurozone is hard but not impossible
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

The eurozone is like a patient with a long-term illness. It has good and bad days. The last couple of days have been quite good, with a new prime minister in Greece and the end of Silvio Berlusconi in Italy. But the bad days will return.

One of the questions I get asked most often is why, if the eurozone is in such a terrible state, the euro is still so strong, particularly against the pound?

Sterling has perked up to the giddy heights of 1.17 in the light of Italy’s deep woes. But if I tell you it was briefly above 1.70 not long after the single currency’s birth 12 years ago, and just short of 1.50 when the global financial crisis broke in summer 2007, the fall from grace is clear.

Sterling is at least 10% below what any measure of fair value would suggest. The euro is also stronger than it should be against other currencies.

Why is this? When it comes to the pound, there is a good argument that it has been a victim of deliberate neglect. Every time it has threatened to recover to any degree, the Bank of England usually does something dovish to knock it back down.

That cannot, however, explain it all. It seems the currency markets regard the euro as greater Germany, while the bond markets see it as a Greek-Italian venture.

What do the currency markets know? They appear to be assuming, despite the brinkmanship among eurozone leaders over first Greece and then Italy, that an implosion - to the extent we have not already had one - will be avoided.

What that means is providing a eurozone bazooka big enough to persuade the markets they should lay off betting against the government bonds of Greece, Italy, Portugal, Spain and the others.

Since the proposed bazooka, expanding the 440 billion euro European Financial Stability Facility to an effective 1 trillion, is in considerable difficulty, the European Central Bank would seem to hold the solution in its hands. It, like all central banks, has the ability to expand its balance scheet, creating money, buying every troubled-economy bond under the sun, and also to swamp the system with liquidity.

To be able to use it, however, first requires a lot of swallowing of German pride and principles. Germany does not want the ECB to do this and neither do most people at the central bank. The assumption, however, is that if the alternative is armageddon, it will happen.

Such a solution cannot solve the euro’s fundamental problem. Instead of being a finely-honed grouping of similar and converged economies, it is a ragtag collection of dissimilar and divergent countries.

“It is clear that the eurozone will remain an unstable, crisis-prone arrangement unless critical steps are taken to place it on a more sustainable institutional footing,” write Simon Tilford and Philp Whyte in a hard-hitting essay for the pro-EU Centre for European Reform.

They argue the eurozone has to go part of the way towards fiscal union by means of debt mutualisation, or eurobonds, all members issuing bonds jointly guaranteed by the others. They are also sceptical about whether it will ever happen.

Which brings us to break-up. Reports last week that France and Germany have been quietly exploring the possibility of a smaller, “core” eurozone pricked up the ears of currency traders last week. In the short-term they expect muddling through, in the long-term they expect a stronger, narrower euro to emerge, which is why they have not been dumping the currency.

I have a lot of sympathy with this, having long argued that the euro would survive but with fewer members. Those who can live with Germany will do so, while others will be forced to go elsewhere. Before anybody worried about Greece, I had thought Italy was the weakest link.

The question is how you get there, or at least how you get there without huge fiscal and financial consequences.

UBS, in a research note, said a country exiting the euro would face “corporate default, collapse of the banking system and collapse of international trade”, a hit of 40% to 50% of gross domestic product in the first year. Not only that, “almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war”.

HSBC, in other research, warned: “Keeping the eurozone together will involve huge financial resources and considerable ingenuity. The alternative would be worse. A break-up of the euro would be a disaster and in a worst-case scenario could trigger another Great Depression.”

In the Financial Times Robert Jenkins, external member of the Bank of England’s interim financial policy committee, set out in gory detail the consequences of just a Greek exit, one being that “bank lending across the European Union ceases”.

So it seems to be a catch-22. We can’t live with the euro as it is, it seems, but we can’t live without it either. Or at least we can’t easily get to the point where the euro has fewer members and is sustainable.

People are right to be concerned. The eurozone is experiencing an aftershock of the global crisis so powerful it threatens to exceed that of the crisis itself. It comes when structures are already weakened.

There is no doubt that the short-term consequences for countries leaving are serious. Money would flood out of the country, the banks would take a huge hit, the new drachma, or lira, in people’s pockets would not be worth as much as the euro it replaced. For a while, countries that left would become bond market pariahs and need help from the International Monetary Fund, which would need every penny of the additional resources it can get.

I cannot believe it is impossible, however, particularly if the alternative involves struggling along with a flawed system. There is more to leaving the euro than devaluation in a fixed-currency system of the kind Britain undertook in 1949 and 1967. The challenges, though, are of a similar nature.

The parallels are not exact but some have recalled John Major’s words six days before Britain was forced out of the European exchange rate mechanism (ERM) in September 1992. “The devaluer’s option” would not be allowed to happen, he said; it would be “a betrayal of our future”.

It was not. And nor would it be a betrayal of the future of Greece, or for that matter Italy, to decide it was better to have a relationship with the euro - with their own currency - rather than be in it. These things are difficult. They are rarely impossible.