Monday, November 29, 2010

Break up of the Euro

Joining the Euro was supposed to be irreversible, but, in practise, there could come a time when countries may feel leaving the Euro is the least worst option. However, for this to occur, the economic situation would have to deteriorate even more.

There are many good reasons to not join the Euro, but once in, it is not so easy to leave. There are certainly many countries who would wish they had never joined the Euro. But, is it possible the Euro will break up?

Countries are certainly struggling with the common monetary policy. Countries facing massive debt, deflation and stagnating economy have very little options to boost growth. They are having to reduce their budget deficits, but, they can't devalue currency or pursue quantitative easing to ease the pain.

Markets are worried about size of government borrowing because they face the twin problem of high debt with low growth prospects. There are now fears that the EU and IMF may be unable to bailout economies the size of Spain. Thus markets are demanding high risk premiums to compensate for increased risk of holding Euro debt.

Yet, though countries like Greece, Spain and Ireland would benefit from being outside the Euro, in practise it is not so easy. Firstly, plans to leave the Euro would lead to significant problems.

For example, if Ireland planned to leave the Euro, people would expect a devaluation of Irish assets (like Irish bonds) therefore there would be a rush to sell, and the country would experience a flight of capital causing problems for Irish / Spanish banks. (see: problems with leaving Euro)

Also debts nominated in Euros, would increase in value making it even more difficult for people to pay back.

This is the main difficulty of leaving the Euro, when markets know there is going to be an exit and capital flight, it becomes self-fulfilling.

However, if there was a capital flight even when a country was in Euro, then it might not make much difference. For example, if investors felt Spain was going to default on its government debt and the EU couldn't / wouldn't bail out Spain, then there would be a mass sale of Spanish bonds and flight from Spanish banks, in this case it may be better if Spain took the chance to regain its own currency and monetary policy.

Is the Euro Doomed?

Not necessarily, EU member countries will try to make it work as they have much invested in the Euro project. If budget deficits can be managed through a combination of austerity and loans from EU and IMF then countries may be able to stagger on. They will face a great difficult in that they are likely to face several years of stagnant growth, and debt deflation. But, to many this may seem like their only alternative.

Two Speed Euro

Another alternative is for strong countries i.e. Germany and other countries who can keep pace with Germany like perhaps Netherlands, France to break away and form a Euro2. This will enable a two speed EURO and two independent monetary authorities. One for the economies with manageable debt, reasonable growth and more concerned about inflation and no longer willing to bail out their profligate neighbours. (see: Why Germany should leave Euro)

The peripheral members would see a floating of the Euro and could pursue a more expansionary monetary policy. But, again this would lead to danger of capital flight from the Euro periphery. It would also not solve the bank defaults that are causing problems in Ireland, though it may give the economy more leeway.

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1 comment:

Vladimir said...

My question is: was somebody thinking about the potential causes of euro-zone crash or voluntary leaving of euro-zone, prior joining the euro-zone?

where there some sophisticated and discussed bestcase/worstcase scenarios, what-if analysis, etc?