Thursday, February 2, 2012

Should we Try and Save the Euro?

How much should we try to save the Euro?

Reasons to Save The Euro

1. Capital flows on Break up. The short term costs of a Euro break up, are potentially very high. The main problem would be massive capital flows from exiting countries (e.g. Greece, Italy)

If Italy left the Euro, Italian bond and Italian savings could see a 20-30% devaluation.
Therefore, investors with Italian bonds and savings will try to sell them and move their savings from Italy to other countries (e.g. Germany, UK, Switzerland and Japan)

This run on Italian banks could be devastating for Italy, but also have knock on effects on other European banks who would lose money through their exposure.

This European credit crunch would precipitate a fall in investment and economic output. To some extent the full scale of the financial fall out is difficult to predict because there are few if any precedents.

2. Other Benefits of the Euro. In comparison to what is happening in Europe now, these benefits seem rather insignificant. See benefits of Euro - but they are the reason for the Euro in the first place.

3. Intervention by ECB. Arguably if the ECB changed its policy stance and agreed to create money and buy bonds, it would be possible to save the Euro at much lower cost than the route of prolonged austerity.

Reasons Not To Save The Euro

The Euro is fundamentally flawed. Countries in Euro have become uncompetitive leading to lower growth and higher unemployment

Different Trends in Competitiveness

Harmonised competitive indicators in the EU (2011 Q1), source: ECB Stats based on unit labour costs indices for the total economy:

This shows how since 1998, Germany (DE) reduced costs by 18.5%. Greece by comparison saw a 9.7% increase in costs. (see more: Competitiveness in Europe) Yet they have the same currency! Therefore, there is inevitably an imbalance. Greek exports have become uncompetitive, but they can't devalue.

The result of competitiveness can be seen in statistics such as the current account.

Current Account deficits in the Euro

2. The Proposed Solution is not a solution

The only real solution offered by the EU, to the EUrozone crisis is to impose budget controls. Whether the Greek budget is managed by Germany directly or not. The message is clear - what we need is repeated spending cuts to meet budget targets. But, this is just a recipe for lower growth and rising GDP to debt ratios. The crisis is not just excessive government borrowing. If it was due to high budget deficits, why is the UK not seeing bond yields rise like Portugal?

It is the lack of competitiveness that the Euro can't deal with. The Euro is creating a climate of economic austerity, which inevitably leads to higher unemployment. Why seek to save a currency which isn't working.

3. The Euro has fundamental problems:

  • Lack of independent monetary policy
  • lack of exchange rate flexibility
  • No lender of last resort causing greater turbulence in bond markets.
  • The ECB is geared towards low inflation in Germany and has little interest in promoting growth in Southern Europe

See: Problems of Euro


It is a really difficult choice. Leaving the Euro could potentially be very damaging. It could lead to a very severe credit crunch and recession. But, patching up the Euro in its present form could lead to persistent high unemployment and low growth - especially in those countries with uncompetitive exchange rates.

Could the Euro work? Well it could in theory, but it's hard to see how the 16 countries can quickly come to economic harmonisation.


richard said...

What happens to those people in the PIGS that have mortgages and loans in Euros if they decide to leave the Euro? How do they pay back?

Anonymous said...

Sorry try again. What happens to the general public who have taken loans and mortgages out in Euros if their country decides to leave the Euro?