Will the Euro Survive the Debt Crisis?
Restoring confidence in the eurozone (EZ) rests on its ability to generate growth and reduce the competitiveness gap in the periphery. As fiscal austerity is bound to deepen the recession, the possibility of debt restructurings, exits and the eventual breakup of the EZ must be taken into account.
The financial crisis has exposed the institutional inconsistencies underpinning the large intra-EMU macroeconomic imbalances that have built up since the inception of the EMU. In our view, nothing short of a sovereign lender of last resort (LOLR) and a countercyclical fiscal shock-absorbing or risk-pooling mechanism, such as eurobonds, are required for a stable institutional framework.
Policymakers’ focus on stricter fiscal safeguards is too restrictive without counterbalancing macro policies in surplus countries. At the same time, the treaty’s constraints prevent the ECB from assuming the LOLR role in an unlimited fashion. Meanwhile, eurobonds are only conceivable at the end of a political integration process that is still a few years down the line — too late for some of the weakest member countries to avoid a sovereign debt restructuring and an exit from the EMU, starting with Greece as early as this year. German parliamentarians’ open speculation about a Greek exit underlines the shifting attitude in policy circles.
The main policy options include a sharp fall in the common currency, aggressive implementation of structural, supply-side reforms or internal devaluation. The ECB’s hawkish policy stance compared to other central banks constrains the devaluation option in an environment of competitive devaluations at the global level. Structural reform would take a decade to show results, whereas the deflationary route is potentially self-defeating for the periphery as surplus countries are unlikely to tolerate higher inflation to accommodate the periphery’s competitiveness adjustment. The insufficient financial backstop capacity for large member countries like Italy and Spain further undermines confidence in the entire EZ project.
In order to make an eventual exit an orderly one, the priority must be taming contagion to other weak links, especially Spain and Italy, by augmenting the EZ’s financial backstop capacity and ring-fencing the EZ banking system. For the exiting country, an orderly process must include a negotiated sovereign debt restructuring and a managed exchange rate regime in order to limit disruptive exchange rate movements. Even so, the economic costs of a unilateral exit include potentially massive capital losses incurred by creditor countries, in addition to trade losses imposed by the new competitor on the rest of the EZ.
For the exiting country, coercive asset and savings redenomination, potential bank runs, deposit freezes, capital controls and inflationary bouts of currency devaluations, which in turn fuel export and growth spurts, need to be weighed against the long-term stagnation and decline in living standards that would result from staying inside the EMU.
Market participants have already started considering the redenomination risk by shifting deposits into core EZ safe havens or abroad. Similarly, companies in peripheral countries are reportedly moving their headquarters into core EZ countries, while high-net-worth individuals are buying property outside the EZ. And in the Greek private-sector involvement deal that still needs to be finalised, the new bonds will be issued under British law in order to incentivise participation by reducing Greece’s ability to change the terms or the currency of payments if a further restructuring is needed.
As the recession in 2012 is bound to deepen, we expect such “flight to safety” dynamics to intensify.
This article appeared in the FT’s Professional Wealth Management “Great Debate” section on January 30, 2012
3 Responses to “Will the Euro Survive the Debt Crisis?”
What conclusion to draw? Exit of Greec today?
I think the Euro's hype is almost gone, way over valued IMO
If Europe doesnt do something very fast to save Greece, i think the situation will be irreversable for the whole periphery. Greece will exit the euro and more will follow. The situation will get out of hand. With the unemployment figures that europe has, the contagious social uprising will be severe and southern-europe will want to go back to their own currencies.
Two years ago we mentioned many times that what was happening (debt-crisis) wasnt a "Greek problem" but a European. They didnt pay attention then and they arent paying attention now.
Europe is heading for a trainwreck. Greece is so unstable at this point that it takes a wind-blow to throw them off the cliff. And that will be the beginning.
When market-sharks smell the first CDS blood, more will gather cause Italy has alot of meat..