Is There No Escape from the Euro?
As I discussed recently, the costs and risks of maintaining the eurozone system are already immense and rising. So is an exit possible? Intuitively, the exit from the euro should be as easy as the entrance. Joining and leaving the club should be equally simple. Leaving is just undoing what was done before. Indeed, many popular articles discuss the prospects of an exit of countries such as Greece or Germany. However, other voices have rightly argued that there are important exit problems. Some authors even argue that these problems would make an exit from the euro virtually impossible. Thus, Eichengreen (2010) states, “The decision to join the euro area is effectively irreversible.” Similarly, Porter (2010) argues that the large costs of an exit would make it highly unlikely. In the following we address the alleged exit problems.
The Maastricht Treaty does not provide for a mechanism to exit the European Monetary Union (EMU). Thus, several authors maintain that an exit from the euro would constitute a breach of the treaties (Cotterill 2011, Procter and Thieffry 1998, Thieffry 2011, Anthanassiou 2009). In an ECB working paper from 2009 Anthanassiou claims that a country that exits the EMU would have to leave the EU as well. As the Lisbon Treaty allows for secession from the EU, withdrawal from the EU would be the only way to get rid of the euro.
The solution to this legal problem could be an exit from both the EMU and EU with an immediate reentering of the EU. This procedure could be negotiated beforehand. In the case of a net contributor to the EU budget such as Germany, the country would probably not face any problem getting immediately readmitted to the EU.
In any case, the referral to the Maastricht Treaty when discussing the legal possibility of exit is intriguing, because the Maastricht Treaty, especially the “no-bailout clause,” has been violated through the bailouts of Greece, Ireland, and Portugal. The European Financial Stability Facility effectively serves to guarantee debts of other nations, not to mention the plans to introduce eurobonds.
In addition, the European Central Bank has violated the spirit of the Maastricht Treaty by purchasing debt of troubled nations. It seems to be a justification, if not an obligation, to leave the euro after the conditions for its existence have been violated. Indeed, the German Constitutional Court ruled in 1993 that Germany could leave the euro if the goals of monetary stability were not attained (Scott 1998, p. 215). After the last couple of years, it is clear that the eurozone and the euro are far from stable. Apart from these considerations it should be noted that a sovereign state can repudiate the treaty (Deo, Donovan, and Hatheway 2011).
Another legal problem results from the possible redenomination of contracts in the wake of an exit from the euro. A government may redenominate euro contracts into the new currency (applying lex monetae — the state determines its own currency). It may do so without problems if the contracts were contracted in its territory or under its law. But what about private and public bonds issued in foreign countries? How would foreign courts rule (Scott 1998, p. 224)?
Imagine a German company that sold a bond in Paris. Will the bond be paid back in euros or in the new currency if Germany leaves the euro? The French court would probably decide that it can or must be paid back in euros. Possibly also the European Court of Justice would rule on such issues. Thus, in the case of an exit, there would be some uncertainty caused by court settlements. There may be one-time losses or profits for the involved parties. However, it is hard to see why these court rulings would constitute important disturbances or insurmountable obstacles for a euro exit.
An exit from the euro may imply the issuing of a new national currency. This involves the costs of printing new notes, melting new coins, exchanging vendor machines, etc. There are also logistic costs exchanging the new currency against the old one. These costs are not higher than the costs of introducing the euro. The costs for introducing the euro in Austria have been estimated at €1.45 billion euros or around 0.5 percent of GDP.
Wage Inflation and Higher Interest Rates
Sometimes it is argued that peripheral countries with uncompetitive wages could just exit the euro and magically solve all their problems. Greece, for instance, suffers from too-high wages mainly because there is no free labor market. Labor unions have caused wages to be too high. The resulting unemployment had been attenuated by government deficit spending and debt accumulation made possible by the Eurosystem. The Greek government employed people at high wages, paid unemployment benefits and retired people early with high pensions.
As strong labor unions prevent wages from falling to recuperate competitiveness, some people recommend that Greece exit the euro, depreciate the currency, and thereby increase competitiveness. This argument contains a problem. If labor unions remain strong, they may simply demand wage increases to compensate for higher import prices (Eichengreen 2010, p. 8). Such a compensatory increase in wages would eliminate all advantages from depreciation. The exit would have to be accompanied by a reform of the labor market in order to improve competitiveness. In any case, after an exit from the EMU, the Greek government could no longer use EMU monetary redistribution and deficit spending to push up wages artificially.
Similarly, an exit without further reforms could lead to a repudiation of government debt. This would imply higher interest rates for the government in the future (Eichengreen 2008, p. 10). An accompanying reform of fiscal institutions such a constitutional limits for budget deficits could alleviate this problem.
The End of Monetary Redistribution between Countries
Some countries benefit from the monetary setup of the EMU. They pay lower interest rates on their debts than they otherwise would. If a country like Greece exits the euro and repays its debts with a devalued new currency, it will have to pay higher interest rates for its debts.
In addition, countries such as Greece could no longer benefit from the monetary redistribution. The Greek government, and indirectly part of the Greek population, benefits from the high Greek deficits and the flow of new money into the country. This process allowed Greece to finance an import surplus and standard of living it would not have achieved otherwise. At least in the short term, an exit from the euro would, ceteris paribus, mean a deterioration of artificially high living standards. In other words, after an exit from the EMU, the size of its public sector and standard of living would likely fall as the EMU subsidies end. These redistribution costs only apply to countries that have been on the receiving end of the redistribution. For fiscally sounder countries, the opposite reasoning applies.
Some authors argue that European trade would collapse in the wake of a euro exit. Trade barriers would be re-erected. In any case there could be an appreciation of the new currency like a new deutschemark (DM). In a UBS research paper, Flury and Wacker (2010, p. 3) estimate that the new DM would appreciate about 25 percent.
In contrast to another UBS research paper (Deo, Donovan and Hatheway 2011) that comes up with horrific costs of a euro break up, we do not regard such trade barriers as very likely for several reasons. First, such barriers would be an economic disaster for all involved parties and would lead to a severe and long depression and a reduction of living standards. Second, net contributors to the EU, such as Germany, could still use their contributions to the EU budget as a negotiating card to prevent such barriers. Third, trade barriers are a blatant violation of EU treaties. Fourth, tariffs could provoke severe tensions between nations, possibly leading to war.
Sometimes it is maintained that an exit implies high political costs. Most importantly, an exit could trigger the dissolution of the euro. The disintegration of the EMU could endanger the development of a federal European state. At least, it would mean an important blow to the “European project.” It could mean the end of the EU as we know today. The EU could “degenerate” into a free-trade zone.
Politicians of the exiting country would lose influence on the policies of other EMU countries. The politicians of the exiting country would also lose appreciation of other EMU politicians and in the mainstream media that has supported the euro staunchly. However, for supporters of a free-trade zone in Europe, these political costs imply immense benefits. The danger of a federal European state would disappear for now.
Procedural Costs and Capital Flows
An exiting nation has to print new notes, mint new coins, reprogram automatic teller machines, and rewrite computer code (Eichengreen 2008, p. 17). This takes time. The case of machines may not be tragic, because, during the transition period, old machines may be in use without chaos. A public parking place using euro coins will not bring the economy down.
The notes-and-coins problem has a fast solution, because on both the country’s origin is visible. Coins have a country-specific image and notes bear a country-specific letter. In a German exit from the euro, all German coins and notes would be redenominated into the new currency and later gradually exchanged into the new notes and coins. Of course, the transition period would involve some checking costs as people have to look at the symbols when transacting in cash.
The most severe problem of a euro exit — one that according to Eichengreen (2010) would pose “insurmountable” barriers — is capital flows when the option of exiting is discussed. Such a discussion takes time in democracies. During this time there may be important capital inflows and outflows.
Let us first discuss the problem of capital outflow such as in the case of an exit of Greece with no accompanying reforms. If Greek senior politicians seriously discuss an exit from the euro, Greek citizens will expect a depreciation of the new currency, a new drachma. Greek citizens will transfer their euros held at Greek banks to accounts in other EMU countries. They will probably not turn in their euro notes to be exchanged for the new drachmas voluntarily.
Greek citizens may also acquire other currencies such as Swiss francs, US dollars, or gold to protect themselves from depreciation. In this way Greece could practically be immunized against the new drachma even before its introduction. As a consequence, the Greek banking system may get into liquidity and solvency problems. Meanwhile, Greek citizens would continue to transact in euros held outside Greek jurisdiction.
This is the so-called “problem” of capital outflows. Yet these outflows are not a problem for ordinary Greek citizens. For them these outflows are a solution to the problem of an inflationary national currency. Moreover, capital outflows are already occurring. The discussion in parliament of a Greek exit would only speed up what is happening already.
The opposite reasoning applies when a more solvent country like Germany discusses an exit from the eurozone. If people expect an appreciation of a newly introduced currency, there would be capital inflows into Germany. The money supply of euros within Germany, which would later be converted into a new currency, would increase. Prices of German assets (e.g., housing and stocks) would increase in advance of the actual German exit, benefitting the current owners of such assets.
A Systemic Banking Crisis
Finally, there may be negative feedback for the banking system as there will most likely be losses for banks both domestic and foreign., Eichengreen (2010) fears the “mother of all financial crises.” Due to connectivity, it does not matter if Germany or Greece leaves the euro. If Greece leaves the euro and pays back its government bonds in a depreciated new currency or defaults outright, there will be losses for European banks that could get into solvency problems. Similarly, if Germany leaves the euro, the implicit guarantee and support to the Eurosystem will disappear. The result may be a banking crisis in Greece and other countries. The banking crisis might negatively affect German banks. The banking crisis would also negatively affect sovereigns, due to possible bank recapitalizations. Other countries may be regarded as possible defaulters or exit candidates leading to higher interest rates on public debts. A systemic financial crisis infecting weak governments would be likely (Boone and Johnson 2011).
Recently, the IMF suggested that European banks face €300 billion in potential losses and urged the banks to raise capital. We should emphasize that the problem of bank undercapitalization and bad assets (most importantly, peripheral government bonds) does already exist in the EMU and will deteriorate without an exit.
It is almost impossible to leave the euro without already-unstable structures collapsing. Yet this collapse would have the beneficial effect of quickly purging unsustainable structures. Even if there are no exits from the euro, the banking problem exists and will have to be solved sooner or later. Potential bank insolvency should therefore be no argument against an exit. In the EMU taxpayers (mostly German) and inflationary measures by the ECB are momentarily containing the situation. An exit would speed up a restructuring of the European banking system.
- Banks with nonviable business models should be allowed to fail, liberating capital and resources for other business projects.
- A debt-to-equity conversion may put many banks on a healthy basis.
- Banks may collect private capital by issuing equity, as they are already doing.
A free-market reform has important advantages:
- Taxpayers are not hurt.
- Unsustainable banking projects are resolved. As the banking sector is oversized, it would shrink to a more healthy and sustainable level.
- No inflationary policies are used to sustain the banking system.
- Moral hazard is avoided. Banks will not be bailed out.
The Problem of Disentangling the European Central Bank
The Eurosystem consists of the ECB and national central banks. The task of disentangling is facilitated because national central banks still possess their own reserves and have their own balance sheets. Scott (1998) argues that this setup may have been intentional. Countries wanted to retain the possibility of leaving the euro if necessary.
Only part of all EMU reserve assets have been pooled in the ECB, making a disentangling easier. On January 1, 1999, national central banks provided €50 billion in reserve assets pro rata to their capital contribution (Procter and Thieffrey 1998, p. 6). National central banks retained the “ownership” of these foreign reserve assets and transferred the management of the reserves to the ECB. (Scott 1998, p. 217). In the case of an exit, both the return of the contribution to the ECB’s capital and the foreign assets transferred to the Eurosystem had to be negotiated (Anthanassiou 2009).
Similarly, there is the problem of TARGET2 claims and liabilities. If Germany had left the EMU in March 2012, the Bundesbank would have found TARGET2 claims denominated in euros of more than €616 billion on its balance sheet. If the euro depreciated against the new DM, important losses for the Bundesbank would result. As a consequence, the German government may have to recapitalize the Bundesbank. Take into account, however, that these losses would only acknowledge the risk and losses that the Bundesbank and the German treasury are facing within the EMU. This risk is rising every day the Bundesbank stays within the EMU.
If, in contrast, Greece leaves the EMU, it would be less problematic for the departing country. Greece would simply pay its credits to the ECB with the new drachmas, involving losses for the ECB. Depositors would move their accounts from Greek banks to German banks leading to TARGET2 claims for the Bundesbank. As the credit risk of the Bundesbank would keep increasing due to TARGET2 surpluses, the Bundesbank might well want to pull the plug on the euro itself (Brookes 1998).
Intellectual honesty requires us to admit that there are important costs to exiting the euro, such as legal problems or the disentangling of the ECB. However, these costs can be mitigated by reforms or clever handling. Some of the alleged costs are actually benefits from the point of liberty, such as political costs or liberating capital flows. Indeed, other costs may be seen as an opportunity, such as a banking crisis that is used to reform the financial system and finally put it on a sound basis. In any case, these costs have to be compared with the enormous benefits of exiting the system, consisting in the possible implosion of the Eurosystem. Exiting the euro implies ending being part of an inflationary, self-destructing monetary system with growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty.