When even the strongly europhile Economist (August 11-17, pp 19-22) publishes a lengthy piece on how the euro might break up, the question must be worth addressing again. For one thing, we should think about how many pieces the euro Humpty Dumpty egg might form when it hits the ground, and what future currency unions might emerge from the wreckage.
The question of costs and benefits in a break-up, which The Economist addressed in detail but not necessarily accurately, is another that's well worth consideration.
The Economist begins by asserting that a Greek exit from the euro is more or less inevitable, absent gigantic subsidies. Here I Agree; it is not just inevitable, but two years overdue. Had Greece been shoved out of the euro in March 2010, when it first came begging for handouts, announcing that its national accounts had been fraudulent for a decade, the effect on other misbehaving Mediterraneans would have been highly salutary.
The Economist also overstates the bill for Greece's exit, putting it at 320 billion euros, about US$380 billion. First it assumes the European Union would need to give Greece yet another 50 billion euros to tide it over on its exit - an absurd assumption, throwing good money after bad (though as Greece would remain a member of the EU and its gross domestic product per capita would be sharply reduced, no doubt it would gain some of the slush-funds for poorer members that prop up the likes of Bulgaria and Romania).
Second, the EU assumes that another 170 million
euros of Greek government debt would have to be written off. Again, that is
absurdly generous - since Greece would have a GDP of 100-120 billion euros,
compared to its current 215 billion, and, after a short interval, a balance of
payments surplus, it should easily be able to support debt of 100 billion euros
(plus any short-term funding for the transition) making the necessary write-off
only 70 billion or so.
However, the most serious overstatement of the cost of a Grexit - and the other potential exits - is the likely Greek default on 100 billion euros of Target 2 payment system obligations to the Deutsche Bundesbank and other "surplus" central banks.
As discussed in an earlier column, these obligations should have never been allowed to arise. They came about because the eurozone payments system routed euro payments between Greece and Germany through their respective central banks. That's not entirely unprecedented; payments from Alabama to New York go through the respective Federal Reserve Banks when the two banks concerned don't have a correspondent relationship.
However, in the US system and when payments are being made between individual banks, the imbalances are not allowed to build up, but are settled on a periodic basis. The Bank of Greece should have been forced to settle accounts quarterly with the Bundesbank - which would have drained the Greek economy of funds years ago, raised Greek interest rates and prevented the country's debts spiraling to the extent they did.
The reality now is that the Target 2 balances are worthless, whether or not Greece remains a member of the eurozone. Given Greece's indebtedness, and the deflation necessary in the Greek economy, it is unimaginable that a Greece that remained a member of the eurozone could find an additional 100 billion euros, over and above its existing debt, in any finite timeframe. That 100 billion euros is thus not a cost of Grexit, it is a cost that the Bundesbank and the other surplus countries must bear whatever the fate of the euro.
The same applies to the gigantic "Target 2" balances between Germany and Italy, Spain and probably France; they are all illusory. Probably two thirds of Germany's 727 billion euros (US$850 billion) of Target 2 claims at July 31, 2012, will never be seen again, and will have to be borne by German taxpayers, euro or no euro.
For German taxpayers, the single most important reform to pursue is the immediate closure of the Target 2 payments system, and its replacement with a system that includes automatic monthly clearing payments between the central banks concerned. (Even the replacement system should be temporary; once equilibrium has been regained; international payments between two countries using the same currency should be left to private-sector correspondent banking).
As for the cost of a "Grexit" over and above costs that must be borne anyway, it is limited to the partial write-off of Greek debt, or about 70 billion euros. That is entirely bearable, and far preferable to the huge economic damage done by leaving Greece as an over-subsidized member of the euro. A similar argument limits the cost of other members leaving the euro, although whether or not they leave, their "Target 2" balances are probably unrecoverable.
If Greece had been thrown out of the euro two years ago, the crisis could probably have been stopped there. Portugal and Ireland would have needed bailouts, but the prospect of life with a currency sharply devalued against its neighbors' would have put the fear of God into PIGGY governments in Spain, Italy and France and made them undertake austerity programs that actually bit. However, we are not in that position, and it thus seems highly unlikely that even a Greece-less euro can remain intact.
Of the countries that received rescues last year, Ireland appears to be on the road to recovery; its problem was primarily one of a banking crisis rather than anything structural in the economy itself. Portugal is more doubtful; the latest figures show second quarter GDP declining by 1.2%, rather more than had been expected.
On its own, Portugal could probably be bailed out, but if other countries (beyond Greece) leave the euro Portugal will do so also. Spain's GDP also fell in the second quarter, but only by 0.4%. Like Portugal, Spain could probably survive with at most a modest further bailout, but if the egg breaks, Spain will be one of the shards.
The two largest problems by far are Italy and France. Italy has failed to address its structural problems, which are primarily those of over-powerful public sector unions. While the replacement last autumn of Silvio Berlusconi by Mario Monti may have pleased The Economist (which sees Italy as remaining in a smaller euro while Spain departs), it has in reality made matters worse because no significant reforms have been carried out and the Monti government has no legitimacy and must be replaced in new elections next March.
Since Italy has the highest government debt in the eurozone (now that part of Greece's has been written off), it is far more likely than Spain to be the trigger for a eurozone breakup. Even though Italian GDP declined in the second quarter by 0.7%, more than Spain's, the markets do not realize this; they currently trade Italy's 10-year government debt on a 5.68% yield compared with Spain's 6.64%. The markets are wrong.
The markets are even more wrong about France, whose 10-year bonds trade at only a 2.16% yield. While France's GDP was flat in the second quarter, that does not reflect the damage being done by the new Francois Hollande government. This has reversed the modest reforms in pension age carried out by Nicolas Sarkozy, has increased the already onerous wealth tax and plans to introduce a 75% top rate of income tax on the rich.
Given that most wealthy Frenchmen speak English and often German, this will cause not only capital flight but emigration over the next year, reducing France's tax base and its GDP, and causing a massive government funding crisis. Even if France survives Greece's exit from the euro, and the inevitable Italian crisis, it will itself need to leave the common currency within the next year, since there are no funds large enough to bail it out.
The obvious euro split would form a "Mediterranean euro" of France, Italy, Spain, Portugal and probably Malta and Cyprus (but not the hopeless Greece.) This would allow the Mediterranean countries to retain much of the efficiency benefits of a multilateral common currency, while gaining trading advantages of a weakening of perhaps 10-15% against the northern euro economies.
However, the eurozone's unhappy history over the last few years has demonstrated that if you don't trust the governments of your neighbors, you don't want to be in a common currency with them.
At the current time, it would be madness for the relatively well run Spain and Portugal to enter into a currency union with Italy and France, without the counterbalance of Germany. Both Italy and France as currently run would see departure from the euro as providing them room for profligacy, the last thing Spain and Portugal should want to tie themselves to. Equally, if France and Italy left the euro, the Spanish and Portuguese economies are probably not strong enough to remain with the northern euro and suffer a further 10-15% uplift in their exchange rates against Italy, France and the world.
Hence a euro split would probably leave Greece in solitary sub-Balkan disgrace (possibly accompanied by Cyprus), while France and Italy each went their own way, their profligacy weakening their currencies but with nobody else tied to their failure. Spain and Portugal could form an "Iberian euro" and might very well be joined by other small economies who, while reasonably disciplined, find the current euro too strong, perhaps Slovenia, Slovakia, Malta and Ireland.
Belgium is a special case; it has very little fiscal discipline but benefits enormously from being at the center of the expanding EU empire - on balance it would probably find its imperial revenues enhanced by remaining a member of the stronger euro.
The remaining euro members - Austria, Finland, Germany, Luxembourg, the Netherlands, and Estonia - would form a relatively compact, well-managed core of members for a strong euro, probably appreciating by 10-15% initially against the Iberian euro and remaining strong against it thereafter. Other strong East European economies with good fiscal discipline, like Latvia and Poland, would eventually join this core, as might Sweden and Denmark, but weaker economies like Bulgaria and Romania would probably never do so.
So that's the probable final score - two separate euros, one stronger one weaker, both fairly well managed, with France and Italy remaining independent as befits their large size and poor fiscal management. Greece, Cyprus, Britain and a few East European countries would remain part of the EU but no longer aspire to membership of a common currency.
However, the most serious overstatement of the cost of a Grexit - and the other potential exits - is the likely Greek default on 100 billion euros of Target 2 payment system obligations to the Deutsche Bundesbank and other "surplus" central banks.
As discussed in an earlier column, these obligations should have never been allowed to arise. They came about because the eurozone payments system routed euro payments between Greece and Germany through their respective central banks. That's not entirely unprecedented; payments from Alabama to New York go through the respective Federal Reserve Banks when the two banks concerned don't have a correspondent relationship.
However, in the US system and when payments are being made between individual banks, the imbalances are not allowed to build up, but are settled on a periodic basis. The Bank of Greece should have been forced to settle accounts quarterly with the Bundesbank - which would have drained the Greek economy of funds years ago, raised Greek interest rates and prevented the country's debts spiraling to the extent they did.
The reality now is that the Target 2 balances are worthless, whether or not Greece remains a member of the eurozone. Given Greece's indebtedness, and the deflation necessary in the Greek economy, it is unimaginable that a Greece that remained a member of the eurozone could find an additional 100 billion euros, over and above its existing debt, in any finite timeframe. That 100 billion euros is thus not a cost of Grexit, it is a cost that the Bundesbank and the other surplus countries must bear whatever the fate of the euro.
The same applies to the gigantic "Target 2" balances between Germany and Italy, Spain and probably France; they are all illusory. Probably two thirds of Germany's 727 billion euros (US$850 billion) of Target 2 claims at July 31, 2012, will never be seen again, and will have to be borne by German taxpayers, euro or no euro.
For German taxpayers, the single most important reform to pursue is the immediate closure of the Target 2 payments system, and its replacement with a system that includes automatic monthly clearing payments between the central banks concerned. (Even the replacement system should be temporary; once equilibrium has been regained; international payments between two countries using the same currency should be left to private-sector correspondent banking).
As for the cost of a "Grexit" over and above costs that must be borne anyway, it is limited to the partial write-off of Greek debt, or about 70 billion euros. That is entirely bearable, and far preferable to the huge economic damage done by leaving Greece as an over-subsidized member of the euro. A similar argument limits the cost of other members leaving the euro, although whether or not they leave, their "Target 2" balances are probably unrecoverable.
If Greece had been thrown out of the euro two years ago, the crisis could probably have been stopped there. Portugal and Ireland would have needed bailouts, but the prospect of life with a currency sharply devalued against its neighbors' would have put the fear of God into PIGGY governments in Spain, Italy and France and made them undertake austerity programs that actually bit. However, we are not in that position, and it thus seems highly unlikely that even a Greece-less euro can remain intact.
Of the countries that received rescues last year, Ireland appears to be on the road to recovery; its problem was primarily one of a banking crisis rather than anything structural in the economy itself. Portugal is more doubtful; the latest figures show second quarter GDP declining by 1.2%, rather more than had been expected.
On its own, Portugal could probably be bailed out, but if other countries (beyond Greece) leave the euro Portugal will do so also. Spain's GDP also fell in the second quarter, but only by 0.4%. Like Portugal, Spain could probably survive with at most a modest further bailout, but if the egg breaks, Spain will be one of the shards.
The two largest problems by far are Italy and France. Italy has failed to address its structural problems, which are primarily those of over-powerful public sector unions. While the replacement last autumn of Silvio Berlusconi by Mario Monti may have pleased The Economist (which sees Italy as remaining in a smaller euro while Spain departs), it has in reality made matters worse because no significant reforms have been carried out and the Monti government has no legitimacy and must be replaced in new elections next March.
Since Italy has the highest government debt in the eurozone (now that part of Greece's has been written off), it is far more likely than Spain to be the trigger for a eurozone breakup. Even though Italian GDP declined in the second quarter by 0.7%, more than Spain's, the markets do not realize this; they currently trade Italy's 10-year government debt on a 5.68% yield compared with Spain's 6.64%. The markets are wrong.
The markets are even more wrong about France, whose 10-year bonds trade at only a 2.16% yield. While France's GDP was flat in the second quarter, that does not reflect the damage being done by the new Francois Hollande government. This has reversed the modest reforms in pension age carried out by Nicolas Sarkozy, has increased the already onerous wealth tax and plans to introduce a 75% top rate of income tax on the rich.
Given that most wealthy Frenchmen speak English and often German, this will cause not only capital flight but emigration over the next year, reducing France's tax base and its GDP, and causing a massive government funding crisis. Even if France survives Greece's exit from the euro, and the inevitable Italian crisis, it will itself need to leave the common currency within the next year, since there are no funds large enough to bail it out.
The obvious euro split would form a "Mediterranean euro" of France, Italy, Spain, Portugal and probably Malta and Cyprus (but not the hopeless Greece.) This would allow the Mediterranean countries to retain much of the efficiency benefits of a multilateral common currency, while gaining trading advantages of a weakening of perhaps 10-15% against the northern euro economies.
However, the eurozone's unhappy history over the last few years has demonstrated that if you don't trust the governments of your neighbors, you don't want to be in a common currency with them.
At the current time, it would be madness for the relatively well run Spain and Portugal to enter into a currency union with Italy and France, without the counterbalance of Germany. Both Italy and France as currently run would see departure from the euro as providing them room for profligacy, the last thing Spain and Portugal should want to tie themselves to. Equally, if France and Italy left the euro, the Spanish and Portuguese economies are probably not strong enough to remain with the northern euro and suffer a further 10-15% uplift in their exchange rates against Italy, France and the world.
Hence a euro split would probably leave Greece in solitary sub-Balkan disgrace (possibly accompanied by Cyprus), while France and Italy each went their own way, their profligacy weakening their currencies but with nobody else tied to their failure. Spain and Portugal could form an "Iberian euro" and might very well be joined by other small economies who, while reasonably disciplined, find the current euro too strong, perhaps Slovenia, Slovakia, Malta and Ireland.
Belgium is a special case; it has very little fiscal discipline but benefits enormously from being at the center of the expanding EU empire - on balance it would probably find its imperial revenues enhanced by remaining a member of the stronger euro.
The remaining euro members - Austria, Finland, Germany, Luxembourg, the Netherlands, and Estonia - would form a relatively compact, well-managed core of members for a strong euro, probably appreciating by 10-15% initially against the Iberian euro and remaining strong against it thereafter. Other strong East European economies with good fiscal discipline, like Latvia and Poland, would eventually join this core, as might Sweden and Denmark, but weaker economies like Bulgaria and Romania would probably never do so.
So that's the probable final score - two separate euros, one stronger one weaker, both fairly well managed, with France and Italy remaining independent as befits their large size and poor fiscal management. Greece, Cyprus, Britain and a few East European countries would remain part of the EU but no longer aspire to membership of a common currency.
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