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The Euro’s Future - Breaking Up is Hard to Do

December 15, 2010
Kip Beckman
Principal Research Associate,
Economic Services

How will the ongoing debt crisis in Europe play itself out over the next few months? Could the euro zone actually collapse as countries flee to the safety of their former currencies like the mark and lira? Nobody knows the answers to these questions but according to economist Simon Johnson there are a number of possible scenarios that are likely to unfold ranging from a relatively optimistic outcome to more dire developments. And breaking up is hard to do – but not impossible.

The most benign scenario assumes that the IMF bailouts for Greece and Ireland are effective in calming down financial markets. Investors are reassured that economic growth over the near term is sufficient enough to enable these countries to manage their existing debt burdens. While the debt levels in Greece and Ireland as well as other vulnerable countries like Portugal and Spain are a huge issue for investors, this scenario assumes that Germany agrees to fund its weak sisters. The anger on the part of German people for having their tax dollars diverted to help weak euro zone members continues, but the German government decides that it must support wayward members because the consequences of a collapsing currency are too unpredictable. Under this scenario, all current euro members remain on board.

The second scenario reflects the current market consensus and assumes that an additional package of support from the IMF and the EU for Portugal and Spain helps these countries weather the ongoing financial storm that eventually spreads to their shores from frantic bond holders. The belief that the crisis can be stopped and not spread beyond the borders of Spain and Portugal may be wishful thinking at best, since it ignores the potential trouble in relatively weak countries like France and Belgium, where debt levels are precariously high. In this scenario, Greece may decide to leave the euro and re-introduce the drachma although the government must carefully weigh the benefits to its exports from a weaker currency against the costs of having to pay off more expensive debt. Many Europeans, who claimed that Greece should have never been allowed to join the euro in the first place, feel vindicated. Ireland remains in the euro but the severe fiscal restraint required to lower high debt levels forces many Irish citizens to emigrate to other countries.

Two other scenarios are more pessimistic and may have been unthinkable only a few months ago but are gaining traction as the financial crisis intensifies. In one scenario, only the members that run responsible and sound fiscal policies continue in the euro. These include Germany, the Netherlands, Austria, Finland and possibly some smaller countries. Italy and France leave the euro. The economies of the countries that give up the euro will be in trouble for a number of years but eventually the positive effects resulting from depreciating exchange rates will stabilize the situation as export demand boosts overall economic growth.

Alternatively, in a complete reversal, the countries with strong economies like Germany become fed up with having to bailout weaker members and decide to leave the euro and return to their own currencies. The German economy would have to deal with a rapidly appreciating mark but its citizens are happy that their tax dollars no longer have to help the Greeks. The weaker countries like Portugal, Greece and Ireland retain the euro, which, under this scenario, would be end up being much weaker than it is today.

The more pessimistic scenarios reflect economic theory regarding the formation of a common currency zone. With exchange rates fixed and monetary policy out of the hands of individual countries, member countries must all be on the same page concerning fiscal policy. This has not happened in the euro zone and the current financial crisis reflects the lack of consensus regarding fiscal policy. The most likely outcome is the second scenario as the EU and the IMF react to the spreading crisis by boosting financing in an attempt to reassure worried bond holders. The euro survives but the exit of Greece, its most troubled member, remains a distinct possibility. However, the more dire scenarios cannot be ruled out, given the sheer magnitude of debt levels in many euro zone countries and the difficulties involved with bringing debt under control when economic growth remain sluggish at best. Breaking up may be hard to do but sometimes it is better than the alternative!

 

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