Thursday, April 29, 2010

How Reversible is Krugman on the Euro?

The Euro crisis is currently deepening, with concern about Spain seriously mounting, as we forecast (with my co-author Philippe Villin) would be the case, in a paper published in the French daily Le Figaro in February (downloadable on my homepage here).

Analysts are now busy constructing exit scenarios as does for instance the staunch pro-euro Wolfgang Munchau, in a briefing note Eurozone meltdown on his website, Eurointelligence. Even Paul Krugman, who, from the start, was quite critical of the euro but lately deemed exit impossible, following Barry Eichengreen , is now reconsidering his position.


“… as Eichengreen argued, any move to leave the euro would require time and preparation, and during the transition period there would be devastating bank runs. So the idea of a euro breakup was a non-starter.

But now I’m reconsidering, for a simple reason: the Eichengreen argument is a reason not to plan on leaving the euro — but what if the bank runs and financial crisis happen anyway? In that case the marginal cost of leaving falls dramatically, and in fact the decision may effectively be taken out of policymakers’ hands.

Actually, Argentina’s departure from the convertibility law had some of that aspect. A deliberate decision to change the law would have triggered a banking crisis; but by 2001 a banking crisis was already in full swing, as were emergency restrictions on bank withdrawals. So the infeasible became feasible.

My comment: I never believed that exit was impossible. First because many countries did exit from monetary unions over the years (see the paper by Andrew Rose who counted that in the postwar period seventy countries exited from currency areas while only sixty remained continuously within unions), and second because, following Herbert Stein’s Law “when something can’t continue indefinitely, it will stop”. As the saying goes, nothing human is irreversible, except death and taxes.

More seriously, as Krugman argues, there is a point where the economic damage from maintaining a far from equilibrium exchange rate exceeds the possible damage incurred by exiting from a non-optimal currency area. And the damage to European economies could grow considerably in the near future if vulnerable European banks are hit by government defaults.

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