Thursday, June 10, 2010

Apocalypse No: Euro Exit Without Tears

The main medium term problems with the euro have been, first, its overvaluation against the dollar and other currencies linked to the dollar such as the renminbi, reaching a maximum of 1.60 dollars for a euro in 2008. And second, the twin disequilibrium of “intra zone real exchange rates” overvaluation of some member countries (the “Club Med” ones) relative to Germany, due to diverging wage costs between them.

These growing handicaps have penalized exports from Italy or Spain and encouraged their imports from Germany and from out of the zone economies. With exports and imports representing a third or more of their GDP, these exchange rate trends have constituted a significant brake on growth.

On this background, the 2007-2009 recession has led these relatively more inflationary countries to borrow heavily on the cheap (because their higher inflation rate and low nominal and uniform ECB borrowing rate resulted in minimal real interest rates) in order to dampen the recessionary shock, since monetary and exchange rate policies were not available at the national level anymore. Hence the large budget deficits, even in countries such as Spain that had previously adhered to quite conservative fiscal policies.

Today, since deflationary policies and massive budget cuts further depress activity and will possibly deteriorate the budget balance even more, these southern countries are caught in a macroeconomic trap.

It is only logical that they contemplate leaving the eurozone to regain some degrees of freedom by a return to national currencies and flexible exchanges rates. Major devaluations against the dollar and against either a “new Mark” or a smaller eurozone currency would help restore these countries’ competitive advantage.

A lot of objections have been raised against such a breakup of the euro, but according to a frequently quoted paper by Barry Eichengreen, while these arguments do not hold water, it is simply impossible to leave the eurozone without plunging the outgoing economy in an awesome crisis. Indeed, entering the euro would be an “irreversible” move because the procedural delays necessary for exiting would unleash speculation that would bankrupt banks and governments.

Here is the “impossibility” scenario:

« The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.

Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises. »

The perspective is scary all right, but wrong. There is a better way out and European countries are already following that trail.

What is the recipe for exiting without tears? Well, just devalue the euro prior to leaving it.

Let’s take the example of the Lira. There exists an exchange rate between the euro and the dollar at which the Italian economy is competitive with the US (and other dollar related countries) or with Germany, despite the faster growing Italian wages. Let’s assume that Italian wage growth has exceeded that of US wages by 25 % during the last ten years and that of German wages by 35 %. Then a fall of the euro relative to the dollar from its recent value of 1.45 dollars down to 0.85 dollars (its 2000 level) would constitute a (1.45 – 0.85)/1.45 = 42 % devaluation.

At that price of the euro a newly created Lira would make the Italian economy super competitive relative to both economies and no further devaluation necessary. We should even expect the new Lira to be revalued in order to return to a PPP equilibrium.

Accordingly, no anticipation of further devaluation in the medium term would form, and thus there would be no reason for a capital flight from the new currency, and no bank run either. At that price the “mother of all crisis” is just a myth.

Eichengreen concludes in his paper that:

« The implication is that as soon as discussions of leaving the euro area become serious, it is those discussions, and not the area itself, that will end. »

On the contrary I claim that when discussions of leaving the euro area become serious, the value of the euro plunges on foreign exchange markets, and thus makes way for a parity at which euro exit for the Lira is possible without any further devaluation, making it both easy and efficient.

Sorry, no apocalypse is in view.

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