Is the Euro Still Irreversible?

Nearly a decade ago Barry Eichengreen argued (“The euro: Love it or leave it?”, VoxEU, originally posted 17 November 2007) that he had found the definitive reason why the euro was irreversible: a country having entered the eurozone could never leave it afterwards because, an exit would require lengthy preparations, which, given the anticipated devaluation, would trigger the “mother of all financial crises” (whatever that could mean!). National households and firms would shift deposits to other Eurozone banks producing a system-wide bank run. Investors, trying to escape, would create a bond-market crisis. A train wreck would follow.

I thought at the time the argument preposterous and named it “the Eichengreen fallacy” in this blog, because nothing in the realm of institutions is really irreversible, and especially not a treaty fixing exchange rates, even if intended “forever”, between sovereign nations as the long list of currency boards and fixed exchange rate regimes breakdowns testifies.

Paul Krugman, who initially adopted the Eichengreen fallacy, later recognized his mistake (“How Reversible Is The Euro?” New York Times, April 28, 2010).

“For a long time my view on the euro has been that it may well have been a mistake, but that bygones were bygones — it could not be undone. I was strongly influenced by the view expressed by Barry Eichengreen in a classic 2007 article (although I had heard that argument — maybe from Barry? — long before that piece was published): 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.”

What now?

The current development in the Greek crisis makes it interesting and timely to raise the question again since there actually is a bank run under way in Greece, and since many politicians now seriously consider Greece opting out of the euro, or being forced out.

So what went wrong in reality? Does Eichengreen acknowledge his mistaken analysis? Not at all! As explained by the editor of VoxEU in the short summary before his post (“Path to Grexit tragedy paved by political incompetence”, July 1, 2015):

“Barry Eichengreen’s VoxEU column arguing that the euro was irreversible has been viewed over 230,000 times. Now it appears to be wrong. In this column, originally posted on the website ‘The Conversation’, he looks to see where his predictions went wrong. Basically the economic analysis – which focused on bank runs – was right. He went wrong in overestimating the political competence of Greece and its creditors.”

In other terms it was all the fault of Tsipras and Varoufakis. They refused the deal generously offered by the Eurogroup :

“Only when Greece stopped negotiating did the Central Bank stop increasing ELA. And only then did a full-fledged bank run break out.

The decision to call a referendum in midstream only heightened uncertainty. It was a transparent effort to evade responsibility. It was the action of leaders more interested in retaining office than in minimizing the cost to the country of the crisis.”

But other European politicians and technocrats shared in the responsibility:

“Still, this incompetence pales in comparison with that of the European Commission, the ECB and the IMF.

The three institutions opposed debt restructuring in 2010 when the crisis still could have been resolved at low cost. They continued to resist it in 2015, when a debt write-down was the obvious concession to Mr Tsipras & Company. The cost would have been small. Pretending instead that Greece’s debts could be repaid hardly enhanced their credibility.

Instead, the creditors first calculated the size of the primary budget surpluses that Greece would have to run in order to hypothetically repay its debt. They then required the government to raise taxes and cut spending sufficiently to produce those surpluses.

They ignored the fact that, in so doing, they consigned the country to an even deeper depression. By privileging their own balance sheets, they got the Greek government and the outcome they deserved.

The implication is clear. Never underestimate the ability of politicians to do the wrong thing. I will try to remember next time.”

The conclusion for this reader is also clear: Eichengreen was right, but politicians botched their jobs. Somehow more surprisingly coming from an economist with such an air of superiority due to his mastery of economic analysis, standard conclusions of textbook international economics has been wrong all the time: devaluations never work and prices don’t matter, at least in the case of Greece:

“Not only would any subsequent benefits (of devaluation, JJR), by comparison, be delayed, but they would be disappointingly small.

With the government printing money to finance its spending, inflation would accelerate, and any improvement in export competitiveness due to depreciation of the newly reintroduced national currency would prove ephemeral.

In Greece’s case, moreover, there is the problem that the country’s leading export, refined petroleum, is priced in dollars and relies on imported oil, which is also priced in dollars. So much for the advantages of a depreciated currency.

Agricultural exports for their part will take several harvests to ramp up. And attracting more tourists won’t be easy against a drumbeat of political unrest.”

Amazing! So let’s return to a sounder judgment from another fellow economist, Paul

Krugman ( “Ending Greece’s Bleeding”, New York Times, July 5) :

“Imagine, for a moment, that Greece had never adopted the euro, that it had merely fixed the value of the drachma in terms of euros. What would basic economic analysis say it should do now? The answer, overwhelmingly, would be that it should devalue — let the drachma’s value drop, both to encourage exports and to break out of the cycle of deflation.

Would Greek exit from the euro work as well as Iceland’s highly successful devaluation in 2008-09, or Argentina’s abandonment of its one-peso-one-dollar policy in 2001-02? Maybe not — but consider the alternatives. Unless Greece receives really major debt relief, and possibly even then, leaving the euro offers the only plausible escape route from its endless economic nightmare.

And let’s be clear: if Greece ends up leaving the euro, it won’t mean that the Greeks are bad Europeans. Greece’s debt problem reflected irresponsible lending as well as irresponsible borrowing, and in any case the Greeks have paid for their government’s sins many times over. If they can’t make a go of Europe’s common currency, it’s because that common currency offers no respite for countries in trouble. The important thing now is to do whatever it takes to end the bleeding.”

Mistakes made by politicians have been to create the euro in the first place, not to try to get out of the system now. And economists who denied that the system was destructive and could not be sustainable, and who actively extolled its supposed virtues along all those years have committed as big a professional mistake as the politicians that they now, belatedly, criticize in a last minute attempt at shunning their responsibilities.

This sad waste of time and resources was avoidable since it was predictable and predicted, even before the start, not by Stiglitz but by Feldstein who correctly anticipated in the 1990s that the euro would become a serious bone of contention between European nations.