Euro break-up – not so simple
20 January 2012
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Many UK economists are pretty sanguine about euro break-up. Patrick Minford, for example, in the minutes of the Shadow Monetary Policy Committee this month wrote that tales of disaster have little credibility and ignore the effortless way in which the Latin Union broke up in the nineteenth century and how easily Britain came off gold. Geoffrey Wood and Forrest Capie wrote along similar lines for City AM. The break-up of the Soviet Union is also cited as an example of a relatively painless break-up.
However, the euro is different. The euro was deliberately designed so that break-up was next-to-impossible. The politicians wanted this so that the relentless march to ever-closer union would continue at speed. The economists wanted it to maximise credibility and therefore reduce borrowing costs.
To break up the euro requires a change to the treaties. This will require a constitutional process. Even if this is not a long process, it will be sufficiently open to prevent the element of surprise that is necessary when breaking up a monetary union. To by-pass the constitutional process may create huge legal uncertainty.
We cannot under-estimate the importance of this situation which is quite different from that faced by previous monetary unions. We have built a framework designed to enforce the rule of law in the EU in the face of possible predatory activities by member states. We cannot simply say that the Eurozone countries can agree to allow Greece to change all euro claims in Greece into drachma – those who have euro claims in Greece will object and they will have credible legal recourse and the legal disputes could go on for years.
Secondly, the EU has a completely integrated banking system. The Soviet Union had recently been a command economy when its currency collapsed. It is easy enough to ring fence bank deposits and currency in a command economy, but when we have deposits in Greek branches of French subsidiaries of banks with holding companies located in the UK or French branches of Greek banks, this is not so straightforward. Not only that, what happens to derivative contracts that are used to hedge (for example) euro-sterling risk when that risk suddenly turns into euro-drachma risk or sterling-drachma risk? Will the debts of a Greek company be in drachma or euro? How is a Greek company to be defined? And so on…
The parallel with the Latin Union is not completely well-founded either. The Latin Union did not have a single central bank and the different countries had separate currencies, so break up was not a huge problem. Round the time of the First World War, we did not have the same institutional background in order to protect private property that we have today – indeed the development of that background is partly as a result of wartime experiences.
The most likely scenario is that a single country such as Greece is allowed to leave – or is told to leave. It is possible that this could be managed without chaos given the relatively small size of the Greek economy and financial sector. But, this is not the end of the story. If one country manages to leave the euro without creating chaos, then there will be more pressure on bigger countries to leave. The irrevocable union will have been revoked and the pressure on other states will mount. When Italy and Spain leave, the ‘fun’ starts.
There will be an impact on the UK, of course. Banks may lose some of their capital if the value of their euro assets falls and this may reduce bank lending. The British banking system will certainly be affected by the seizing up of the euro-zone banking system. And the euro might plummet against ‘safe-haven’ currencies such as sterling making life very difficult for UK exporters. Of course our supply chains will be affected too.
So, what are the options? I do not think there is any pain-free option. The best option depends on the type of pain you are willing to tolerate. Here are some possibilities.
If Greece is the only country to exit at first, then the following scenarios are possible:
The last is my favoured option. However, the collapse of a currency zone with a single central bank, with integrated banking systems, with free capital flows and with strong protection of property rights is a rare – if not unique – event. Parallels only tell us so much.
However, the euro is different. The euro was deliberately designed so that break-up was next-to-impossible. The politicians wanted this so that the relentless march to ever-closer union would continue at speed. The economists wanted it to maximise credibility and therefore reduce borrowing costs.
To break up the euro requires a change to the treaties. This will require a constitutional process. Even if this is not a long process, it will be sufficiently open to prevent the element of surprise that is necessary when breaking up a monetary union. To by-pass the constitutional process may create huge legal uncertainty.
We cannot under-estimate the importance of this situation which is quite different from that faced by previous monetary unions. We have built a framework designed to enforce the rule of law in the EU in the face of possible predatory activities by member states. We cannot simply say that the Eurozone countries can agree to allow Greece to change all euro claims in Greece into drachma – those who have euro claims in Greece will object and they will have credible legal recourse and the legal disputes could go on for years.
Secondly, the EU has a completely integrated banking system. The Soviet Union had recently been a command economy when its currency collapsed. It is easy enough to ring fence bank deposits and currency in a command economy, but when we have deposits in Greek branches of French subsidiaries of banks with holding companies located in the UK or French branches of Greek banks, this is not so straightforward. Not only that, what happens to derivative contracts that are used to hedge (for example) euro-sterling risk when that risk suddenly turns into euro-drachma risk or sterling-drachma risk? Will the debts of a Greek company be in drachma or euro? How is a Greek company to be defined? And so on…
The parallel with the Latin Union is not completely well-founded either. The Latin Union did not have a single central bank and the different countries had separate currencies, so break up was not a huge problem. Round the time of the First World War, we did not have the same institutional background in order to protect private property that we have today – indeed the development of that background is partly as a result of wartime experiences.
The most likely scenario is that a single country such as Greece is allowed to leave – or is told to leave. It is possible that this could be managed without chaos given the relatively small size of the Greek economy and financial sector. But, this is not the end of the story. If one country manages to leave the euro without creating chaos, then there will be more pressure on bigger countries to leave. The irrevocable union will have been revoked and the pressure on other states will mount. When Italy and Spain leave, the ‘fun’ starts.
There will be an impact on the UK, of course. Banks may lose some of their capital if the value of their euro assets falls and this may reduce bank lending. The British banking system will certainly be affected by the seizing up of the euro-zone banking system. And the euro might plummet against ‘safe-haven’ currencies such as sterling making life very difficult for UK exporters. Of course our supply chains will be affected too.
So, what are the options? I do not think there is any pain-free option. The best option depends on the type of pain you are willing to tolerate. Here are some possibilities.
If Greece is the only country to exit at first, then the following scenarios are possible:
- Greece exits in a constitutional manner. There are years of legal wrangling and uncertainty. The banking systems in other EU countries then empty pending their exit and their exit causes chaos.
- Greece exits in an unconstitutional manner. It is made absolutely clear that euro claims are no longer euro claims and the EU establishment makes clear that it will move heaven and earth to resist any legal claims by those who have their assets turned into drachma. The same happens in other EU countries and the EU is on the road to the third division of economic freedom.
- Greece exits in an unconstitutional manner and leaves the EU at the same time. This might work. Other countries will not want to leave the EU and thus some credibility will remain. Property rights will be protected in the EU even if Greece takes a large step backwards in its economic development.
- The northern countries exit, leaving the markets with the assumption that the euro will become an inflationary currency. This has the advantage that the countries that are likely to have stronger currencies will be exiting.
- The treaties are changed to allow Eurozone countries to produce their own currencies whilst the euro remains a legal tender currency. This does not solve the ‘debt problem’ but will lead to more labour market flexibility going forward. It has the advantage of separating out the ‘debt default’ and ‘non-optimal currency area’ problems and will lead to much greater legal certainty.
The last is my favoured option. However, the collapse of a currency zone with a single central bank, with integrated banking systems, with free capital flows and with strong protection of property rights is a rare – if not unique – event. Parallels only tell us so much.
3 thoughts on “Euro break-up – not so simple”
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These parallels are pretty meaningless – one could on that basis raise the break-up of various Empires (British, Austro-Hungarian) or the attempted secession of the Confederacy from the USA!
However, even the last option will still, as you say, leave the debt problem which is surely the central issue that the EU faces and the issue (if any) that would drive it apart. Exit by one or more countries will ultimately surely happen when the perceived pain of staying in is greater than the perceived pain of leaving (or if the benefits of having that state in the union outweigh the downsides). Legal and practical barriers make the pain higher but not insurmountable – if states retain their sovereign authority they can’t ultimately be prevented. However, as such thresholds can only be estimated this will never be a ‘rational’ choice.
The precedent for possible Scottish exit of the Union might also be interesting…
There seem to be two essential matters for several countries in the eurozone to deal with:
First, to default on part of their government debts. Second, to restore competitiveness with other eurozone countries.
We can already see that recognising the need to default is not easy, even for an obvious basket case like Greece. It may be just as big a pill to swallow for Portugal, Ireland, Cyprus, Spain, Italy and so on. The ECB is desperate not to have to accept losses on its holding of eurozone member-states’ government bonds, but I believe this is unavoidable.
As for restoring competitiveness, I believe the only practical way to do this is to devalue (as a part of the process of introducing supply-side reforms, especially in labour markets). Although in theory, one could envisage a number of Club Med countries staying together in some sort of currency union, and devaluing collectively, it is hard to think this could happen in reality. So restoring national currencies, which might not be too unpopular with voters, seems much the most likely way to achieve necessary devaluations.
As Philip says, there don’t seem to be any painless alternatives. And while sanguine observers might hope for an organised departure from the euro, the level of incompetence that has so far been evident in the euro’s short life leads me to expect a disorderly disintegration of the single currency experiment, with several countries leaving the euro (if not the EU).
The financial chaos that will ensue will badly affect the UK too.
I agree with many of the sentiments expressed here; however, even one country leaving [and in my view it is now a virtual certainty that Greece must leave] will immediately plunge the entire Euro-zone into chaos. All holdings which are now denominated in Euros, across more than one country will need to be re-assessed; along with the relative split of assets and liabilites and their location. I would not want to be left with liabilities in Germany and assets in, say, Greece and Portugal as the Euro falls apart: the currency exhcange gap between them would widen rapidly and to obiviate any losses all assets will be moved into safe’ havens. I regard the break-up as the inevitable consequence of politics pushing economics, ignoring uncomfortable realities such as the need for complete fiscal unity to make currency unions a success. In addition the incompetence shown by European leaders so far t certain that it will be very messy. The only thing to do is to plan for the worst – eg euro-gotterdammerung – and make sure you are as well protected as possible.