The IMF, in its latest updated “World Economic Outlook,” recently said that eurozone policies to rebuild confidence and stability were central to a recovery, while a stalling eurozone could hit Asia and the rest of the world through a combination of trade and financial channels.
The IMF’s latest “Global Financial Stability Report” noted that crossborder bank exposures provided a channel for the spillover of sovereign risks to banks, which in turn could lead to problems for banking systems in Europe and beyond.
Meanwhile, recent comments in the U.K. press (the Sunday Times, the Sunday Telegraph and the Observer) about Christopher Smallwood’s report for Capital Economics entitled “Why the Eurozone Needs to Break Up” really captured my attention.
Smallwood is an economist who has been economic adviser to HM Treasury, the Bank of England and a member of the U.K .Monopolies and Mergers Commission.
In his report, he said “the eurozone with Germany at its core operates as a system with a strong deflationary bias – one in which the whole burden of adjustment falls on deficit countries obliged to take strong deflationary action. As long as the eurozone continues to play by these rules, there is no alternative to many years of economic pain.”
The solution, as he sees it, is remarkably straightforward.
“For the sake of the future economic health and success of the European Union, the eurozone needs to break up.”
This, he concluded, would allow the weakest members (which are by now very well known) of the current system to “grow more vigorously again as exchange-rate movements restored their competitive edge.”
Smallwood’s opinion is a view that, at least in my opinion, can be called logical. However, I do have serious difficulties seeing, technically speaking of course, how the euro could be broken up. We also must admit this is no longer a complete impossibility.
In this context, it might be good to remember the “Legal Working Paper” the European Central Bank published in December under the title “Withdrawal and Expulsion from the EU and EMU: Some Reflections.”
Click Here to Read the Full ECB Report
So, if this is true, allow me to play devil’s advocate and ask which eurozone nation would likely leave first. Sorry, but I’m obliged to consider that the most logical solution would be a German exit.
It seems clear that if it were possible to reintroduce the German mark (DEM), then the German currency would trade with a substantial premium to the euro, which would continue to include all the other existing actual eurozone member states.
No doubt, this would bring with it massive headwinds for Germany’s export-oriented industries as their economy would be forced to rebalance, while the German banks holding euro-denominated debt would also find themselves under major pressure because the German mark would rise substantially against the euro.
Yet it is also arguable that neither of these problems is not an insurmountable task for Germany as it has accomplished far heavier tasks before.
We should not forget that Germany has rarely been worried about the impact of its strong currency on its major exporters “prior” to the introduction of the euro. Their strong German mark still allowed them to prosper. Moreover, it is worth highlighting that EUR/USD currently sits a good 22 percent below its 2008 peak.
Finally, with regard to the uncomfortable position the German banks might find themselves in, it could be that the government of German Chancellor Angela Merkel might find it more cost-effective to support its own banking industry than to be on the hook for bailouts in the rest of Europe.
Such a move could also prove politically popular with the German electorate. Most importantly, it would give Germany unambiguous control of its own fiscal and monetary policy.
It also can’t be excluded that other eurozone members might find Germany’s exit quite a rather attractive proposition.
It is arguable that prior to the introduction of the euro, almost every European currency crisis in the 1980s and 1990s did come down, at least in part, to German “intransigence.”
Besides, it now seems clear that Germany has won few friends within Europe during the past few months.
Hence, many might be starting to think that a eurozone without Germany could not only allow them to regain much of the competitiveness they have lost during the past decade (remember that some peripheral European nations have seen a 30 percent competitiveness loss against Germany while even France has suffered a 15 percent deterioration) but also make a meaningful push toward a “real” fiscal union.
A eurozone without Germany could also finally have an ECB policy that would be more aligned toward the needs of its eurozone member states in the south and west.
But please don’t misunderstand me. No, I don’t think this is the most likely outcome from the current crisis.
However, the very fact that discussion of this issue is now really becoming commonplace, which is something that wasn’t true even a couple of moths months ago, shows clearly how the perceptions about what is or isn’t possible in the eurozone are changing rapidly.
Yes, I maintain my view that I expect the euro to move down again.
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