The euro area may need to shrink to survive.
As its sovereign-debt crisis nears a third year and rescue efforts fail to stop the rot in financial markets, economists from Pacific Investment Management Co.’s Mohamed El-Erian to Harvard’s Martin Feldstein say ensuring the euro’s existence may require members to leave the 17-nation currency region.
The result would be what El-Erian, Pimco’s Newport Beach, California-based chief executive officer, calls a “smaller, much better integrated, fiscally strong euro zone.” While leaders such as German Chancellor Angela Merkel consistently rule out that option, El-Erian told “Bloomberg Surveillance” with Tom Keene on Aug. 17 that they eventually may embrace it over the fiscal union required to maintain the status quo.
“We’ve been warned by European policy makers never to underestimate their commitment to economic and monetary union, but that can also be interpreted as perhaps them, in the end, choosing quality over quantity,” said Stephen Jen, managing partner at SLJ Macro Partners LLP, an investment and advisory firm in London. “Political commitments to resolving the crisis cannot be infinite. We can’t have all the chips on the table.”
That the euro’s membership is even in debate is testament to the failure of its leaders to snuff out a debt turmoil that began in Greece in late 2009 before spreading to Portugal and Ireland. It now threatens Italy and Spain and this month has jolted France.
So far the rescue bill includes 365 billion euros ($524 billion) in official loans to Greece, Portugal and Ireland, the creation of a 440 billion euro rescue fund and 96 billion euros in bond buying by the European Central Bank.
Investor concern that the turmoil will drag on was evident last week amid fear the global economic expansion is running out of energy, in part because of Europe’s woes. The Euro Stoxx 50 sank for a fourth week, falling 6 percent, and the cost of insuring against default on European sovereign and corporate debt rose. Questions about the ability of European banks to fund themselves pushed the price of insuring their senior bonds against default above the level when Lehman Brothers Holdings Inc. collapsed in 2008.
“Politicians have to have a game plan and get in front of the market, but unfortunately I don’t see any readiness to do so as they are frightened of thinking the unthinkable,” said David Marsh, co-chairman of the Official Monetary and Financial Institutions Forum, a London-based research group, and author of “The Euro: The Battle for the New Global Currency.”
El-Erian isn’t alone in questioning the number of nations using the euro, which grew from 11 in 1999. Feldstein, a professor at Harvard University in Cambridge, Massachusetts, warned in a 1998 paper that monetary union would prove an “economic liability.” He has long said the single currency could falter because divergent economies couldn’t fit under one monetary roof and nations such as Greece could take a “holiday” from it.
Any exit would occur “by mutual consent,” Feldstein said by e-mail today.
“Even if Germany and the others are willing to pay the cost of avoiding a default, they would not solve the longer-term problem of Greece and Portugal trade deficits and their inability to be competitive without a gradual adjustment of their currency,” he said. “So they would have to keep borrowing to finance their trade deficits and there would be perpetual debt problems.”
Joachim Fels, Morgan Stanley’s London-based chief economist, wrote at the outbreak of the crisis in April 2010 that Germany “might conclude” it would be “better off with a harder but smaller currency union” comprising only countries that share its support for price stability. Nobel laureate Paul Krugman said in an Aug. 18 interview in Stockholm that there is more than a 50 percent chance Greece will leave and 10 percent odds of Italy following.
“It’s a scary story,” said Krugman, who three months ago put the risk of Italy and Spain being forced to leave the common currency at 1 percent.
The euro initially was envisaged as the currency for a band of northern European economies led by France and Germany. The project swelled when then-German Chancellor Helmut Kohl and French President Francois Mitterrand decided in the early 1990s that broader membership would deliver deeper economic integration.
Even as the inflation-sensitive Bundesbank shuddered at opening the door to the deficit-prone southern European nations, Kohl turned the group into a political tool by declaring he wanted “the greatest possible number of countries” in the bloc. That was a rallying call for Italy, Spain and Portugal to meet the economic targets required for membership in 1999 and Greece two years later.
Once in -- and perhaps even before, given that Greece later admitted it had fudged its budget math to win entry -- countries started to break the fiscal curbs. Every year since Greece began using the euro, it has failed to keep its budget deficit below the required 3 percent of gross domestic product. Germany and France weakened the rulebook when they, too, failed to meet the standards.
The euro area is far from the optimum currency zone outlined by Nobel laureate Robert Mundell, proving instead to be a collection of disparate economies amassed under the same currency and interest rate.
Societe Generale SA economist Klaus Baader says growth rates in the region have never been so divergent under the euro as they are now, with a standard deviation of more than 3 percent. Debt varied from 143 percent of GDP in Greece to Estonia’s 7 percent last year, while unemployment is 21 percent in Spain and 4 percent in Austria.
And while ECB President Jean-Claude Trichet once cheered the convergence in bond yields toward Germany’s, Greece now pays 14 percentage points more than Germany to borrow for 10 years and Portugal pays 8 percentage points more.
Growth differentials and the likelihood that countries will prove unwilling to continue bailouts will mean a break-up of the euro by 2013, the London-based Centre for Economics and Business Research said in a June report. It predicted average growth from 2011 to 2015 of 1.2 percent for Italy, 1 percent for Spain and 0.6 percent for Portugal, while Greece contracts 0.5 percent.
Europe’s leaders are refusing so far to countenance the idea of slimming down. Defending the single currency means taking ‘the necessary steps to do so,” Merkel said last week at a summit with French President Nicolas Sarkozy, who expressed “absolute determination.” Trichet said June 13 that leaving the euro is “not a working assumption” for any government. Greek Prime Minister George Papandreou said in a July 19 interview that Greece assumes the crisis is “something that we are going to get through.”
The meeting between Sarkozy and Merkel shows that the major euro nations “want to do everything” to keep Greece in the currency area, “so I am seeing a bigger chance of that,” billionaire investor George Soros told Hungarian news portal hvg.hu last week.
That’s because the advantages of being bound together, such as easier trade and a deeper single market, still outweigh the disadvantages, said Julian Callow, chief European economist at Barclays Capital in London. The Maastricht Treaty that created the euro also lacks an escape hatch through which a country can abandon or be forced out of the euro region.
For now, the likely fallout on economies and bank balance sheets from an exit is enough for officials to keep pumping money into the so-called periphery, said Joerg Kraemer, Commerzbank AG chief economist in Frankfurt. Among the risks: Banks could be pounded by speculative attacks and suffer losses, financial markets could be roiled by investor uncertainty, the core countries that remain might lose trade as the new euro surges, weaker members could face pressure to quit, too, and the departed could be locked out of markets and suffer insolvencies as their new currency slides.
“Excluding a country would be chaotic, so to avoid difficulties, politicians are likely to stick with the bailouts,” Kraemer said.
That will require even more money and unity than they’ve provided so far, says Marchel Alexandrovich, an economist in London at Jefferies International Ltd. Governments need to at least triple the size of their euro-area-wide rescue facility and consider issuing joint debt, he said. Merkel and Sarkozy rejected these initiatives last week, choosing instead to promote ideas already in the works, such as national balanced- budget amendments and a financial-transactions levy.
Economists also disagree on which countries would leave. Greece and perhaps Portugal may decide financial stability and the bailouts aren’t enough to compensate for the continued austerity and bet it would be easier to write down debt, spur exports and improve competitiveness with a cheaper currency.
AAA-rated members such as Finland also may come under domestic pressure for a rethink of their own if they find themselves dispatching continued dollops of cash to the debt- stricken nations such as Greece, Callow said.
The euro-skeptic True Finns won record backing in April elections, making them Finland’s third biggest party. Creating a U.S. level of integration would force Germany to transfer 3.5 percent of GDP compared with the 0.7 percent it contributes to the current EU budget, economists at Nomura International Plc in London estimate.
“Sometime in the next two years, we probably will see an exit as it becomes increasingly impossible for the euro to overcome its internal contradictions,” Marsh said. “It’s like cutting off a gangrenous leg to preserve the body.”
© Copyright 2017 Bloomberg News. All rights reserved.