Why the EU won’t break up

Wilders brings the drachma back

The nationalists bring the drachma back. Literally.

If the Eurozone breaks up, so will the European Union. At least in the form we know it. Everybody talks about it and it’s true. The current crisis is however a reason, why the European union will survive and become stronger.

At the end of May, the Greek Commissioner for fisheries Maria Damanaki told the media that the question of Greece leaving the Eurozone is now on the table. Together with an unsourced sentence from der Spiegel it brought a wave of political speculations and increased volatility in bond and foreign exchange markets.

Many economists and politicians keep repeating that highly indebted countries would solve all their problems through devaluation and would export themselves out of their debts. Since there is no possibility of devaluation within the Eurozone, they clearly imply that leaving it is the only and the easiest solution.

I firmly believe that some mean it seriously. I am convinced that many of them wish it. However, for a country to leave the Eurozone or its breakup as a whole would be by far the worst solution of all. It’d be as well the worst solution for everybody, including EU countries outside the Eurozone and the remainder of the world.

More problems instead of solutions

There are many reasons why the Eurozone breakup would not solve any crisis but just become another problem. Not because of dangerous side effects to those affected by europhilia (including the present writer) but because of clearly catastrophic economic outcomes. A highly indebted country leaving the Euro would figuratively cut its hurting leg just before climbing a mountain. It wouldn’t feel the blisters any more but it simply wouldn’t be able to walk.

In the first place, leaving the Eurozone would worsen the debt situation. Let’s take the example of Greece. Greek government bonds are denominated in euros and there is no legal way to change the denomination to any other currency, e.g. to the new drachma. Such legal change in bond denomination would be equal to a declaration of a payment default. Greek creditors would take it as a legally coherent signal to run on issuers of credit default swaps, which would in turn blow a big part of the financial insurance market.

Greek government would have to pay its debts in euros, but Greeks would have to operate their economy and pay taxes in drachmas and then convert them under a different exchange rate. Drachma being devalued by tens of per cent, the Greek debt to GDP ratio would rise by the same part. With or without default, this would not relieve or help anybody in the financial and real markets. The huge losses on both sides would be almost exclusively dead weight.

Following assumptions of labour market effects on currency valuations, the new drachma would be devalued by roughly fifty per cent. This would mean doubling of the Greek debt to GDP; enough to wipe out any positive effects of a partial default. Greece and other threatened countries would have to default on the entirety of their sovereign debts to make the devaluation have a tolerable effect on the new aggregated debt.

Let’s admit the new drachma would not go into hyperinflation and that the exchange rate would stabilise on a slightly higher level than two drachmas to one euro. A higher competitiveness of exports would surely “improve” the Greek trade balance, but due to the ridiculously low Greek exports, it would not wipe out the increase in the sovereign debt caused by devaluation. In addition, Greece would have to pay back the debt for punitive interest rates, not for the current arguably preferential rates from the EU and the IMF.

If Greece then did not write off all of its debts, the radically higher costs on serving the remainder would lead to an uncontrolled and uncontrollable default. And if it did write off all of its debt (I would be curious to see how it would manage to do that), the contagion would spread and many fragile European countries would follow the suit in a similarly messed up way.

Something like that would really be a Lehman-like event. The currently discussed rolling over of Greek debts would be just an unnoticeable detail compared to the panic in bond and all financial markets, which would erupt in the case of Greece leaving the Eurozone.

Stamping Greek euros

The situation with ordinary bank deposits and liquidity would also be very painful. Of course, it is theoretically possible to exchange money in pockets of Greek citizens or, firstly, stamp them as it was the case during the Velvet breakup of Czechoslovakia. But only in case you have something to stamp.

If the Greece announced today that it intends to leave the Eurozone, Greek retail banks would run out of liquidity in terms of hours. And nobody would give to the government the precious content of their wallets, pockets and mattresses, because the latter would be significantly depreciated. Withdraw money and hide it from the government in foreign accounts is much simpler than it was in Slovakia in 1993.

The example of the Czechoslovak monetary breakup is not useful in this case for other reasons too. The difference between the potential of the Slovak and Czech crowns as well as financial interconnection of Czechoslovakia with hard-currency countries were ridiculously small compared to financial mobility and differences in real parities that reign over Europe today. According to some, Czechoslovakia was even an optimum currency area: Despite these facts, queues formed in front of Slovak banks and monetary reserves of the Czech central bank decreased in few weeks to a half; a record that has not been reached ever since in absolute or relative terms.

Shock therapy

Alternative to the above mentioned would be to implement a shock therapy. The announcement would coincide with the legal decision of leaving the Eurozone and an obligation to limit withdrawals.

This is somehow a more likely but at the same time even more unrealistic scenario. In an incredible conspiracy – that almost nobody would be allowed to know about – banks would have to prepare for weeks the implementation of limits on withdrawals and stamp the virtual money following a key, which does not exist and could not be rationally invented unless being arbitrary and impoverishing or prone to cause hyperinflation.

Those who would know what is about to happen might become easily dollar billionaires in terms of hours, while millions of ordinary people short of this very concrete piece of information, would lose tens of thousands. It would be a moment of the biggest one-off redistribution of wealth in the history of Europe and probably of the world. The Argentinian crisis of 2001 or the UK Black Wednesday of 1992 would be ashamed when judged by historians.The only incident that would somehow compare to this event is the Asian monetary crisis of 1997.

The effects on Greek households and banks would be immense. And in these times of crisis, Greece would have to declare bankruptcy or increase radically its debt service, which would paralyse either financing of the whole economy or the government. Very likely, there would not be enough liquidity in Greece for years and government would have no choice but to increase the monetary supply artificially and massively, bringing a realistic risk of credibility loss and hyperinflation. State bankruptcy and contagion to other states would be imminent.

Yet, we have not taken into account legal barriers, which would make from this event the most ugly monetary operation in modern history. Law and justice would have to stand back to feasibility. Unmerited profits of few and huge losses of many would have to be accepted as a price of the final objective.

And what if everybody did it?

This apocalyptic vision concerns only the example of Greece, which is (despite all the contagion it managed to cause) a very small country. Just imagine that everybody left the Eurozone or – if you will – that the Eurozone broke up.

How would it affect financial flows in Europe? What effect would it have on businesses and households? On European real economy and world financial system? What would happen with Euros in non-European central bank reserves?

Panic, massive runs on banks, collapse of financial sector, an end to export superpowers, contagion, abrupt downgrade of countries’ credit ratings, serial government defaults and a global recession… this all might at the end be a very optimistic scenario.

Maybe one day, but certainly not now

The best moment to leave the Eurozone is paradoxically a period of economic growth, settling of trade imbalances and stabilisation of sovereign debts. This moment might never come in our lifetimes. And if it did, in such an ideal atmosphere, everybody would benefit from the existence of a common currency and hardly anybody would think about an exit.

Even on a flat see of European economy the differences of potential currency parities would be high enough and division of currencies so arbitrary that a similar action would simply not be worth it; nobody would risk it just to solve a future crisis, which could come in decades if ever.

Even the worse scenario, which includes several defaults would not be so catastrophic as the ultimate end of the common currency. The Eurozone countries will pay a high price for the inadequacy of its institutions, but the currency will survive. It has no other choice. The way back to national currencies would be much more costly. Current problems will paradoxically strengthen the willingness for more fiscal coordination or even a fiscal union, more political control and ultimately a democratic one. This will strengthen the European Union.

Originally published in Czech on Aktuálně.cz

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About Ales Chmelar

Economist. Researcher at the Centre for European Policy Studies (CEPS).

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