THE BEAR'S
LAIR The
euro break up By Martin
Hutchinson
When even the strongly
europhile Economist (August 11-17, pp 19-22)
publishes a lengthy piece on how the euro might
break up, the question must be worth addressing
again. For one thing, we should think about how
many pieces the euro Humpty Dumpty egg might form
when it hits the ground, and what future currency
unions might emerge from the wreckage.
The
question of costs and benefits in a break-up,
which The Economist addressed in detail but not
necessarily accurately, is another that's well
worth consideration.
The Economist begins
by asserting that a Greek exit from the euro is
more or less inevitable, absent gigantic
subsidies. Here I
agree; it is not just
inevitable, but two years overdue. Had Greece been
shoved out of the euro in March 2010, when it
first came begging for handouts, announcing that
its national accounts had been fraudulent for a
decade, the effect on other misbehaving
Mediterraneans would have been highly salutary.
The Economist, incidentally, indulges in
the Winston Churchill "I read Ancient Greek at
school so they must be OK" fallacy, when lamenting
that Greece might "sink into the criminal swamp of
the Balkans."
That, gentlemen, is a gross
insult to the Balkans, in particular to Macedonia,
a much poorer country neighboring Greece that has
received little or no help from the world, largely
because of disgraceful Greek opposition. Currently
Macedonia, admirably run since 2006 under Prime
Minister Nikola Gruevski, ranks 69th on
Transparency International's Corruption
Perceptions Index, 43rd on the Heritage
Foundation's Index of Economic Freedom and 22nd on
the World Bank's Ease of Doing Business Index,
compared with Greece's 80th, 119th and 100th
respectively.
The reality is that whatever
the (overrated) glories of Periclean Athens in the
fifth century BC, they have nothing whatever to do
with the modern Greeks, alien 6th century invaders
who, since their independence from the Ottoman
Empire, have failed to live up to even the modest
Balkan standards of competence and integrity.
The Economist also overstates the bill for
Greece's exit, putting it at 320 billion euros,
about US$380 billion. First it assumes the
European Union would need to give Greece yet
another 50 billion euros to tide it over on its
exit - an absurd assumption, throwing good money
after bad (though as Greece would remain a member
of the EU and its gross domestic product per
capita would be sharply reduced, no doubt it would
gain some of the slush-funds for poorer members
that prop up the likes of Bulgaria and Romania).
Second, the EU assumes that another 170
million euros of Greek government debt would have
to be written off. Again, that is absurdly
generous - since Greece would have a GDP of
100-120 billion euros, compared to its current 215
billion, and, after a short interval, a balance of
payments surplus, it should easily be able to
support debt of 100 billion euros (plus any
short-term funding for the transition) making the
necessary write-off only 70 billion or so.
However, the most serious overstatement of the
cost of a Grexit - and the other potential exits -
is the likely Greek default on 100 billion euros
of Target 2 payment system obligations to the
Deutsche Bundesbank and other "surplus" central
banks.
As discussed in an earlier column,
these obligations should have never been allowed
to arise. They came about because the eurozone
payments system routed euro payments between
Greece and Germany through their respective
central banks. That's not entirely unprecedented;
payments from Alabama to New York go through the
respective Federal Reserve Banks when the two
banks concerned don't have a correspondent
relationship.
However, in the US system
and when payments are being made between
individual banks, the imbalances are not allowed
to build up, but are settled on a periodic basis.
The Bank of Greece should have been forced to
settle accounts quarterly with the Bundesbank -
which would have drained the Greek economy of
funds years ago, raised Greek interest rates and
prevented the country's debts spiraling to the
extent they did.
The reality now is that
the Target 2 balances are worthless, whether or
not Greece remains a member of the eurozone. Given
Greece's indebtedness, and the deflation necessary
in the Greek economy, it is unimaginable that a
Greece that remained a member of the eurozone
could find an additional 100 billion euros, over
and above its existing debt, in any finite
timeframe. That 100 billion euros is thus not a
cost of Grexit, it is a cost that the Bundesbank
and the other surplus countries must bear whatever
the fate of the euro.
The same applies to
the gigantic "Target 2" balances between Germany
and Italy, Spain and probably France; they are all
illusory. Probably two thirds of Germany's 727
billion euros (US$850 billion) of Target 2 claims
at July 31, 2012, will never be seen again, and
will have to be borne by German taxpayers, euro or
no euro.
For German taxpayers, the single
most important reform to pursue is the immediate
closure of the Target 2 payments system, and its
replacement with a system that includes automatic
monthly clearing payments between the central
banks concerned. (Even the replacement system
should be temporary; once equilibrium has been
regained; international payments between two
countries using the same currency should be left
to private-sector correspondent banking).
As for the cost of a "Grexit" over and
above costs that must be borne anyway, it is
limited to the partial write-off of Greek debt, or
about 70 billion euros. That is entirely bearable,
and far preferable to the huge economic damage
done by leaving Greece as an over-subsidized
member of the euro. A similar argument limits the
cost of other members leaving the euro, although
whether or not they leave, their "Target 2"
balances are probably unrecoverable.
If
Greece had been thrown out of the euro two years
ago, the crisis could probably have been stopped
there. Portugal and Ireland would have needed
bailouts, but the prospect of life with a currency
sharply devalued against its neighbors' would have
put the fear of God into PIGGY governments in
Spain, Italy and France and made them undertake
austerity programs that actually bit. However, we
are not in that position, and it thus seems highly
unlikely that even a Greece-less euro can remain
intact.
Of the countries that received
rescues last year, Ireland appears to be on the
road to recovery; its problem was primarily one of
a banking crisis rather than anything structural
in the economy itself. Portugal is more doubtful;
the latest figures show second quarter GDP
declining by 1.2%, rather more than had been
expected.
On its own, Portugal could
probably be bailed out, but if other countries
(beyond Greece) leave the euro Portugal will do so
also. Spain's GDP also fell in the second quarter,
but only by 0.4%. Like Portugal, Spain could
probably survive with at most a modest further
bailout, but if the egg breaks, Spain will be one
of the shards.
The two largest problems by
far are Italy and France. Italy has failed to
address its structural problems, which are
primarily those of over-powerful public sector
unions. While the replacement last autumn of
Silvio Berlusconi by Mario Monti may have pleased
The Economist (which sees Italy as remaining in a
smaller euro while Spain departs), it has in
reality made matters worse because no significant
reforms have been carried out and the Monti
government has no legitimacy and must be replaced
in new elections next March.
Since Italy
has the highest government debt in the eurozone
(now that part of Greece's has been written off),
it is far more likely than Spain to be the trigger
for a eurozone breakup. Even though Italian GDP
declined in the second quarter by 0.7%, more than
Spain's, the markets do not realize this; they
currently trade Italy's 10-year government debt on
a 5.68% yield compared with Spain's 6.64%. The
markets are wrong.
The markets are even
more wrong about France, whose 10-year bonds trade
at only a 2.16% yield. While France's GDP was flat
in the second quarter, that does not reflect the
damage being done by the new Francois Hollande
government. This has reversed the modest reforms
in pension age carried out by Nicolas Sarkozy, has
increased the already onerous wealth tax and plans
to introduce a 75% top rate of income tax on the
rich.
Given that most wealthy Frenchmen
speak English and often German, this will cause
not only capital flight but emigration over the
next year, reducing France's tax base and its GDP,
and causing a massive government funding crisis.
Even if France survives Greece's exit from the
euro, and the inevitable Italian crisis, it will
itself need to leave the common currency within
the next year, since there are no funds large
enough to bail it out.
The obvious euro
split would form a "Mediterranean euro" of France,
Italy, Spain, Portugal and probably Malta and
Cyprus (but not the hopeless Greece.) This would
allow the Mediterranean countries to retain much
of the efficiency benefits of a multilateral
common currency, while gaining trading advantages
of a weakening of perhaps 10-15% against the
northern euro economies.
However, the
eurozone's unhappy history over the last few years
has demonstrated that if you don't trust the
governments of your neighbors, you don't want to
be in a common currency with them.
At the
current time, it would be madness for the
relatively well run Spain and Portugal to enter
into a currency union with Italy and France,
without the counterbalance of Germany. Both Italy
and France as currently run would see departure
from the euro as providing them room for
profligacy, the last thing Spain and Portugal
should want to tie themselves to. Equally, if
France and Italy left the euro, the Spanish and
Portuguese economies are probably not strong
enough to remain with the northern euro and suffer
a further 10-15% uplift in their exchange rates
against Italy, France and the world.
Hence
a euro split would probably leave Greece in
solitary sub-Balkan disgrace (possibly accompanied
by Cyprus), while France and Italy each went their
own way, their profligacy weakening their
currencies but with nobody else tied to their
failure. Spain and Portugal could form an "Iberian
euro" and might very well be joined by other small
economies who, while reasonably disciplined, find
the current euro too strong, perhaps Slovenia,
Slovakia, Malta and Ireland.
Belgium is a
special case; it has very little fiscal discipline
but benefits enormously from being at the center
of the expanding EU empire - on balance it would
probably find its imperial revenues enhanced by
remaining a member of the stronger euro.
The remaining euro members - Austria,
Finland, Germany, Luxembourg, the Netherlands, and
Estonia - would form a relatively compact,
well-managed core of members for a strong euro,
probably appreciating by 10-15% initially against
the Iberian euro and remaining strong against it
thereafter. Other strong East European economies
with good fiscal discipline, like Latvia and
Poland, would eventually join this core, as might
Sweden and Denmark, but weaker economies like
Bulgaria and Romania would probably never do so.
So that's the probable final score - two
separate euros, one stronger one weaker, both
fairly well managed, with France and Italy
remaining independent as befits their large size
and poor fiscal management. Greece, Cyprus,
Britain and a few East European countries would
remain part of the EU but no longer aspire to
membership of a common currency.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
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