13 November 2011

Douglas J Elliott: Dear Europe - breaking up is a foolish risk

Writing for Brookings in the US, Elliott asks should Greece or other nations be allowed to leave the eurozone, or even be forced out? He adds that those questions were considered heresy among European leaders until mere days ago.

Why would a eurozone break-up, even a partial one, be a bad idea? The short answer is that no one knows for sure if it would be, because there aren't any good comparisons. But there are many reasons not to risk what would appear to be a big mistake. If one of the weaker members, such as Greece, abandoned the euro, they would surely set a much weaker exchange rate for their new currency.

Knowing this, any hint of an impending withdrawal could trigger a massive run on that nation's banks, as citizens rush to move out their euros to avoid devaluation. That would destroy the banks of the withdrawing country, creating a huge credit crunch that could lead to a severe recession or even a depression. (Look at how badly our [US] economy was hit by our own, much milder, problems with our financial system. Worse, there could be bank runs in other weak countries where the citizens might fear an abandonment of the euro.

This contagion would spread recession across much of Europe and likely lead weaker countries to default on their debts unless they receive guarantees from stronger nations like Germany. Any defaults would spread chaos, credit crunches, and recession further across Europe. Companies owing international debts in euros but holding domestic assets in the new, devalued, drachma or escudo might also go bankrupt.

There would, however, be some offsetting benefits. Those countries would likely become more competitive internationally, if nothing else changed. But it's unlikely that citizens would sit still while inflation spikes, and as imported goods become perhaps twice as expensive. Workers will demand higher wages, undoing much of the benefit of the devaluation. Even if the first devaluation worked partially, history has shown that devaluations can be like heroin, habit-forming and destructive.

Strong countries like Germany would see their exports to Europe drop sharply, and the value of their loans and investments in the weaker European nations decline as well. They might also see their remaining euro currencies rise substantially after things settled out, making all their export efforts significantly harder. If I am right, all the eurozone nations would lose from the withdrawal of any.

Perhaps this is wrong, but it seems a foolish risk to take, since the benefits are not nearly as clear as some would claim.

Full article

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