Here is how Hatheway frames the end of the world:
The unfolding Eurozone crisis is not something to be taken lightly. The consequences of policy action are material, not just for the 330-odd million residents of the Euro area, but assuredly for the world economy and financial system as well.
This week, Europe’s heads of state gather again to see if they can finally get on top of the problem. The challenges confronting the Eurozone are complex and defy easy solution. Sadly, that hasn’t prevented some observers from proposing some silly ideas. Indeed, it is distressing to see how many misconceived ‘remedies’ are put forward by seemingly reasonable people. In what follows we review some of the odder ones and explain why they don’t make sense.
Why a euro break up is the end of the world: Take 1 – base case
The Eurozone was flawed from the start. The wrong countries joined and the Euro area lacks the appropriate policy framework to deal with its imbalances, lack of growth, and internal inflexibility.
So, the remedy must be to break it up, right?
The preferred outcome is to fix what is broken.
But before we go further, let’s make one point absolutely clear. Even if fixing the Eurozone is better (on any measure) than breaking it up, that does not imply that break-up can’t happen. Countries, like individuals, often make decisions they subsequently regret. When passion (populism or nationalism) dominates reason, stuff happens.
Back in September, my colleagues Paul Donovan and Stephane Deo and I outlined the costs of breaking up the Eurozone. The interested reader can refer to the relevant research for details (available on request). Suffice it to say that the combination of cascading cross-border defaults, collapsing banking systems, soaring risk premiums, and currency dislocations would result, according to our estimates, in losses approaching 20% of GDP for creditor countries and 40% of GDP for departing debtors.
On reflection this author, at least, feels the estimates are probably conservative—the true costs could well be higher. That’s because once Europe (and the world economy) finds itself in depression, policy probably couldn’t arrest the decline. Broken financial systems and ruined economies are the stuff of prolonged deflation or worse. And it is by now abundantly clear that even unconventional macro-policy cannot deliver results if the financial system is in tatters.
Our report received a lot of attention from clients and in the press. And to our knowledge, its findings have never really been disputed. So here’s the point. If most observers agree that a Eurozone breakup significantly increases the risk of widespread economic and financial mayhem, how can’t be best? Reasonable people don’t play Russian roulette. So why are some economists suggesting that Europe should?
Why a euro break up is the end of the world: Take 2 – crank it up a notch
It’s only Greece, why worry?
Ok, the break-up crowd grudgingly admits. You’ve got a point—Italy can’t leave. But what about Greece? Surely it is so small its departure won’t matter?
And its economy is so broken, wouldn’t Greece benefit from leaving the Euro? Wrong again. First, Greece is unlikely to be better off outside the Eurozone than in it. Forced conversion of bank deposits and strict capital controls would be required to prevent massive capital flight in the event a ‘new drachma’ is introduced. While Greek government debt might be redenominated into ‘new drachma’, private sector debt owed to non-Greek financial institutions would remain liable in euros, dollars, Swiss francs or whatever the currency of the original obligation. With the ‘new drachma’ depreciating in the currency markets (why else issue it?), the Greek private sector would experience large and rolling defaults. That’s because after more than a decade of current account deficits, Greek residents owe the rest of the world a lot. Specifically, since the euro was introduced, Greece has racked up external liabilities (cumulative current account deficits) of nearly $300bn, just over 100% of its GDP.
So the Greek financial sector would collapse, alongside much of the nonfinancial sector. Credit would evaporate and recession (more like depression) would result. But that’s not all. Given a very open economy to trade, drachma weakness would result in rising import price inflation, eroding domestic purchasing power (hence deepening the downturn) and undermining the hopedfor competitiveness stemming from nominal depreciation.
So the tally is depression, widespread private sector bankruptcy, a ruined financial sector, and surging inflation, offset by modest gains in competitiveness.
That’s not a terribly persuasive case for exit.
But the biggest reason why the ‘it’s only Greece’ narrative is naive and dangerous is that it almost certainly would not be ‘only Greece’. Once one country leaves the Eurozone, residents in other at-risk member countries would plausibly conclude their country might be next to go. Logic dictates they would send their wealth abroad, resulting in a run on their domestic banks, precipitating a collapse of their financial sectors and economies.
The ‘it’s only Greece’ crowd conveniently fails to consider the risks to the rest of the Eurozone.
Stuff—in this case, contagion—happens.
Why a euro break up is the end of the world: Take 3 – bring up the cheating spouse analogy: that will get their attention
I promise, really, I’ll only cheat once
Recently, another bad idea has made the rounds. How about a weekend exit, where a country (say, Greece) leaves the Euro area, devalues and rejoins, all by breakfast on Sunday, primed to compete against the mighty Germans.
It is hard to know where to begin with the instantaneous exit and re-entry ‘remedy’. Leave aside the legal and practical challenges involved (Can a country exit and rejoin without treaty change? Is it legal to re-denominate private sector assets?). The notion is fundamentally flawed on its own.
To be sure, the new lower real exchange rate would boost competitiveness. But what about borrowing costs? Undoubtedly, they will soar and remain high for a long time. That’s because creditors (who just suffered a currency haircut over the exit/re-entry weekend) have memories.
Unsustainable sovereign credit risk premiums would be replaced by unsustainable currency risk premiums. This ‘remedy’ is, after all, no more than a return to a fixed-but-adjustable exchange rate system with all the credibility problems it embeds.
And currency risk premiums would appear not only in the ‘weekend divorce’ country. Others in a similar predicament would lose credibility and suffer rising bond yields—once again contagion effects.
In essence, the ‘weekend divorce’ only works if the jilted partner (the creditor) is gullible enough to believe that the other partner will only ‘cheat’ once.
I don’t know about you, but…
Why a euro break up is the end of the world: Take 4 – time for some carpet bombing imagery “inception”
What if Napoleon had a B-52 at Waterloo?
The last of our weird reasoning cases is the idea that banks, companies and even countries can somehow prepare for Eurozone break-up. In recent weeks various stories have appeared in the press about foreign exchange brokers, multinational companies, banks, and even countries mobilizing teams to figure out how to deal with new currencies, recalibrate cross-border accounting and invoicing systems,or estimate the costs and benefits(?) of break-up.
Talk about fantasy. That’s like asking Wellington to stress test his army against a scenario where Napoleon has a B-52 at Waterloo. You don’t re-position the troops—you retreat as quickly as