For the last year, the outpouring of writings on the Eurozone crisis has been huge. For some time, my view has been that it should be broken up because it is dysfunctional as an economic unit. In essence, we have a simple problem: economists of all persuasions (from Friedman to Feldstein to Krugman) have argued persuasively that for countries where labor is not mobile and cultural, social and political systems are different, the use of a common currency is a recipe for disaster. Markets don't clear, setting up serious imbalances, i.e., Greece. And countries lose control over monetary policy because there is s single central bank/currency issuer. In such circumstances, there is little reason to give up the one tool for getting back into equilibrium - a change in the exchange rate. Far better to admit that the original idea was flawed, wind it up as quickly and cleanly as possible and move ahead.
The Doomsday Writers
This piece addresses the arguments made by the doomsday writers who claim the Eurozone must be saved because its breakup would cause unacceptable global economic chaos and destruction.
Perhaps the most unequivocal doomsday statement was made by Wolfgang Münchau who wrote: "A collapse [of the EMU] would constitute the biggest economic shock of our age." Münchau is not alone in feeling this way. Probably the most thorough and well-documented gloom piece was recently written by Anders Åslund, and his will be my primary reference point moving forward.
Analogies from the Past - The Soviet Union/Yugoslavia Breakups
What does history tell us? An important part of the Åslund argument stems from his personal experience in the dissolution of prior historical cases that involve fixed exchange rate regimes, involving common currencies and clearing arrangements for foreign trade (as in the case of the Soviet Ruble). He reviews a number of different cases but focuses primarily on the dissolution of the Hapsberg Empire, the Yugoslav and the former Soviet Bloc. And he apparently considers the latter case the most relevant. His conclusions from the breakup:
- In the former Soviet Union, 10 out of 15 republics had hyperinflation;
- The combined output falls were very large; the average output fall in the former Soviet Union was 52% (42% in the Baltics);
- By 2010, 5 out of 12 post-Soviet Countries had still not reached their GDP per capital levels (in purchasing power parity terms).
He concludes, "Thus the historical record is that half the countries in a currency zone that breaks up experience hyperinflation and do not reach their prior GDP per capita as measured in purchasing power parities until about a quarter century later".
It should be noted that there are an extremely large number of cases of the breakup of fixed exchange rate regimes that could be cited as relevant for the Eurozone. Some cases involve common currencies and clearing systems but others do not. The key problem is how quickly can a country with a badly aligned exchange rate re-adjust its internal and external economy and resume a normal growth pattern.
When put that broadly, it immediately becomes obvious that success depends on a large number of different factors. Certainly, the willingness of domestic officials to allow competitive forces to emerge is critical. But, in addition:
- a country's geographical proximity to growing markets;
- a country's previous historical relationship with other economies;
- an environment free of war and disaster, and for the extremely fortunate (e.g. East Germany);
- a favorable political relationship with a donor willing to ease the transition path;
--- All of these factors have played important roles in the past and will do so undoubtedly in the future.
Table 1 provides data that we assembled on the collapse and recoveries of:
- Former Soviet Union countries that used the Ruble and
- Neighboring countries affected by the Soviet Union breakup that used their own currencies.
The table measures how much GDP per capita2 fell from the last good year before the breakup to the bottom year and how many years it took countries to get back to the prior-breakup year level.
Table 1. - Collapse and Recovery for
Soviet Union and Neighboring Nations
Source: World Bank
Many of Åslund's conclusions are confirmed by our assessment. Most of the countries - particularly those that used the Ruble as a local currency, lost a decade of growth, and many wound up at the end of the decade worse than at the start.
Why Åslund's Analogies Do Not Fit
So what does this mean for Eurozone countries? Broadly speaking, the data suggests that countries leaving a currency union are in for significant and lengthy periods of re-adjustment. But the data also suggests that if the starting conditions are favorable and if countries take advantage of whatever opportunities that exist in the neighborhoods and beyond, the path ahead need not be one of unmitigated disaster.
Åslund goes to great lengths to document the devastation resulting from the breakup of the Soviet Union and Yugoslavia. But the analogies to a possible Eurozone breakup do not fit; they make no sense. The Soviet Union and Yugoslavia were central planning disasters. The only thing that held them together was Russia's size and trade credits to other countries. Russia went from Tzardom to Stalinism without any experience with the use of market mechanisms. And Russia has not changed. Its economy remains an inefficient mess. It survives solely on natural resource exports.
There is no question that for most of the countries that left the Soviet fold, recovery has been extremely problematic. The conversion from a totally government controlled, central planning system to ones placing considerable reliance on market mechanisms has not been easy. And most of these countries do not have Russia's natural resource export base to save them. The same holds for the ex-Yugoslavia countries: in addition to having to make a basic economic system transition, these countries decided they hated one another enough to go to war. As long as Tito, like Saddam Hussein later, ran military dictatorships, the hatred was contained. In conclusion, it is incorrect to attribute the economic problems of these countries to the breakup of their regional economic blocs. Their economies were dysfunctional and in shambles.
The Eurozone is different. Granted, Greece and the other "weak sisters" (Italy, Portugal, and Spain), are not as efficient and competitive as Austria, Germany, and the Netherlands but they all have market-oriented economies. In essence, the problem in the Eurozone is that there are more and less productive countries, and trying to force Greece, Spain, Portugal, or Italy to be as efficient and as competitive as Austria, Germany, or the Netherlands will not work.
Of course, there will be severe "transition problems" and great uncertainty, but the analogy to the breakup of the Soviet Union and Yugoslavia is simply not apt.
The Doomsayers' Chaos Claims
The following two statements by Åslund are fairly typical of the doomsayers' assertions:
- "Exit from the EMU cannot be selective: It is either none or all. The breakup of a currency zone is far more serious than a devaluation. When a monetary union with huge uncleared balances is broken up, the international payments mechanism within the union breaks up, impeding all economic interaction."
- "Exit of any country is likely to break this centralized EMU payments mechanism. These rising uncleared balances are a serious concern because nobody can know how they will be treated if the EMU broke up. Any attempt to cap them would risk disruption of the EMU. These balances need to be resolved but in a fashion that safeguards the integrity of the EMU."
Åslund is fixated by concerns over uncleared balances. In his piece, he mentions "uncleared balances" 38 times. In comparison, unemployment is only mentioned twice in his 12,000 word article. There is no doubt the unpaid balances will be a problem. But we know this in advance. Good! So let's distinguish between two types of balances:
- The normal fluctuations in bank balances that are part of the money clearing process;
- Various forms of debt and debt derivative contracts.
For the first type, task the European Central Bank to work with the private banks to keep normal banking operations going. And figure out a way to insure all deposits. For the second type of balances, leave it to the parties involved to resolve as many issues as they can. The rest will go to the courts. And let the lawyers argue over the unresolved issues for decades. Foolish loans were made and foolish derivative contracts were written. People gambled and lost. Too bad. That happens frequently in capitalist systems.
Doomsayers Offer No Remedies for Critical Eurozone Problems
I would have more sympathy for the doomsayers if they took the Eurozone problems seriously and offered suggestions on how to deal with them. But they don't. For example, this fuzzy statement from Åslund is typical: "Hopefully the fundamental problems of euro area governance are now being resolved with the formation of a stricter fiscal union, a banking union, and a sufficiently large bailout fund."
This shallow statement suggests no understanding of the real problems in the Eurozone. A stricter fiscal union? Just a little more austerity? In a recent article, I projected what would happen to unemployment in Greece if the current austerity requirements were kept in place. In 2013, the Greek unemployment rate would reach 33%! You talk about riots and chaos. That is not going to happen. The austerity approach has failed. What is the primary Eurozone problem right now? It has nothing to do with banks or anything else financial. The main problem right now is the high unemployment rates of Greece (22.5%), Spain (24.8%), Portugal (15.0%), and Italy (10.8%). What caused these rates to get so high? The utterly misguided German austerity push enforced by the IMF. I would be more sanguine if I saw any indication that the IMF or Eurozone leaders understand and are prepared to address these issues now. But I don't. All I hear about is the need for a bigger fund to support the banks.
Beyond high unemployment, major differences in competitiveness between the Euro nations remain. Why is this a problem and how is it manifested? Competitiveness is manifested in production costs, and if all countries are using the same currencies, the goods of the less competitive countries will cost more. That means they will not sell, and this will manifest itself in a negative trade balance. No country can run a trade deficit indefinitely. At some point, capital inflows will cease, it will have borrowed all it can and it will have used up all its international reserves to cover its trade deficits - like Greece. If Greece had its own currency, its higher costs could be eliminated by a market-induced, gradual devaluation of its currency. This release valve is not available when all countries are using the same currency.
The doomsayers project that if Greece were to leave the Eurozone and start issuing its own currency, there would be a devaluation of up to 80%. Indeed, in the early days, there will be panic and this could happen. But after some panic and wild fluctuations, things will settle down. The IMF estimates that Greece needs a devaluation of at least 15-20% against the Eurozone on average, and somewhat more against Germany to balance its current account.
OK - Let's Try To Keep Eurozone Together
But for a moment, let's accept the doomsayers'' dire prediction and let's do something the doomsayers should have done but have not: set forth a realistic plan to save the "weak sisters", recognizing that political chaos will envelop them if their unemployment rates do not come down. What will this take? The exact opposite of what the Euro powers are now thinking. I offer the following:
- Launch a stimulus plan to lower unemployment rates in weak sister countries to 8%; this stimulus will require billions of Euros from European countries and the IMF (see below).
- During the stimulus period, get the Eurozone pick up tab for higher debts of weak sisters during stimulus period (including debt amortization and their current account deficits), and get the European Central Bank to guarantee bank deposits and worry about uncleared balances.
- Reforms to make the "weak sisters" more competitive can be started during the stimulus period, but no reforms should be started that would negate the stimulus effects.
- Once unemployment rates down to 8%, expand the economic reform program, recognizing that competitive gap for the weak sisters is probably in the 15% - 30% range.
Table 2 contains a rough estimate of the stimulus needed to reduce unemployment rates in the "weak sisters" to 8%. The average wage for the jobs to be created in each country was assumed to be 85% of the GDP to total employed ratio.
Table 2. - Eurozone Stimulus Needed for 8% Unemployment
(in bil €)
Source: IMF WEO Database
With all the money the Eurozone is putting out to save the banks, €295 billion is a pittance.
Will the strong Euro countries and the IMF agree to this? No.
So where are we left? Unemployment rates will continue to rise in the weak sister countries. This will cause political collapse and great global uncertainty.
You haven't heard much about the Eurozone crisis recently because the Euro power-brokers are on vacation. But you will. The clouds are very dark. Expect major swings in equity markets as one crisis after another hits.
1 This article has benefited from the comments and contributions of Dave Denny, an economist and friend who was with me at the University of Michigan. Dave is primarily responsible for the section examining the breakup of the Soviet Union.
2 Measured in constant local currency units.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.