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Thursday, January 15, 2009

Help Jake Understand: Is it Possible that a Country will Leave the Eurozone?

I must admit that I am no expert in the field of International Economics (in fact I do not understand it), but I am trying to grasp some of the consequences that a single currency (either through the adaption of the Euro or a fixed exchange rate) has on a country when it limits that country's monetary policy. For all those that understand this topic much better than I, PLEASE POST AND HELP ME OUT.

Point (the case for a Eurozone breakup)

Ben Bittrolff at the Financial Ninja kicks off the discussion:

Abandoning the USD in favor of the higher yielding Euro is a dangerous trade. The risks of the Euro unraveling are growing larger by the day. Recent volatility in the foreign exchange markets should definitely raise eyebrows. In the end, the USD is still the undisputed reserve currency of the world. Spain and Italy are the most likely candidates for sovereign default.

The Short View: “If the eurozone could find a way to deal with a member country’s national default, that might confirm the euro’s status as the world’s next reserve currency. But if a solution could not be found, and a country exited, any such ambition would be over, says John Authers.”

Tuesday night, I saw an eerily similar post over at Across the Curve. Before diving in, a little background on the ERM (European Exchange Rate Mechanism) which is discussed below, via Wikipedia.
The European Exchange Rate Mechanism, ERM, was a system introduced by the European Community in March 1979, as part of the European Monetary System (EMS), to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of a single currency, the euro, which took place on 1 January 1999.
In a nutshell, before the ERM (or European Monetary Union “EMU”, which in its third stage introduced the Euro as the real currency), a country controlled their own monetary policy and could devalue their currency when the situation deemed appropriate. No longer… as a result we see a growing divergence between the haves and have-nots. To Across the Curve:
Belgian 10-year spreads over Germany have widened 16 bp over the past five days in line with Spanish spreads. Dutch spreads have widened 10 bp over the same period, in line with Italy and in sharp contrast to the 2bp widening by France. On a three month basis, Belgian spreads have widened 37bp, also in line with Spain and vs. 32 bp for Holland and 21 bp for France. As we noted yesterday, part of the widening of Spanish - and also Belgian - spreads may reflect liquidity premiums but, at least for Spain, also likely reflects competition. Prior to ERM , a devaluation of the Spanish currency enabled the country to boost its competitiveness.
It appears to me that the ERM and/or the EMU has limited the ability of a country, such as Spain, to react to the specific situation occuring in their economy, as each country is forced to accept the monetary policy best suited for the union as a whole. In other words (back to Across the Curve):

ERM membership blocks / eliminates that policy action and risks a deeper economic crisis.
Spain, which is under severe economic strain, cannot respond with a devaluation of their currency and a flooding of liquidity, as they need to move forward with a policy best meant for the larger powers (i.e. Germany), which have not experienced the same home boom / bust and are still worried about reigniting inflation after all they went through in the 1930's.

In fact, just the reverse situation has occurred... the money supply in Spain (as measured by M3) has actually decreased over the past three months, just as the country is in desperate need for liquidity.

And things seem unlikely to improve anytime soon. As Forbes reports:
Restrictions on foreign financing have collapsed Spanish housing and consumer spending booms and sent unemployment to the highest rate in the European Union at 13.4 percent in November. S&P saw the risk of prolonged weak growth after the Spanish economy entered its first recession in 15 years during the fourth quarter.
Counter-Point (no breakup)

The counter-argument comes from Willem Buiter (hat tip Naked Capitalism):
Three issues are being linked in this passage. The emergence of high levels of sovereign default risk premium differentials between different eurozone member states, the external value of the euro and the likelihood of the eurozone breaking up. There is no self-evident link between these three issues. The first is neither necessary nor sufficient for the second or the third. More than that, the threat or reality of sovereign default by a eurozone member state is much more likely to reduce that country’s incentive to leave the eurozone than to increase it....
Would a eurozone national government faced either with the looming threat of default or with the reality of a default be incentivised to leave the eurozone? Consider the example of a hypothetical country called Hellas. It could not redenominate its existing stock of euro-denominated obligations in its new currency, let’s call it the New Drachma. That itself would constitute a further act of default. If the New Drachma depreciated sharply against the euro, in both nominal and real terms, following the exit of Hellas from the eurozone, the real value of the government debt-to-GDP ratio would rise.
Go read the whole thing, but to say I'm uncertain would be an understatement...