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...


  1. I think Buiter makes a very convincing argument, so I don't try to restate it in my own words. BTW, I think talking about a break-up is overly dramatic if one really talks about single, peripheral countries possibly leaving the EMU. I don't see Germany, France and the lowlands leaving for any reason.

  2. how about spain, italy, greece, or portugal?

  3. You can find convincing arguments on both sides. Martin Feldstein has been a skeptic from day one. You might want to read his thoughts. Here is a link to his latest comments-

    Personally, I think that the survival of the community as anything more than just the major players depends on the severity of the downturn. If it gets to depression or semi-depression levels then the pressure to leave will be irresistable for the smaller countries. It's not inconceivable that internal politics could cause one of the major countries to pull out as well.

    It's probably just as wise to read what historians and political scientists have to say about it in addition to the economists punditry. They haven't been terribly right lately.

  4. As you noted, in a monetary union the countries don't have the ability anymore to set rates according to their own needs. In the EMU, e.g., the rates where some prolonged time always to high for Germany as some other countries (Ireland, Spain, ...) had booming economies that needed higher interest rates. The euro rate is always a trade-off between the needs of all participants.

    The high rates forced Germany to break up inefficient structures and work on competitiveness. Now Germany is the most competitive economy in the Eurozone and the other have to deal with their structural problems. That might cause headache for some politicians, especially Sarkozy and Berlusconi. They might be temped to leave the Eurozone, but Buiter argues convincingly that this is not likely to happen.

    Ireland, btw., is the country with the worst shape in the Eurozone. At least the country with the highest credit spread. Its 215BP. A list with all spreads you can find in my blog.

    (sorry. It's in German)

  5. Well, what about the PIIGS? They face a tradeoff between easing their burden now against losing the benefits of belonging to a larger monetary space (with the bonuses of liquidity, price stability and trust into the monetary policy). One of the countries leaving EMU would at least practically, if not legally constitute a default on their obligations, with the following results for long term cost of financing. Someone else made the argument about credit from foreign sources to private agents in the countries - hard to believe that this credit would be automagically swaped into the new local currency, so with the expected devaluation the governments debt may be eliminated, but the private debt would explode in local currency.

    I can think of some extreme cases were it would pay of for the government to leave, e. g. if Irelands guarantee for all bank debt should ever be called. But short of this, i think the long term costs will dominate the short term gains.

  6. PS: About the language: Hearing someone say "breakup of eurozone", i understand the general abolishment of the currency, and every nation reverts to a national currency.I think this is almost surely impossible, while i suppose there is a small, not-negligable possibility that one or more of the countries in dire straits might leave the EMU.

  7. how's that?

    i appreciate the feedback.

  8. impossible.

    a breakup would create unseen financial turmoil felt around the world.

    a country opting out would see its trade collapse, it´s (new-old) currency collapse and a huge flight of capital.

  9. Hi Jake,

    thanks for your blog, maybe we can help you now with this one.
    The chances of the Euro system breaking down are close to zero. The benefits for the major countries are much greater staying in the Eurozone than the benefits from leaving. Having a currency union with Germany helped all countries to get lower interest rates as well for the government and the firms. It also made it possible to offer large bonds that wouldn´t been possible in the smaller countries.
    The argument that one interest rate and one currency policy doesn´t cope with the need of everybody is also true for the USA. Just take NY, Michigan, Florida and Nevada. In the past Michigan with its tumbling production and its falling land prices might have wanted lower interest rates, when the others might have needed higher interest rates. It still wasn’t a reason for Michigan to leave the Dollar. And just think of Hawaii, Alaska or Michigan leaving the Dollar, would it really hurt the currency? So would it really hurt the Euro, if the weakest country leaves the system? It just would make it stronger in my opinion.

  10. I think these are all great points, but I do question the comparison to states. If a state is about to go under (i.e. California) they can get bailed out by the Federal Government, which has the power over the monetary policy.

    A country in the Eurozone (i.e. Ireland, Spain, etc...) does not have a "parent" that will provide them money... at least I do not believe that is how it works.

    In addition, there is a lot of nationalism in the U.S. that covers states, while I am not so sure a German would take it well if Germany was bailing out / guaranteeing Italy's debts.

  11. Jake, maybe - for some theoretical background - you should have a look at a second generation model of currency crises (e. g. Obstfeld (1994) The logic of currency crises, NBER WP 4640), but with a very high weight for keeping the fixed exchange rate in relation to output stability.

    Based on this, it will be in the best interest of the government to credibly commit itself to staying in EMU, but with an exit-clause if output losses would become just too dreadfull otherwise. But the weights of the tradeoff will be much more in favour of staying with EMU because of the higher losses in the case of an exit (e. g. a country that gives up a fixed exchange rate against another currency can revert to this regime allmost imideatly after the devaluation, but a country leaving EMU will shut itself out for a very long time).

  12. The break up of the Eurozone is inevitable! I have read in blogs discussions about Europe’s future. My opinion is, that It won’t be weakest countries the ones leaving the EU, but the wealthiest leaving, because they are being dragged down by the poorer. The premise, that weakest will leave, so they could devaluate their own currency is hard to accept, because as soon as they leave they will face trade barriers put by the rest of EU countries. It is going to be cheap to export with devalued currency, but is going to be hard exporting, if there is backlash against the separationist country.

    The current EU welfare state is unsustainable. Cultural and political differences are standing on the way of a budgetary reform. Here in US we don’t have such big cultural and political differences and every state is standing for the union. We are even going to bail out California soon. I lived in Europe and just cannot see EU members bailing out one of their own. The EU is made of very diverse sovereign nations, who would defend their national interest befor the interest of EU. European Union has failed to fulfill the promises about significantly increase in trade between the members and mobility of the work force, as we have them here between the states (read How Has the Euro Fared After Ten Years?) Another expected effect, of the common European currency - that differences in prices—in particular in price levels—should decrease because of the ‘law of one price’. Differences in prices can trigger arbitrage and by accepting one common currency they thought it is going to eliminate the opportunity of someone trading inside the eurozone buying low and selling high same product in neighbouring countries. This also hasn’t happened. My opinion is that this is because of the wage difference between the member countries. You cannot have a huge wage differences and expect the same product to cost and sell the same price in every country of EU (see Big Mac Index). And believ me it is not only the Big Macs priced different in different countries of EU. And how different are the wages - minimum wages are varieing widely, from 112 euros per month in Bulgaria to 1610 euros per month in Luxembourg - (download the pdf file for more info).

    EU probably will not fall apart in the next year, but in a long run 10-15 years from now, I don’t see it to exist keeping todays structure, laws, trade restrictions, wage differences, etc.

    And for those who are still not convinced in EUs demise read this - Support for euro in doubt as Germans reject Latin bloc notes. Ordinary Germans have begun to reject euro bank notes with serial numbers from Italy, Spain, Greece and Portugal, raising concerns that public support for monetary union may be waning in the euro zone’s anchor country. Yep, same currency, same value, printed in different countries makes them psyhologicly valued differently.

    Sorry, links are not working, go to to read the whole article and see the data supporting the above

  13. "...Germans have begun to reject euro bank notes with serial numbers from Italy, Spain, Greece and Portugal..."

    as a german resident i can tell you that´s not true. i never even heard a single word about that.

    wealthy nations will never opt out since it was them that pushed decades for the EU.

    their trade would be hit too.
    lets say Germany as the biggest european exporter opts out.
    hence a reintroduced DM would jump incredibly to the euro, effectively destroying competitivness of german exporters over night.

    as far as the bailout of members goes - they will always find a way, if nothing goes there´s still the IMF backdoor.

  14. Here it says ..."Germans have begun to reject euro bank notes with serial numbers from Italy, Spain, Greece and Portugal"... it is from
    I haven't sucked it from my thumbs.. :)

    "wealthy nations will never opt out since it was them that pushed decades for the EU"
    They thought they will get bigger and unrestricted market for goods and labor thus producing less expensive products and introducing them to larger population resulting in bigger profits and wealth for the nation as a whole. Instead they got flooded with cheap labor from the ex communist countries and the unions in Germany, UK France didn't like this at all - they pushed for restricted labor movement. And what about those quotas for the different goods made by certain members in EU - its like the tariffs before the union, but worst if u are restricted by those quotas.

    And lets see how long the wealthy nation will tolerate to be taxed and the money being spread to the nations as Bulgaria, Romania, Estonia, Latvia... who take the money and don't really produce any results benefiting the union.

  15. Jake: are you asking for help understanding how the EMU was constructed, and the rules the member countries have to follow?

    If so, the best I understand, entering the ERM required limits on government debt, and central bank efforts to keep exchange rates between currencies reasonably stable. Which is to say, even though Europe doesn't have a federal government like the USA, there is a central bank, and the stronger countries (Germany, France) have intervened to keep the weaker countries (Spain, Portugal, especially Italy) in line.

    From what I recall reading while I lived in Spain, Germany was getting tired of subsidizing all this, but there have been many economic benefits, and I think little by little, people are growing to favor the union. So I suspect the EMU will endure.

    There's a so-so Wikipedia article on the ERM:


  16. Found this few hours ago
    "Monetary union has left half of Europe trapped in depression"

    ...Greece no longer dares sell long bonds to fund its debt. It sold €2.5bn last week at short rates, mostly 3-months and 6-months. This is a dangerous game. It stores up "roll-over risk" for later in the year. Hedge funds are circling.

    Traders suspect that investors are dumping their Club Med and Irish debt immediately on the European Central Bank in "repo" actions.

    In other words, the ECB is already providing a stealth bail-out for Europe's governments – though secrecy veils all.

    An EU debt union is being created, in breach of EU law. Liabilities are being shifted quietly on to German taxpayers. What happens when Germany's hard-working citizens find out? ...

  17. it seems like we'll find out soon enough (or not) how this will all play out. similar to what is happening in "the states" it is equal parts interesting as frightening. thanks all for the insights.

  18. Hope it helped you, Jake.

    If you have any specific questions, just ask. As an economist working in Germany I can tell you that at the moment there are no serious thoughts of any country about leaving the EU or the currency union. The opposite is the case, since other small countries like Denmark thing about joining.
    Germany and France are the both states that together provide a large domestic market to all the other smaller countries. None of which are interested in loosing that large home markets due to leaving the union.
    The EU also gives politicians the possibility to make unpopular changes by taking the way over the European Commission, which than have to be transformed into national law, without having a big debate.
    So to make it short: At the moment the EU works, the EURO as a currency is respected and accepted in every member of the currency union. There are no signs of anyone leaving, instead we will see new members joining in.

    @ TheCynicalEconomist

    Sorry, but you are mixing up a few things regarding the EU and the currency union. And as far as i know there has never been a refection of Euro notes because of their origin, since the are all from the EZB.

  19. @CynicalEconomist:

    As far as Germans rejecting Mediterranean-issued Euros, that Telegraph article seems pretty alarmist. It goes on to say that some Germans continue to hoard Deutschemarks at home. Both claims are probably true, but neither act makes any sense. I'm pretty sure you can no longer exchange EMU member currencies for Euros, and thinking that if the Euro collapsed, countries would resume printing the old currency seems delusional. In short, evidence of the impending collapse of the Euro will have to come from the words and acts of European leaders, not the occasional paranoid citizen.

    Jake, I guess another way of thinking about your question is: what would a departing country have to do in order to leave the currency union? The obvious, big answer is "print a new currency and educate its citizens on it." This took months to years, depending what parts you count in the process. I'm not saying it will never happen, only that it will be easy to see it coming.


  20. The euro: love it or leave it? by Barry Eichengreen
    Professor of Economics and Political Science at the University of California, Berkeley; and formerly Senior Policy Advisor at the International Monetary Fund. CEPR Research Fellow

  21. A couple of days late, but I have some relevant comments (I think).

    First, CynicalEconomist, Ambrose Evans Pritchard is rather "breathless" in style. Fun to read, but take what he writes with a grain of salt. Take for instance this passage "...Greece no longer dares sell long bonds to fund its debt. It sold €2.5bn last week at short rates, mostly 3-months and 6-months."

    On Wednesday, Greece sold 5.5 billion Euros of 5 year notes

    But you're right that if any country is going to leave the Euro, it would be a wealthy one, not a poor one.

    The Economist's Free Exchange has a nice blog entry (with links) on this topic

    The blog entry brings up the argument that the Euro is like the Gold Standard in the 1930's, preventing countries from devaluating to re-establish their competitive edge. But it also points out how difficult to be for a country to leave the Euro, so that they could devaluate their new currency.

    Briefly, if a country, say Italy, starts contemplating leaving the Euro so that they could then devalue their New Lira, market participants would pre-emptively shift their deposits to other euro-area banks outside of Italy. This would cause a run on the Italian banking system. Now seeing as Italy is contemplating leaving the Euro, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises. (see the blog for a fuller description)

    Realistically, any country leaving the Euro would have to have the financial resources to support its own banking system from a financial run. None of the poorer countries have the resources to do so, but maybe Germany does (maybe).