As I discussed recently, the costs and risks of maintaining the eurozone system are already immense and rising. So is an exit possible? Intuitively, the exit from the euro should be as easy as the entrance. Joining and leaving the club should be equally simple. Leaving is just undoing what was done before. Indeed, many popular articles discuss the prospects of an exit of countries such as Greece or Germany. However, other voices have rightly argued that there are important exit problems. Some authors even argue that these problems would make an exit from the euro virtually impossible. Thus, Eichengreen (2010) states, “The decision to join the euro area is effectively irreversible.” Similarly, Porter (2010) argues that the large costs of an exit would make it highly unlikely. In the following we address the alleged exit problems.
The Maastricht Treaty does not provide for a mechanism to exit the European Monetary Union (EMU). Thus, several authors maintain that an exit from the euro would constitute a breach of the treaties (Cotterill 2011, Procter and Thieffry 1998, Thieffry 2011, Anthanassiou 2009). In an ECB working paper from 2009 Anthanassiou claims that a country that exits the EMU would have to leave the EU as well. As the Lisbon Treaty allows for secession from the EU, withdrawal from the EU would be the only way to get rid of the euro.
The solution to this legal problem could be an exit from both the EMU and EU with an immediate reentering of the EU. This procedure could be negotiated beforehand. In the case of a net contributor to the EU budget such as Germany, the country would probably not face any problem getting immediately readmitted to the EU.
In any case, the referral to the Maastricht Treaty when discussing the legal possibility of exit is intriguing, because the Maastricht Treaty, especially the “no-bailout clause,” has been violated through the bailouts of Greece, Ireland, and Portugal. The European Financial Stability Facility effectively serves to guarantee debts of other nations, not to mention the plans to introduce eurobonds.
In addition, the European Central Bank has violated the spirit of the Maastricht Treaty by purchasing debt of troubled nations. It seems to be a justification, if not an obligation, to leave the euro after the conditions for its existence have been violated. Indeed, the German Constitutional Court ruled in 1993 that Germany could leave the euro if the goals of monetary stability were not attained (Scott 1998, p. 215). After the last couple of years, it is clear that the eurozone and the euro are far from stable. Apart from these considerations it should be noted that a sovereign state can repudiate the treaty (Deo, Donovan, and Hatheway 2011).
Another legal problem results from the possible redenomination of contracts in the wake of an exit from the euro. A government may redenominate euro contracts into the new currency (applying lex monetae — the state determines its own currency). It may do so without problems if the contracts were contracted in its territory or under its law. But what about private and public bonds issued in foreign countries? How would foreign courts rule (Scott 1998, p. 224)?
Imagine a German company that sold a bond in Paris. Will the bond be paid back in euros or in the new currency if Germany leaves the euro? The French court would probably decide that it can or must be paid back in euros. Possibly also the European Court of Justice would rule on such issues. Thus, in the case of an exit, there would be some uncertainty caused by court settlements. There may be one-time losses or profits for the involved parties. However, it is hard to see why these court rulings would constitute important disturbances or insurmountable obstacles for a euro exit.
An exit from the euro may imply the issuing of a new national currency. This involves the costs of printing new notes, melting new coins, exchanging vendor machines, etc. There are also logistic costs exchanging the new currency against the old one. These costs are not higher than the costs of introducing the euro. The costs for introducing the euro in Austria have been estimated at €1.45 billion euros or around 0.5 percent of GDP.
Wage Inflation and Higher Interest Rates
Sometimes it is argued that peripheral countries with uncompetitive wages could just exit the euro and magically solve all their problems. Greece, for instance, suffers from too-high wages mainly because there is no free labor market. Labor unions have caused wages to be too high. The resulting unemployment had been attenuated by government deficit spending and debt accumulation made possible by the Eurosystem. The Greek government employed people at high wages, paid unemployment benefits and retired people early with high pensions.
As strong labor unions prevent wages from falling to recuperate competitiveness, some people recommend that Greece exit the euro, depreciate the currency, and thereby increase competitiveness. This argument contains a problem. If labor unions remain strong, they may simply demand wage increases to compensate for higher import prices (Eichengreen 2010, p. 8). Such a compensatory increase in wages would eliminate all advantages from depreciation. The exit would have to be accompanied by a reform of the labor market in order to improve competitiveness. In any case, after an exit from the EMU, the Greek government could no longer use EMU monetary redistribution and deficit spending to push up wages artificially.
Similarly, an exit without further reforms could lead to a repudiation of government debt. This would imply higher interest rates for the government in the future (Eichengreen 2008, p. 10). An accompanying reform of fiscal institutions such a constitutional limits for budget deficits could alleviate this problem.
The End of Monetary Redistribution between Countries
Some countries benefit from the monetary setup of the EMU. They pay lower interest rates on their debts than they otherwise would. If a country like Greece exits the euro and repays its debts with a devalued new currency, it will have to pay higher interest rates for its debts.
In addition, countries such as Greece could no longer benefit from the monetary redistribution. The Greek government, and indirectly part of the Greek population, benefits from the high Greek deficits and the flow of new money into the country. This process allowed Greece to finance an import surplus and standard of living it would not have achieved otherwise. At least in the short term, an exit from the euro would, ceteris paribus, mean a deterioration of artificially high living standards. In other words, after an exit from the EMU, the size of its public sector and standard of living would likely fall as the EMU subsidies end. These redistribution costs only apply to countries that have been on the receiving end of the redistribution. For fiscally sounder countries, the opposite reasoning applies.
Some authors argue that European trade would collapse in the wake of a euro exit. Trade barriers would be re-erected. In any case there could be an appreciation of the new currency like a new deutschemark (DM). In a UBS research paper, Flury and Wacker (2010, p. 3) estimate that the new DM would appreciate about 25 percent.
In contrast to another UBS research paper (Deo, Donovan and Hatheway 2011) that comes up with horrific costs of a euro break up, we do not regard such trade barriers as very likely for several reasons. First, such barriers would be an economic disaster for all involved parties and would lead to a severe and long depression and a reduction of living standards. Second, net contributors to the EU, such as Germany, could still use their contributions to the EU budget as a negotiating card to prevent such barriers. Third, trade barriers are a blatant violation of EU treaties. Fourth, tariffs could provoke severe tensions between nations, possibly leading to war.
Sometimes it is maintained that an exit implies high political costs. Most importantly, an exit could trigger the dissolution of the euro. The disintegration of the EMU could endanger the development of a federal European state. At least, it would mean an important blow to the “European project.” It could mean the end of the EU as we know today. The EU could “degenerate” into a free-trade zone.
Politicians of the exiting country would lose influence on the policies of other EMU countries. The politicians of the exiting country would also lose appreciation of other EMU politicians and in the mainstream media that has supported the euro staunchly. However, for supporters of a free-trade zone in Europe, these political costs imply immense benefits. The danger of a federal European state would disappear for now.
Procedural Costs and Capital Flows
An exiting nation has to print new notes, mint new coins, reprogram automatic teller machines, and rewrite computer code (Eichengreen 2008, p. 17). This takes time. The case of machines may not be tragic, because, during the transition period, old machines may be in use without chaos. A public parking place using euro coins will not bring the economy down.
The notes-and-coins problem has a fast solution, because on both the country’s origin is visible. Coins have a country-specific image and notes bear a country-specific letter. In a German exit from the euro, all German coins and notes would be redenominated into the new currency and later gradually exchanged into the new notes and coins. Of course, the transition period would involve some checking costs as people have to look at the symbols when transacting in cash.
The most severe problem of a euro exit — one that according to Eichengreen (2010) would pose “insurmountable” barriers — is capital flows when the option of exiting is discussed. Such a discussion takes time in democracies. During this time there may be important capital inflows and outflows.
Let us first discuss the problem of capital outflow such as in the case of an exit of Greece with no accompanying reforms. If Greek senior politicians seriously discuss an exit from the euro, Greek citizens will expect a depreciation of the new currency, a new drachma. Greek citizens will transfer their euros held at Greek banks to accounts in other EMU countries. They will probably not turn in their euro notes to be exchanged for the new drachmas voluntarily.
Greek citizens may also acquire other currencies such as Swiss francs, US dollars, or gold to protect themselves from depreciation. In this way Greece could practically be immunized against the new drachma even before its introduction. As a consequence, the Greek banking system may get into liquidity and solvency problems. Meanwhile, Greek citizens would continue to transact in euros held outside Greek jurisdiction.
This is the so-called “problem” of capital outflows. Yet these outflows are not a problem for ordinary Greek citizens. For them these outflows are a solution to the problem of an inflationary national currency. Moreover, capital outflows are already occurring. The discussion in parliament of a Greek exit would only speed up what is happening already.
The opposite reasoning applies when a more solvent country like Germany discusses an exit from the eurozone. If people expect an appreciation of a newly introduced currency, there would be capital inflows into Germany. The money supply of euros within Germany, which would later be converted into a new currency, would increase. Prices of German assets (e.g., housing and stocks) would increase in advance of the actual German exit, benefitting the current owners of such assets.
A Systemic Banking Crisis
Finally, there may be negative feedback for the banking system as there will most likely be losses for banks both domestic and foreign., Eichengreen (2010) fears the “mother of all financial crises.” Due to connectivity, it does not matter if Germany or Greece leaves the euro. If Greece leaves the euro and pays back its government bonds in a depreciated new currency or defaults outright, there will be losses for European banks that could get into solvency problems. Similarly, if Germany leaves the euro, the implicit guarantee and support to the Eurosystem will disappear. The result may be a banking crisis in Greece and other countries. The banking crisis might negatively affect German banks. The banking crisis would also negatively affect sovereigns, due to possible bank recapitalizations. Other countries may be regarded as possible defaulters or exit candidates leading to higher interest rates on public debts. A systemic financial crisis infecting weak governments would be likely (Boone and Johnson 2011).
Recently, the IMF suggested that European banks face €300 billion in potential losses and urged the banks to raise capital. We should emphasize that the problem of bank undercapitalization and bad assets (most importantly, peripheral government bonds) does already exist in the EMU and will deteriorate without an exit.
It is almost impossible to leave the euro without already-unstable structures collapsing. Yet this collapse would have the beneficial effect of quickly purging unsustainable structures. Even if there are no exits from the euro, the banking problem exists and will have to be solved sooner or later. Potential bank insolvency should therefore be no argument against an exit. In the EMU taxpayers (mostly German) and inflationary measures by the ECB are momentarily containing the situation. An exit would speed up a restructuring of the European banking system.
At this point I would like to give the following recommendation for a solution of the banking crisis. There are important free-market solutions to bank-solvency problems.
- Banks with nonviable business models should be allowed to fail, liberating capital and resources for other business projects.
- A debt-to-equity conversion may put many banks on a healthy basis.
- Banks may collect private capital by issuing equity, as they are already doing.
A free-market reform has important advantages:
- Taxpayers are not hurt.
- Unsustainable banking projects are resolved. As the banking sector is oversized, it would shrink to a more healthy and sustainable level.
- No inflationary policies are used to sustain the banking system.
- Moral hazard is avoided. Banks will not be bailed out.
The Problem of Disentangling the European Central Bank
The Eurosystem consists of the ECB and national central banks. The task of disentangling is facilitated because national central banks still possess their own reserves and have their own balance sheets. Scott (1998) argues that this setup may have been intentional. Countries wanted to retain the possibility of leaving the euro if necessary.
On January 1, 1999, the ECB started with capital of €5 billion. In December 2010 the capital was increased from €5.76 billion to €10.76 billion.
Only part of all EMU reserve assets have been pooled in the ECB, making a disentangling easier. On January 1, 1999, national central banks provided €50 billion in reserve assets pro rata to their capital contribution (Procter and Thieffrey 1998, p. 6). National central banks retained the “ownership” of these foreign reserve assets and transferred the management of the reserves to the ECB. (Scott 1998, p. 217). In the case of an exit, both the return of the contribution to the ECB’s capital and the foreign assets transferred to the Eurosystem had to be negotiated (Anthanassiou 2009).
Similarly, there is the problem of TARGET2 claims and liabilities. If Germany had left the EMU in March 2012, the Bundesbank would have found TARGET2 claims denominated in euros of more than €616 billion on its balance sheet. If the euro depreciated against the new DM, important losses for the Bundesbank would result. As a consequence, the German government may have to recapitalize the Bundesbank. Take into account, however, that these losses would only acknowledge the risk and losses that the Bundesbank and the German treasury are facing within the EMU. This risk is rising every day the Bundesbank stays within the EMU.
If, in contrast, Greece leaves the EMU, it would be less problematic for the departing country. Greece would simply pay its credits to the ECB with the new drachmas, involving losses for the ECB. Depositors would move their accounts from Greek banks to German banks leading to TARGET2 claims for the Bundesbank. As the credit risk of the Bundesbank would keep increasing due to TARGET2 surpluses, the Bundesbank might well want to pull the plug on the euro itself (Brookes 1998).
Intellectual honesty requires us to admit that there are important costs to exiting the euro, such as legal problems or the disentangling of the ECB. However, these costs can be mitigated by reforms or clever handling. Some of the alleged costs are actually benefits from the point of liberty, such as political costs or liberating capital flows. Indeed, other costs may be seen as an opportunity, such as a banking crisis that is used to reform the financial system and finally put it on a sound basis. In any case, these costs have to be compared with the enormous benefits of exiting the system, consisting in the possible implosion of the Eurosystem. Exiting the euro implies ending being part of an inflationary, self-destructing monetary system with growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty.
-  Reiermann (2011) discusses rumors of a possible Greek exit. Desmond Lachman (2011) maintains that Greece exit from the eurozone is inevitable. Feldstein (2010) recommends that Greece take a “holiday” from the euro. Johnson (2011) and Roubini (2011) recommend that Greece leave the euro and default. Alexandre (2011) and Knowles (2011) wonder how a Greek exit could be achieved. Edmund Conway (2011), on the contrary, thinks that Germany should leave the eurozone. David Champion (2011) also considers the possibility of a German exit.
-  Smits (2005, p. 464) writes, “There is no legal way for a separate exit from the eurozone. So, an intention to give up the single currency can only be realized by negotiating an exit agreement, or, failing successful conclusion thereof, leaving [the EU altogether] after the two-year notice period.”
-  Anthanassiou (2009, p. 19), in contrast, argues that no country can leave the eurozone in protest.
-  Mann (1960) maintains that if it is unclear which currency should be applied, the courts should use the law specified in the contract. So if the bond of the German company is sold in Paris under French law, the contract would be paid in euros. Porter (2010, p. 4) reaches the same conclusion.
-  Thieffry (2011, p. 104) fears a “serious legal dislocation of government bond markets and a long period of uncertainty.” Problems for irresponsible governments to finance deficit spending might actually be seen as advantageous.
-  See Newsat (2001).
-  The argument of increased competitiveness via depreciation has more fundamental problems (Rallo 2011, p.158). While it is important to lower some prices vis-à-vis the foreign world (e.g., wages in some sectors), depreciation lowers all prices to the same extent. Moreover, it makes imports more expensive. If a country has to import commodities and goods that are later exported, the depreciation may not increase competitiveness at all.
-  The authors estimate the costs for “weak” countries to leave between €9,500 and €11,500 per person and €6,000 to €8,000 per person for “strong” countries. The authors contrast these numbers with the relatively small cost of €1,000 per German in the case of a 50 percent haircut on Greek government debt. These estimations neglect some important benefits of exit and exaggerate the costs. For instance, they do not take into account the long-term costs of a fiscal union, nor the higher inflation. Moreover, they assume that the “strong” leaving country would have to “write off its export industry” and civil disorder in weak countries, while the possibility of such disorder it actually higher staying within the eurozone.
-  On the history of the political project of the euro as a means toward a central European state see Bagus (2010).
-  Flury and Wacker (2010) estimate one year of transition to fully establish the new currency.
-  An alternative solution would be to stamp all notes in the exiting country within a short period of time. Yet, there is the problem of massive inflow of notes or a population that does not bring in their notes to be stamped due to fear of future depreciation. Thus, we regard the exchange of notes bearing the national letter more practical, even though some of the notes are circulating in other EMU countries.
-  Smith (2005, p. 465) points to the instability caused by speculations about an exit: “even the threat of withdrawal will affect the euro stability and may lead to speculation against the single currency.” Scott (1998, p. 211) argues that speculation on which country is to leave may lead to a breakup of the eurozone.
-  Porter (2010, p.6 ) depicts the following scenario: If Germany is expected to introduce a strong currency. banks will transfer deposits to Germany. They could lend at the marginal lending rate of their central banks and deposit at the Bundesbank. The Bundesbank balance sheet would expand substantially. Porter suggests a surprise shut down of the TARGET2 system.
-  Another alleged problem is contagion. If one country leaves the eurozone, investors may sell the debt of other weak EMU governments and their banks triggering more exits. The contagion problem does not concern us here, because we want to discuss the possibility of exit. If exit is possible and desirable, contagion is no insurmountable problem but may even be recommendable.
-  As Porter (2010, p. 5) points out, an exit would result in a currency mismatch of many companies and banks. Suddenly they would have assets or debts denominated in a foreign currency with a changing value resulting in windfall profits or losses. As Germany has a net foreign-asset position and an exit would likely lead to an appreciation of the new German currency, losses would result. The losses would damage balance sheets.
-  Flury and Wacker (2010) discuss this and other problems related to a German exit from the euro.
-  See Reddy (2011).
-  One may also ask whether a country should have rejected the possibility of secession from the Soviet Union in fear of banking problems.
-  For a detailed plan and critique of the 2008 bailouts, see Bagus and Rallo (2011).
-  Ideally, this conversion would be voluntary. If bank creditors are unwilling to convert their investments into equity, the bank would have to be liquidated with high losses due to fire sales. Thus, there is an incentive for creditors to convert bank debts into equity, if the business model is be viable. Doing so they can prevent the higher losses from a liquidation. On the contrary, Buiter (2008) has suggested an involuntary, across-the-board debt-equity conversion. This measure is unnecessary if we allow for bank failures.
-  The Bundesbank capital share is 27.1 percent. The paid up capital is €1.4 billion. (The Bundesbank’s capital share is 18.93 percent including both eurozone and noneurozone members.)
-  A depreciation of the euro implies a loss of almost €100 billion.
-  Note that the claims or liabilities in the TARGET2 system are not against other national central banks, but a single net bilateral position is established vis-á-vis the ECB only (Whittaker 2011). See also Bundesbank (2011b, p. 34).
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This article was previously published at Mises.org.
This is a very well written and researched article however there is on point I want to pick you up on.
“Finally, there may be negative feedback for the banking system as there will most likely be losses for banks both domestic and foreign.”
It is possible that systems analysis will have lost control of its terminology before much longer. What you are discribing is possitive feedback!
Possitive feedback accentuates an anomaly
Negative feedback corrects an anomaly
In the context of banking and stock markets negative feedback is a “good thing” that stabilises markets. Possitive feedback is a “bad thing” that can cause systemic breakdown.
Hello Prof. Bagus,
You wrote in you Mises piece, to which you link:
A government like the Greeks’, with high deficits, prints government bonds bought and monetized by the banking system. As a consequence, there is a tendency for prices to rise throughout the monetary union. The higher the deficit of a government in relation to the deficits of other countries, the more effectively it can externalize the costs of a deficit. The incentives of this setup are explosive as governments benefit from deficits higher than those of their eurozone neighbors.
Is this really the case? If what you’re saying is correct, then what the politicians tell us – that a monetary union cannot exist (with a central bank) without fiscal union would be correct. I always thought this to be a lie to suit their own political purposes of promoting fiscal union at every turn.
Given that it is not the central bankt that is monetising the bonds issued by the various nations (in this case Greece), but rather the banks themselves, surely there is room for the banks to price the bonds of the different governments accordingly? This should, therefore, limit the ability of the various member governments from expanding too much. The reason it did not happen this way was – therefore – a result of an assumption by the private sector that the profligate governments would be bailed out by the more disciplined ones. Hence periphery country bonds were priced at the same level as core, allowing the periphery to expand the public sector and for the private sector to become increasingly uncompetitive.
Surely if the private sector was told from the off: in no case will we ever bail out Greece, then the system could have functioned more effectively?
Frankly, I don’t think any system based on fiat currency, government debt and crony banks will ever function effectively.
The purpose of such a system is to centralise political power and the financial resources needed to support it. Since this type of system is fundamentally based off of fraud and theft it sews the seeds of its own eventual destruction regardless of what the banks are told up front.
Such a system is unsustainable because it operates at odds with economic reality.
I broadly agree with the directiong of what you’re saying Robert. However, I am still puzzled by what Prof Baggus writes in that the pricing of the government bonds for individual nations has not historically been directly influenced by a central bank or by a foreign government, but rather by assumed implicit support by private actors. I would hope he’d be able to clarify.
Comments are closed.