Wednesday, December 22, 2010

Four scenarios for the euro

FT Deutschland last week outlined what it considered the four possible scenarios for the eurozone in 2015, in a thought-provoking piece.

Here are the scenarios, slightly paraphrased from the original article.

Business as usual, punctured by crises:

The EU continues to fight the symptoms, rather than the causes. Attempts at improving coordination of economic policies amongst member states fail, as EU leaders cannot agree on a single approach. In the summer of 2011, France tables a proposal for a centralised economic government. The German Chancellor, who has suffered a very heavy defeat in regional elections in Baden-Württemberg in March 2011, declares to the German Parliament that such a government won't include Germany.

In early 2013, Greece is again shut off from the markets. The EU and IMF extends the loan guarantees, fearing that a debt restructuring would be too dangerous.

Subsequently, the eurozone aid package is multiplied by 10, which calms the markets - but only until autumn 2015, at which point the Spanish government collapses because reform of the country's pension system is blocked by the Parliament. The euro falls 5 percent in one day.

Barroso makes an emergency call to Merkel...

Probability: 50 percent

A stronger economic union:

At an EU summit in February 2011, Chancellor Merkel declares that "we need to become a real economic and political union, at least within the eurozone". Everybody understands that the UK will not take part in this. Measures include joint decisions by the German and French government on their national budgets, and more harmonisation of fiscal policies in the eurozone, including on taxes.

Portugal needs to be bailed out, but Spain only needs a one-off loan in May 2011 in
order to fight off speculation. The ECB buys more government debt and waits as long as it possibly can to increase interest rates.

By 2015, there's a de facto two-speed Europe, with some of the EU's by now 29 member states opting out of the economic union. The European Stability Mechanism (ESM) has evolved into a mix between a European Monetary Fund and a Eurozone Finance Ministry. The European Commission, which now has new economic powers, continues to suffer from a lack of democratic checks.

Interestingly, FTD claims that this arrangement would benefit the German economy as EMU and the internal market would remain intact. Eurozone growth would increase overall, as struggling countries overcome austerity shocks. We see it as unlikely that overall eurozone growth would receive a boost in this scenario, since even with austerity and/or even competitiveness reforms, the periphery economies will still be stuck with an overvalued currency and inappropriate interest rate policy, undermining their efforts to gain competitiveness.

Probability: 50 percent

‘Mild’ break-up of the eurozone in two separate blocks:

Rome, December 2015. With a huge smile, Italian PM Silvio Berlusconi gets out of his Lancia limousine, stopping for a brief moment to pose for the cameras. He has just had a visit from his counterparts from Slovakia, Spain, Portugal, Greece and Slovenia in his villa in Sardinia. He announces that their common southern currency "Seuro" will be renamed "Silvio". At the same time, he announces, the currency will be devalued yet again - which has been a frequent occurence since the eurozone split up in 2011.

The break-up took place after growing spreads in bond yields made it impossible to save the euro. The event was dubbed "Lehmann II" by the media.

The continuing devaluations of the Seuro anger German Chancellor Merkel and French President Strauss-Kahn, as exports from Northern Europe are hurt and European banks face persistent problems. Axel Weber, President of the Central European Central Bank, raises the issue with his Southern European colleague Mario Draghi.

Probability: 5 percent

The assessment of this solution for the eurozone seems to ignore some important factors. In particular, the assumption that revaluation would inevitably be a bad thing for Germany is something that can't be accepted at face value. As Frankfurter Allgemeine Zeitung has put it : “Already before the introduction of the euro, Germany was a strong exporting nation. Continuing revaluations of the D-Mark stimulated German companies to become even more productive. For citizens every revaluation brought welfare gains, as imports and travelling became cheaper."

Collapse of monetary union:

All countries return to their national currency. An unemployed Dutch person, who used to work for an import-export firm in Rotterdam, drives to Greece, passing by 11 currency zones: the Dutch Guilder, the Flemish Guilder, the Walloon-Luxembourgish Franc, the German-Austrian D-Mark, the Italian Lira, the Slovenian Tolar, the Croatian Kuna, the D-Mark pegged currencies in Bosnia, Montenegro and Macedonia, and the Nea Drachma.

The break-up happened in 2012, following an ultimatum by Greek PM Giorgos Papandreou to Chancellor Merkel on lowering interest payments on the bailout - or his country would leave the currency union. Merkel's reply: "well, then go".

However, the Chancellor was not aware that China had just opened a €20bn credit line to Greece, while Nea Drachma notes were being printed in China. In July 2012, Greece starts negotiations for its debt restructuring, forcing the ECB and German government bank KfW to write off billions.

Panic on the markets lead to CDU leaders demanding that all struggling countries leave the euro. German Finance Minister Schäuble resigns. Merkel, who makes an attempt at keeping a Northern Eurozone, sets out hard terms for France. New French President Strauss-Kahn refuses, deciding that his country will keep the name euro for its currency, with Southern-Belgium and Luxembourg pegging their new Franc to it.

Chaos breaks out, with investors seeking refuge in hard currencies, while banks and the provision of cash are under threat. Devaluations in the south of Europe lead to an increased debt burden for the region - a debt that is still denominated in euros. Living standards of Europe's population in the south sinks. In Germany, the export sector is hit, though imports become cheaper and inflation is low.

Probability: 10 percent

This is a useful and quite interesting exercise, which should, of course, be taken with a pinch of salt. The FTD depicts the political union alternative with rose-tinted spectacles, but these do seem like the four possible scenarios for the future of the euro. One thing is clear: none of them will be painless. Apart from blaming the politicians who speculated with Europe's future by setting up a monetary union with clear flaws and without thinking through all the implications, the least expensive long-term solution to the ongoing euro crisis should prevail. As we've argued before, it's hard to see how this will not involve an adjustment to the membership of the euro.

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