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Thursday, February 24, 2011

Studying the cost of Greece leaving the euro

The "European Economic Advisory Group", CESifo, is a joint venture by two of Germany's most respected research institutions. Earlier in the week, it published an interesting report examining the various potential policy responses to the eurozone crisis.

One of the authors is CESifo Director and heavyweight economist Dr. Hans-Werner Sinn (pictured). When he speaks, Germany listens.

Here are some of the key points in the report:

On establishing a permanent "transfer union" - in which taxpayers in stronger economies subsidise weaker countries, such as happened between Western and Eastern Germany - the report notes:
The persistent flow of public funds has in the end helped eastern Germany only a little, if at all. It has made it another European Mezzogiorno – a region stuck in a low-development equilibrium.


Whether the EU budget should be expanded for this purpose is a distributional question that will have to be decided by the political process. Politicians should not overlook, however, that there is the risk of Greece becoming addicted to the transfers, since it seems to have become addicted to the capital flows of the past.
It warns against the harmonisation of wages across the EU, citing regional differences in Italy as an example:
The Italian Mezzogiorno has been caught in such an equilibrium for half a century and more. Its GDP per capita is about 60 percent of that of the rest of Italy and does not show any sign of convergence. In Italy, the causes for this situation can be sought in a common wage policy, mainly dictated by the conditions of the North, which has always resulted in wages that were way too high for the South and resulted in persistent mass unemployment.

The under-development has forced the state to help out with transfers from the North. These transfers have provided an alternative income source in the South to which the political system and the economy have grown accustomed, perpetuating the situation, as it seems, even more.
They also explore the alternative to a transfer union - devaluation.

There's a distinction between internal and external devaluation. The former means tough austerity measures and squeezes on wages and jobs at home, as in Latvia (whose economy, as CESifo notes, shrunk by 19 percent in 2009).

The other option is external devaluation, which would involve Greece leaving the eurozone. From page 118 onwards, the report looks at such a scenario, with special focus on Greek banks. They note that if Greece did decide to leave the eurozone there would undoubtedly be a bank run, amongst other problems, therefore the ECB would probably need to guarantee all Greek bank deposits.

After demonstrating that Greece would take a big hit should it embark on external devaluation and head for the exit, they make an important observation: Greek banks might suffer just as much if no devaluation occurs, while private sector companies would be clear winners in the case of an external devaluation:
As Greek banks are net borrowers abroad and net lenders at home, the external depreciation will probably hurt them by shrinking the eurovalue of their assets more than shrinking the eurovalue of their liabilities.

However, this analysis forgets the additional write-off losses on claims against the companies of the real economy that will be driven into bankruptcy after an internal depreciation. If these write-off losses are taken into account, it is not clear whether banks fare better after an internal depreciation than after an external one. It is only clear that companies of the real economy will fare better after an external depreciation.

In view of these uncertainties in the analysis, the EEAG has decided not to opt for a particular policy alternative but only to inform policymakers of the relevant arguments. Definitely, there is no alternative that clearly dominates the other in all dimensions.
This is not a call for Greece to leave the eurozone, but the distinguished economists are clearly toying with the idea - though stressing that every scenario involves huge costs.

Meanwhile, FAZ today reports today that more than 200 German Professors, amongst them Dr. Sinn, have warned in a petition to the German Government, against extending the eurozone bailout. They call upon the German government to prepare
for a possible failure of the eurozone aid scheme and (...) prepare a detailed insolvency plan for eurozone countries with excessive debt
This is the only way, they argue, to avoid
collectivising the debt of member states, which leads to higher taxes and higher inflation in the EU as a whole.
It's not getting any easier for Angela Merkel.

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