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Wednesday, January 21, 2009

Considerations to bear in mind

We had a feature on "Will the euro break up?" in both our outlook papers on "the EU in 2007" and "the EU in 2009". Recent reports include credit downgradings of Italy, Spain, Portugal, Greece and Ireland, calls for Ireland to leave the eurozone ,and coverage of how Spain has suffered from eurozone membership.

A new paper by Simon Tilford at the CER, titled "The euro at ten: Is its future secure?", doesn't mention how the euro has caused housing bubbles in Spain and Ireland, but is worth reading as it points at the "considerable" risks existing for the common currency. Revisiting arguments made in a 2006 report entitled, "Will the eurozone crack?", it says that "despite the current strength of the euro, and obvious advantages of a safe haven that membership provides at a time of financial turmoil, the concerns raised then are even more valid today."

Some excerpts:

"the growing divergence in competitiveness between the various members of the eurozone, and the extreme caution of consumers in Germany (and the Netherlands), mean that the imbalances within the eurozone have worsened substantially over the last two years. (…) When I wrote our 2006 report on the euro, the spread between the yield on German government debt and that of Italy and Greece was about 30 basis points (0.3 of a percentage point). As of early January 2009 the spread between Greek and German debt had widened to 220 basis points and that between German and Italian debt to over 140 basis points.”

“Greece and Italy are probably most vulnerable to such a loss of confidence. Both are inflexible and bear the weight of very high levels of public debt. So they are likely to have a battle on their hands to attract funds.”

It summarises:

“In short, too much attention has been devoted to the safe haven effect of eurozone membership, and too little attention to the impact of prolonged weak economic growth on fiscal solvency.”

Even clearer it is made here:

“Sterling has certainly weakened dramatically since the start of 2008, but the spread between the yield on UK debt and German bunds was just 5 basis points at the beginning of January 2009, lower than the equivalent for any member-state of the eurozone. (...) But the widening bond yield spreads within the eurozone highlight that membership is no panacea: membership insulates countries from the risk of a currency crisis, but currency risk can be replaced by credit risk.”

Tilford thinks that on the basis of these trends, a number of scenarios are possible, ranging from countries defaulting and leaving the eurozone in order to devalue their currency, to "faster political integration within the eurozone and a move to some kind of fiscal federalism.” The latter scenario he deems unlikely as it “would require big political shifts, not least in the richer countries that would have to share their fiscal credibility and provide direct financial support.”

Of the former he says:

“A decision to quit the currency union might not be as big a catastrophe as is sometimes predicted for the country in default. But there is no doubt it would be hugely damaging for Europe. A decision by one member-state to leave would probably trigger a chain reaction, with investors forcing other countries out of the currency union. That would do untold damage to the credibility of the EU. The single market could be severely damaged if the remaining members of the eurozone erected protectionist barriers against imports from countries that had created national currencies and embarked on competitive devaluations. European integration would suffer a devastating blow.”

Hard to predict what the political consequences would be of, say, Italy leaving the eurozone. However: is the UK harming the internal market now with its competitive devaluations attracting thousands of extra shoppers to London? Maybe to some extent, but surely not enough to let continental Europe close it trade borders for Britain.

Tilford thinks that the most likely scenario is almost certainly the first – wrenching fiscal retrenchment in hard-hit member states and some modest moves by Germany and others with large external surpluses to rebalance their economies. He might be right, but if Italy’s budget suffers more than expected from the economic downturn, which would make even the harshest budget cuts insufficient, we’re in a whole different scenario. Then Italy might well opt for the devaluation scenario (which is hard to execute from within the eurozone).

The paper expresses many valid concerns on the currency which is spanning whole different sets of economies. Still, however, Tilford mentions the CER "believes that the UK’s political interests would be served by joining". The considerations in this paper haven't convinced us of that, to say the least. Funny how supporters of giving the EU more power through the Lisbon Treaty are acknowledging the huge risks with that other grand EU project - the common currency.

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