Breaking Up is Hard to Do: the Euro and the Credit CrisisPaul Donovan, Stephane Deo and Sophie Constable, UBS, London.
This article appeared in the November 2008 issue of Current Economics with permission of the author.
Key Concepts: Monetary Union | Euro | Optimal Currency Area |
Key Economies: Euro Zone |
As the financial crisis has continued to play out, one question has been raised in more and more investor meetings (around 80% of meetings in Asia, during a recent marketing trip): “Will the Euro break up?” We believe that this question is being driven by the fact that the crisis has highlighted (again) some fundamental problems in the structure of European Monetary Union, and also by the fact that the crisis is encouraging investors to “think the unthinkable”.
The Problem at the Outset
At the very outset of European Monetary Union (EMU), economists identified two potential problems with the project. On the basis of most analysis, EMU was not an “optimal currency area”; that is to say at least some participants were likely to enjoy stronger growth outside of the union than within it. In addition, EMU failed to provide a clear lender of last resort function; those institutions with responsibility for defending the banking system (the national central banks) had finite resources, and the institution with the resources to deal with any banking crisis (the European Central Bank) was prohibited from doing so.
The credit crisis has brought both of these problems to the forefront of many investors’ minds. Questions about a break-up of the Euro have been raised more frequently in the last six months than at any time since the introduction of the physical notes and coins.
We must acknowledge that the relative costs of staying within monetary union have risen as a result of the current crisis and — critically — as a result of policy makers’ responses to the crisis. However, those costs remain infinitesimally small when set against the economic and political costs of breaking up the Euro, or seeking to secede from it. Rather than looking on the current crisis as something that may rend the Euro asunder, we believe that the crisis means that the Euro is unlikely to expand its membership in the future. At the very least it seems unlikely that the Euro will readily absorb any large economies. Denmark may seek to join, reflecting the well known costs of maintaining a currency peg arrangement (which will always entail a higher domestic interest rate than is necessary). Countries unencumbered by any attempt to maintain a Euro peg are likely to have less incentive to join, and / or be less welcome as members in the wake of the current financial problems.
Why Break Up? Optimal Currency Area Arguments
A monetary union is, economically speaking, a “good” idea if the membership constitutes an optimal currency area. This occurs under one of two conditions. Either the area is so homogenous that the component economies all move in the same direction at roughly the same speed, at the same time. Alternatively, the economies are sufficiently flexible that any differences in economic performance can be relatively swiftly corrected.
An optimal currency area is a necessary condition for an economically beneficial monetary union, because a monetary union entails a single monetary policy. Thus, if a majority of the monetary union require an interest rate increase, the minority of the monetary union will have to accept the economic consequences of that interest rate increase whether they “need” higher interest rates or not.
It has been clear from the outset that the Euro area as currently constituted is not an optimal currency area. Indeed, since the inception of the Euro, the economic performance of the component states has tended to diverge. This means that, for some participants at least, monetary policy would be more appropriate if set at a national rather than a pan Euro area level.
The credit crisis has hit the Euro area as an asymmetric shock. Different countries have differing degrees of economic exposure to the crisis. In Spain, indebtedness has escalated rapidly (in part because of Euro participation), leaving the country vulnerable to the interest rate cycle. The fact that domestic mortgage rates are commonly tied to Euribor has left the economy peculiarly vulnerable. Germany is exposed to the weakness of international trade, a slowdown in investment and the shaky state of Eastern Europe. France is far less exposed to either problem. The result is that the French economy’s deterioration in 2009 is half that of Spain, and almost half that of Germany.
These economies seek different policy prescriptions. For Spain, efforts to reduce interest rates would be most advantageous (not as a means of encouraging new borrowing, but as a means of reducing the policy drag that is currently acting on existing borrowers). Germany is, perhaps, more focused on the exchange rate as a means of compensating for economic weakness. France has less need for either form of stimulus (though of course does require some stimulus given the weakness of growth). The divergence persists for the smaller economies of Europe — one can imagine Ireland is casting somewhat covetous glances at the agility with which the Bank of England has reduced interest rates to salve the wounds of the credit crisis. The somewhat stodgy response of the ECB is not especially helpful for Ireland.
The economic burden of membership of an unsuitable monetary policy is not something that can be lightly dismissed. The US monetary union fragmented to all intents and purposes in the early 1930s, as the pain of the New York Federal Reserve’s interest rate policy raised the economic costs for some parts of the union. The NY Fed was pursuing a relatively restrictive monetary policy in order to bolster the gold standard position of the dollar. Meanwhile, in the agricultural states, state legislatures passed laws prohibiting interest rates above specified levels — so that a dollar in New York was potentially more valuable than a dollar in an agricultural state. The economic pain of the agricultural states led to a splintering of monetary policy — and it took considerable political will (and reform of the Federal Reserve) to glue the monetary union back together.
Why Break Up? Lender of Last Resort Functions
The Euro created an awkward anomaly from the start. Responsibility for monetary policy lies with the European Central Bank, but responsibility for the banking system lies with the national central banks (the NCBs). This means, in extremis, that Europe lacks a credible lender of last resort.
It should be stressed that this does not mean that the European Central Bank (ECB) has failed to provide adequate liquidity to the market. Clearly that is not the case — the ECB has been early and generous as a provider of liquidity. However, the point about a lender of last resort is that they can offer the ultimate guarantee of deposits, even for insolvent institutions. An effective lender of last resort will be able to print the money to ensure depositors get their money back. The ECB can not do this — it can inject liquidity into the banking system, but it needs to get (less liquid) assets in exchange for the liquidity it provides.
An NCB, or indeed the national government of a Euro area participant, can not provide the banking system with a limitless guarantee. The credibility of any banking system guarantee is bounded by the limits of the government or NCB’s own resources. There is a finite amount of Euro cash available to the national institutions, and the printing press can not be turned on to meet the shortfall (because the ECB controls the printing press). Again, it is important to note that this does not mean that the banking guarantees from European governments are redundant. They are useful, up until the bound that is created by the level of Euro resources.
This means that there exists an obvious and unfair arbitrage opportunity within the Euro area banking system. Backing for a bank is only as good as financial markets’ perception of the government’s strength. Thus, a relatively strong bank (implicitly or explicitly) backed by a government that is perceived as having a weak financial position is at a competitive disadvantage. A weak bank backed by a strong government is at a competitive advantage. Clearly, the issue of differentiation is only present at the extremes of perceptions about government credit worthiness — but some anticipation of that may well creep in.
What effectively is happening is that the Euro Area’s structure encourages credit rating of the national banking system and the national government converge on some intermediate point — which of course varies from country to country. In some respects, this is a milder version of the Icelandic problem — the Icelandic banking system having liabilities in non-Icelandic currencies. Iceland’s sovereign credit rating deteriorated as it sought to guarantee the domestic banking system, because Iceland had limited access to the foreign currency necessary to bail out its banks. Iceland can not, of course, “print” foreign money in order to meet any shortfall.
Euro area participants can not “print” Euros, and to that extent are in the same position as Iceland with regard to “foreign” currency liabilities. However the Euro area problems are less acute than those of Iceland. Euro area participants have the power to tax in Euros (Iceland can not tax its domestic citizens in Euro or sterling), and so have a wider scope for offering guarantees.
This compares with the situation in a country that retains monetary sovereignty. In this situation, one would expect the domestic currency rating of the banking sector to converge down to the domestic credit rating of government — which should be AAA, as the domestic government has the power to print money. The reaction of the credit rating agencies to unlimited printing of money in defence of a banking system may be to reduce the rating of the sovereign — but markets would in all likelihood ignore this and accept that the economy has unlimited resources to bail out its banks.1
Thus the price of Euro area participation in this instance is that the banking system’s credit is not as good as it would be outside of the Euro area, and the government’s credit may be adversely affected by domestic banking system guarantees.
Why Break Up? Debt Burdens
The final rationale for a break up lies with the dynamics of debt. Monetary union limits the ability of a government to offer stimulus to the domestic economy. Currency depreciation, which tends to boost profitability for exporters, is not an option (at least, not as far as the exchange rate of a Euro participant’s major trade counterparts are concerned — for there is no possibility of realignment within the Euro). Monetary policy is in the hands of an institution that may be charting an entirely unsuitable course for interest rates, when viewed from the perspective of the domestic government. The only recourse available to policy makers for economic stimulus is fiscal policy.
Recognition of this policy constraint was a key reason for the budget deficit limits of the Maastricht Treaty. However, with these constraints being (de facto) abandoned in the face of the worst economic outlook in a quarter century, a more significant problem now emerges.
Dependence on fiscal policy as the key domestic response to the external crisis raises with it the risk of a country pursuing an unsustainable debt trajectory. Thinking about this in terms of a debt to GDP dynamic — the level of debt continues to increase as the government attempts to stimulate the economy. Simultaneously, the monetary policy environment (potentially combined with an asymmetric shock) creates a drag on growth. The debt:GDP ratio then rapidly becomes an unsustainable dynamic. Credit downgrades raise the cost of domestic borrowing (because the Euro country can not print money, it has no automatic “right” to AAA status). The higher-than-optimal interest rate of a common monetary policy will generate higher short- term borrowing costs.
To some extent this is reflected in the divergence of government bond yields and of credit default swap rates.
Italy in particular has continued to see its spread over Bunds widen out. The level is nothing like that of the ERM crises (1992, for instance), although we should recognise that the pre Euro era should naturally generate wider credit spreads. While a country remains within the Euro, its bonds are acceptable as collateral by the ECB, which creates a limiting arbitrage opportunity if bond spreads widen too far.
Confronted with a situation of unsustainable fiscal dynamics, it is conceivable that an economy would consider leaving monetary union in order to restore a wider arsenal of policy options to stimulate growth. Alternatively, the country may prefer to secede to avoid the growth deflation that fiscal rectitude would entail within the Euro, in the absence of an independent monetary policy.2 Certainly, if default is increasingly likely within monetary union, the cost of defaulting by departing from monetary union (highlighted below) disappears in a relative sense.
It should be noted that an unsustainable fiscal position does not have to be resolved by departure from the Euro area. As we identify below, an alternative solution is that countries with stronger fiscal positions subsidise those with weaker fiscal positions.
Why Not to Break Up? The Legal Position
The legal position on a break up of the Euro is relatively simple: legally, there is no provision for a break up of monetary union. The Treaty of Maastricht that established the terms of EMU deemed the union to be irrevocable.
The key point here is that there is no way a weak state can be “forced out” of the Euro through the action of a stronger state (or group of stronger states). This lack of legal penalty was one reason why the Treaty of Maastricht established so many conditions as to the economic positions of member states.
This does not mean that a state can not leave the union. Members of the Euro area are sovereign states, and could chose to break or revoke the Treaty of Maastricht. To do so would, of course, have wide reaching consequences (discussed below). However, the key point is that the decision to depart lies with the departing economy or region.
Why Not to Break Up? The Cost of Leaving
Rationally, an economy would choose to leave monetary union if the costs of staying in exceed the costs of departure. Once a country has voluntarily surrendered its currency and its monetary policy independence to a common currency area, the costs of leaving that monetary union and establishing a new national currency (NNC) are huge. Some are certain, some merely probable. However, five of the main costs are summarised below.
1. Default on domestic debt
The second and more probable option is the forced conversion of Euro denominated debt into NNC debt. This would constitute a default in the eyes of most investors.
Default on sovereign debt — in either example — generates lasting economic costs as the long-term cost of capital for the government increases. The international cost of capital for domestic corporates is also likely to be impacted — not only because of the “sovereign ceiling” (corporates rarely have higher credit ratings than their domestic governments) but also because of the nature of the default. If the government is changing the currency of the country, it will (in all likelihood) force the change on the domestic corporate sector who will thus share the government’s default.
2. Collapse of the domestic banking system
Confronted with the obvious uncertainties surrounding the establishment of a NNC, the obvious response of anyone with exposure to the secessionist banking system is to withdraw money from the bank as quickly as possible. This could be done electronically — unless the government puts in place stringent capital controls. In that event, the wise depositor anticipating the creation of a NNC would withdraw their money in physical Euro form, pack it into a suitcase and head over the nearest international border — unless the government seals their borders to the movement of people. In that event, the sensible depositor would withdraw their money in physical Euro form, pack it into a suitcase and bury it in their garden. The only way that can be prevented is to shut the banking system entirely, or perhaps place a limit on the amount of withdrawals that can be made over the transition period.
The only real way to prevent a run on the domestic banking system would be the introduction of the NNC as a “shock” event, which was entirely unanticipated by the world at large. Given the enormous complexity involved in introducing a NNC, this is not a practical possibility.
3. Departure from the EU
Quite how severe the rupture would be is unclear. It may be that some negotiated agreement between the seceding state and the rest of the European Union could be kept in place.
4. Tariffs and protectionism
5. Civil disorder
Even if not driven to that extreme, it does seem unlikely that the domestic population would take the “debauching” of their savings and investments in a benign fashion. At the very least, widespread protests could be expected.
Leaving the Euro therefore suggests default on the national debt, the collapse of the domestic banking system, exit from the European Union (its legal structures, trade agreements etc), tariffs imposed against the country’s exports by its most important trading partners, and the possible break-up of the seceding country itself. This seems to be a relatively high cost. The cost of Euro participation has undoubtedly risen as a result of the credit crisis, but is still as nothing when weighted in balance against the anarchic potential of secession.
The Cost of Cooperation
If the current monetary union is to stay together, what is this likely to mean for existing participants? The default position should be that the union does hold together, but that there will also have to be some attempts to offset some of the rising costs of membership.
Changing the Institutional Arrangements
The failure of Europe to come up with a coordinated, far less a pooled response3 to the credit crisis is disappointing. A supranational response would have helped to offset the distinction between the ability of individual governments to bail out their banks, and lowered the costs of Euro membership. Indeed, the first thought of those that orchestrated the Euro was that a crisis like this would change the institutions of the Euro area (just as the crisis of 1933 changed the US financial system’s governance). Romano Prodi as Commission President declared “I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created” 4 (emphasis added).
In the absence of credible supra-national institutions, some individual countries will have to endure higher costs of borrowing — as identified earlier, economies are having to take on (on a contingent basis) domestic financial sector liabilities, without the power to print money to fund the demands for liquidity. It is noticeable, for instance, that Italy has shied away from comprehensive support of its banking system, perhaps fearing the domestic debt costs (Italy has, however, said that it will make sure no depositor loses money — effectively a piecemeal backing for the system that has yet to be tested).
This crisis may have come too early in the history of the monetary union. With a longer-lived Euro, it is more likely that the necessary institutional changes would have been undertaken (allowing, even obliging the ECB to act as lender of last resort, for instance). It is still possible that the current credit crisis will prompt some further revision of the Euro area financial institutions. At the moment the momentum seems to have stalled. Ultimately, we believe that there will have to be some attempts at a pan-Euro area lender of last resort, in order to mitigate the costs of domestic financial systems. This could include a Euro area banking regulator as well. Such cooperation on the financial system will not be easily achieved. Attempts to create common EU regulation for the insurance industry in the early 1990s were enormously time consuming, complex, and the effectiveness of the outcome can be questioned. If this crisis does not provoke a “federal” pan-Euro regulator, then the next crisis surely will, to lessen the unnecessary risk premium on the Euro area national governments.
Cross Country Fiscal Bail-Outs
The asymmetry of the economic shock does raise the possibility of cross country fiscal bailouts. Unsustainable debt trajectories for individual member states look increasingly likely, and as a consequence we would expect a de facto process of sharing the burden of debt. Wealthier countries’ taxpayers will have to contribute towards the fiscal deficits of the less disciplined (or the economically weaker).
This process happens in most established monetary unions, simply through the mechanism of a central fiscal policy and automatic stabilisers. Tax revenues from wealthier areas support social spending in areas that are suffering from economic weakness.
Without a process of cross border fiscal transfers being initiated, there are very severe costs being imposed on the more indebted economies of the European Union. This is not the same situation as the component States of the United States — while considerable fiscal power rests with the States, the pooled resources of the Federal government accounts for the majority of government spending and (critically) has undertaken the financial obligations necessary to bail out the major institutions of the financial system.
It seems unlikely that anything too direct can be initiated. German taxpayers are likely to baulk at the idea of directly transferring money to Italy, for instance. However, the façade of a centralised fiscal pool may help smooth the adjustment. If countries contribute to a central budget, which disperses money according to economic (or fiscal) need, then the blunt reality of the transfer of cash may be clothed in a more politically acceptable disguise.
Why Not to Expand?
The current crisis may increase the desirability of Euro participation for some economies. For a less developed economy of Eastern Europe, the desirability of lowering funding costs through participation in the Euro is considerable. Subsuming one’s national currency into the structure of the Euro also removes a source of currency volatility (and, of course, removes the attendant external market force discipline over domestic policy, which may be politically attractive). As such, these are attractive short- term gains that politicians may wish to pursue.
The short-term desirability of seeking entry into the Euro area comes up against two counter arguments: the long-term benefits of entry may not exist (or are less clear); and, the existing membership of the Euro area may not want additional participants.
The long-term costs of participation in the Euro remain, at least until there is further institutional reform of the Euro area. The more fragile an economy’s banking system (threatened by the Euro lender of last resort problem), or the more unsynchronised the structure of the economy (threatened by the sub-optimal currency area) the more potentially damaging Euro membership would be. There is nothing new in any of this, of course — though perhaps the current crisis has highlighted the problem.
What the current crisis should do, however, is increase concern among existing members about acquiring new partners in the Euro venture. The potential costs in terms of bailing out a banking system in Eastern Europe — or the damage to the collective whole (via the foreign exchange markets punishment of the Euro) if there is a serious financial crisis in a new Euro participant — make expanding the club a less attractive option. The Polish central bank, indeed, has suggested that Poland may need to consider its participation in the ERM II (a precondition for Euro participation), as a result of the crisis.
In addition, increasing the number of participants in the Euro is likely to increase the divergence of the economic experience. To the extent that this is not accompanied by an increase in flexibility this will make monetary policy less and less suitable for the existing participants of the Euro area. For example Spain (projected to experience negative growth in 2009 and 2010) is unlikely to welcome higher interest rates any time soon, just because the Polish economy enjoys a faster recovery in 2010.
In spite of speculation by investors, we do not believe that the Euro is likely to disintegrate or experience secession by any of its members. The current crisis has highlighted the pre-existing problems of the Euro area, and potentially raised the cost of membership. However, the cost of leaving the Euro is so high as to outweigh the inconvenience of participation.
The main impact of the crisis on the structure of the Euro seems likely to focus on three areas:
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