Put the euro zone out of its misery

November 9, 2011

By Laurence Copeland. The author is a professor of finance at Cardiff University Business School. The opinions expressed are his own.

Let me make a wild guess – just a hunch, a vague feeling, the kind you get when you hear a football club chairman say “the manager has my full support”. My forecast is that the IMF monitors currently poring over the Italian government’s books will uncover a black hole somewhere, probably one big enough to swallow the euro zone, and the discovery will leave them as shocked as Captain Renault when he found there was gambling going on at Rick’s Bar in Casablanca.

My gut feeling is based on a deeply rooted suspicion of Italian statistics dating back to the early 1970’s, when I got my first job in academic life, as a research assistant in the University of Manchester. In that more tranquil era, it seemed possible to uncover a number of stable relationships between macroeconomic variables for all the other countries in the industrial world, but somehow never for Italy, which was always the outlier. Suspicion of the data is reinforced by the well-established claim that as much as 25 percent of Italy’s production is in the economia sommersa, the underground economy, exempt from taxation, unmonitored and unregulated (in fact, the Italian authorities have sometimes seemed to take a pride in its size, notably in 1987, when by a sleight of the statistician’s hand, Italy’s GDP was deemed to have overtaken that of Britain, thanks to an overnight reassessment of the scale of the country’s black market).

Even if Italy’s predicament is no worse than it appears from official statistics, the outlook is grim. It is hard to imagine a Berlusconi-led government successfully enforcing a serious austerity regime, but neither is it likely that an opposition dominated by ex-Communists could succeed where he failed. Moreover, as with Greece, those who are enthusiastic for a non-partisan administration made up of technocrats forget that mustering support in parliament is not enough. Restoring Italy to fiscal health will need a government able and willing to enforce spending cuts, raise taxes (or at least collect them more vigorously) and deregulate labour markets in the face of bitter and potentially violent opposition from trade unions, the professions and probably much of the public. It is not obvious to me that a government of supposedly neutral technocrats is better placed to achieve all this.

With a total debt of nearly two trillion euros, even a relatively modest haircut for Italy would be ruinously expensive to the European Financial Stability Facility (EFSF), and a Greek-style coiffure of 50 percent or more would use up all the additional funding promised (but not yet delivered). Moreover, there would be devastating consequences for the creditworthiness of the core countries — France in particular, but even Germany, and of course for all the major European banks.

For months now, commentators have been urging the EU authorities finally to get ahead of the curve, something they have repeatedly failed to do in the case of Greece. They began by refusing to admit the need for a bailout, then denied the inevitability of a partial default, then were forced to recognise the need for a 20 percent haircut, and have now been reduced to begging Greece to accept a 50 percent writedown, an offer which will still leave the country facing a crippling debt-to-GDP ratio for a decade or more and which may be rejected anyway — in which case we will end up with a disorderly default after all.

The same sort of slow-motion trainwreck with Italian debt will sink Europe’s (and possibly the world’s) banking system – yet the authorities in Brussels and Frankfurt seem set on that course. To those who ask whether we face another Lehman Brothers, the answer is yes – and probably worse than in 2008.

There is no real solution to the euro zone’s problems. By now, it is obvious that there is only one way out of the mess, and that is by putting the euro zone out of its misery once and for all. It has been an avoidable, totally predictable catastrophe, created by the wishful thinking of politicians ignorant of economics employing economists ignorant of politics.

What comes after the euro?

There is a lot of loose talk of the new architecture being a Europe divided into Northern and Southern blocs. I can certainly imagine a German bloc including Netherlands, Austria, possibly Finland, and maybe Denmark, but would the ClubMed countries really be willing to accept the discipline needed to preserve a common currency for the South? I doubt it. And where would France fit into this structure?

My guess is that we are going to end up back where we started, with a free-for-all of floating exchange rates for all countries, so we may as well start preparing now. The question is how to manage the transition.

Unfortunately there is no chance of a smooth touchdown in a post-euro zone world. But as the markets are turbulent in any case, and will continue to deteriorate as long as investors have to peer into the future through a fog of uncertainty, there is far less to lose by openly planning a dissolution of the union than is often implied. In fact, by reducing the uncertainty, mapping the road ahead might actually help to calm the markets a little.

The way forward should start with an announcement by Germany that it is going to relaunch the deutschmark (DM), leaving other countries to decide for themselves whether they want to stick with euros or revive the legacy currencies. At the same time, the EU needs to outline a plan made up of three key elements: the blueprint of a transition mechanism, arrangements for recapitalising the banks and, most importantly, a firm commitment to maintaining the integrity of the single market in labour, goods and services.

There is no need to replace the euro. As long as the ground rules are clear, the markets will establish an exchange rate between the two currencies which can provide a basis for converting assets to the new regime. (In fact, if the euro had been introduced as an option alongside the old currencies in the first place, it might well have been a success.)

In the meantime, the European Central Bank (ECB) and the other acronyms established in the last few months have to stop throwing money at insolvent governments, leaving it up to each member country to decide for itself whether it is able or willing to stand the pain of repaying its debts in full (as Greece is deciding right now anyway). The ECB should instead concentrate its firepower on recapitalising Europe’s major banks, if necessary swapping debt for equity, and possibly buying euro-denominated debt from the private sector, which will suffer if or when the euro’s value collapses in advance of the changeover.

Without the euro zone, it is often said that German industry would be unable to cope with a strong DM relative to a weakened rump-euro or a relaunched franc and lira and a pound which has already fallen in value, and may yet fall further. This is the other side of the frequently heard argument that Germany has derived enormous benefits from the euro zone. Yet if this is your worry about Germany, you should by the same token be very optimistic about the prospects for Greece if or when it reverts to using the drachma.

Germany may indeed have problems in the immediate aftermath of a euro-zone breakup, but logic, experience and academic research all suggest that, in the long run, exchange rates make little difference. The benefits to competitiveness from devaluation and the damage from revaluation are eroded quite quickly, so that after about five or six years, inflation or deflation take things back to where they started, other things being equal. If this were not the case, Italy’s eternally weak lira would have made it the strongest economy in Europe while Germany would have been the weakest – and the Swiss would by now have been reduced to eating Alpine grass. In the end, it is the Casablanca Model: the fundamental things apply …as time goes by.

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