Euro wreckage reloaded

This post is a guest contribution by Joachim Fels* of Morgan Stanley.

A pyrrhic victory… The joint euro area/IMF financial backstop package and the ECB’s recent climb-down on its collateral rules have clearly reduced the short-term liquidity risks for Greece. However, as our European economists have emphasised, long-term solvency risks remain firmly in place. More broadly, and more worryingly, recent developments significantly raise the (long-term) risk of a euro break-up, in our view.

… which gives rise to moral hazard: The bail-out and the ECB’s softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time.  If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union. And because the Maastricht Treaty does not provide for the possibility of expelling euro area members, the only way how Germany could achieve this would be by leaving the euro to introduce a stronger currency.

Seceding to revalue is easier: It has been our long-standing view that such a break-up scenario – where a country or a group of countries want to leave to introduce a stronger currency – is more likely than a scenario where a country wants to leave to devalue. The reason is that the costs of leaving to devalue are extremely high.

• First, borrowing costs for the seceding country would likely rise significantly as investors will demand a currency and inflation risk premium.

• Second, while contracts between parties in the seceding country could by law simply be redenominated in the new currency, redenomination would not easily apply to cross-border contracts. Foreign creditors would still demand to be repaid in euros (‘continuity of contract’). Thus, a country that secedes and devalues would still have to honour its foreign-held debt in euros and would thus face a rising debt burden.  If it decided to default instead, it would, at least for some time, be totally shut off from foreign financing.

• Third, a country that decided to leave the euro to devalue would immediately face a bank run by domestic depositors who would want to shift their funds into banks in other euro area member countries. This would provoke a financial meltdown which could only be prevented by a freezing of bank deposits and the imposition of strict capital controls.

By contrast, none of these costs would apply for a country that wanted to secede in order to revalue. Its borrowing costs would likely fall rather than rise as it would attract an inflow of funds.

How it all started… None of these deliberations are new. In fact, we first started to worry about a potential euro break-up along these lines in 2003-04 in a series of notes (see, for example, Euro Wreckage? January 22, 2004, and Debating ‘Euro Wreckage’, February 9, 2004, with a reply by Noble laureate Robert Mundell).  Back then, it had become increasingly clear that the move towards political union in Europe had stalled, partly because the EU has simply become too large and diverse a club due to successive enlargements.  Moreover, the old Stability and Growth Pact (SGP), which was meant to ensure fiscal discipline within the euro, was effectively buried in late 2003 when both Germany and France kept violating the 3% budget deficit limit