Euro Trouble

Another sign the euro is in trouble: this week's Economist has an article on how a member country might leave the currency union.  It concludes:

The cost of breaking up the single currency would be enormous. In the ensuing chaos and recrimination, the survival of the EU and its single market would be in jeopardy. But by believing that a break-up cannot happen, the euro zone’s authorities will always tend to stop short of the radical measures needed to hold the project together. Given the likely and devastating chaos, it would be a mistake for a country to choose to leave. But mistakes occur in times of stress. That is why some are beginning to contemplate the unthinkable.

Germany may be the country that walks - the Guardian reports:

At the Brussels dinner on 28 October attended by 27 EU heads of government or state, the presidents of the European commission and council, and the head of the European Central Bank, witnesses said Papandreou accused Merkel of tabling proposals that were "undemocratic".

"If this is the sort of club the euro is becoming, perhaps Germany should leave," Merkel replied, according to non-German government figures at the dinner. It was the first time in the 10 months since the euro was plunged into a fight for its survival that Germany, the EU's economic powerhouse and the lynchpin of the euro's viability, had suggested that quitting the currency is an option, however unlikely.

Much of the difficulty in Europe stems from German attitudes on monetary policy (though their deeply ingrained aversion to inflation is understandable) and their influence on the ECB.  Ryan Avent put it well last week:

A demonstration of commitment to Europe requires a little bit from everyone, and what it requires from the ECB is that it act like the European Central Bank, rather than just a Bundesbank that gets to impose unreasonably hard money on everyone in the single currency. Mr Trichet, who has had to earn his post by acting as German as a Frenchman can possibly be expected to act, seems to be realising that that's not actually what's required of the ECB.

The recent "bailout" of Ireland does not impress Barry Eichengreen:

The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan.

According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.

This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.

Even measures like this, which fall far short of what would be necessary to end the crisis, are tough to get the Germans to sign off on.  Though its not surprising that loans to Greece and Ireland are bad politics in Germany, it needs to be remembered that the problems of some of the peripheral countries are due, in part, to the fact that ECB policy, which placed more weight on Germany (because its bigger) was too loose for them. This helped create the bubbles that have now burst.  Moreover, much of the debt involved is owed to German (and other European) financial institutions, so this is really a "bailout" of Germany's banks.

Europe faces both sovereign debt and monetary policy problems.  Some of the countries have too much debt, and a restructuring is probably in order.  But if they're going to avoid that - and they seem determined to (though don't they always?) - a more expansionary monetary policy would help them grow (and inflate) their way out of trouble.  Without more inflation, the peripheral countries really need not just loans, but fiscal transfers from those that are in better shape (i.e., some kind of fiscal union is needed - on this, see Gavyn Davies).

Neither way out seems palatable to Germany.  The Economist's article argued that the disruption of leaving the euro would be considerably lower for Germany than for the peripheral countries, since the likely appreciation of the Mark would ease some of the tangles associated with re-denominating debt.  Perhaps the rest of the eurozone should consider taking Chancellor Merkel up on her offer...