Currency union vs fixed exchange rate – Greek Euro Exit

2011-09-24

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There is a profound difference between a currency union and a fixed exchange rate. It is one thing entering the euro, it is wholly another exiting from it. The latter is parallel to collective suicide.

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On September 23 I wrote an article titled “Default and euro exit will destroy Greece”. Some of my readers posed objections to my principle idea that an exit from the euro under the current economic conditions of Greece, will practically be a jump off a cliff that will lead to poverty, agony and third-worldliness. An exit from the euro, under the current conditions will not lead Greece back to its pre-euro era (back to the late 1990s) but back to some 1950s’. The objections mainly centered around the largely correct finding that the euro has been the cause of many of Greece’s structural problems and today is like a straitjacket that does not allow Greece to be competitive. In fact an exit from the euro has been proposed by many prolific personalities such as Krugman, Soros, Roubini and many others, so I do understand the objections, yet I remain defendant of my view and I shall prove what I mean by that.

The argument put forward by those who support an exit from the euro is straight forward: A country has entered a downward spiral and cannot inflate its way out of it. With debt growing and the recession deepening a default is inevitable. So if a default cannot occur within the euro, as then the other European states should be called to contain the shock wave in many ways (no need to explain it here), then it must happen outside the euro – thus exit from the euro and default. It is rational indeed, but it fails to see a number of issues identified in the profound difference between a currency union and a fixed exchange rate. Even a completely broke country like Greece cannot exit the euro, since it will signal its return back to the 19th or early 20th century, while it will also trigger a series of cascading events that will eventually cause the collapse of the whole union. A mere hypothesis of the events preceding and following a euro exit will be enough to illustrate my point.

Suppose that today the Greek Prime Minister addresses the Parliament and calls for all necessary preparations legal and technical for exit from the euro and the reconstitution of the drachma (the Greek national currency) and for a formal default. Let us say that the Prime Minister allows them a whole week to carry out all actions (a week is a very short period of time for such a change). What will be the immediate effect of that? Financial panic. Within minutes the ATM’s across the country will dry up, the banks will be filled with depositors willing to draw out their Euros so as not to lose from the eventual devaluation of the drachma. Banks will be unable to offer back the savings to everyone since no bank in the world has all savings in its deposits (only a portion of it stays in the bank the rest is given away in loans). So banks will be forced to shut down for that week. In practice this will mean that all economic activity in the country (or at least most of it) will cease for a whole week. For a country experiencing a deep recession, where even a lost working hour is a huge cost, a whole week with no economic activity will be catastrophic (so even more suffering for the Greek people who are already on the edge).

Now assume that the Greek Prime Minister was aware of the above and together with the college of experts that surround him, has decided to take that step. What will be the effect on the rest of the eurozone countries? Should German, Dutch, Austrian and Finnish taxpayers start partying now that the “irresponsible” Greeks are finally kicked out and the Euro is finally cleansed from its most “profligate” member? I am afraid that the party will soon turn into a funeral gathering. The reason lies in the chain effect that will follow the announcement of the Greek PM. The ECB will lose around a hundred billion euro in one instant (money owed to the eurosystem by the Greek banks) plus around €40 billion of Greek bonds it purchased since May 2010. This means that the ECB itself will come to the need of being recapitalized and who is going to pay for that? Those who were about to party. Also consider the interconnection of private banks across the eurozone and the fact that the European banking system is already verging on insolvency, this means that one bank will start falling after the other within days. Again those who were about to party will have to pay to prevent a total financial meltdown. And as if those events were not enough, imagine what will be the impact on the money markets, where speculators will be betting on the next to follow Greece outside the euro, meaning that market fears and uncertainty will drive Irish, Portuguese (and others) sovereign bonds into exorbitant levels once again, thus making their recovery impossible and forcing them to take the same path Greece did.

Anyone willing to get on that train of thought will see how all the above will escalate through Italian and Spanish bonds, French, Belgian and German banks and how it will eventually knock the door of the European core. And again those who will be called to pay are the taxpayers of surplus countries, which they will prefer not to do so and bail themselves out of the euro instead, which means that the euro will collapse. Another problem that immediately follows is that the new Deutschmark or perhaps a currency union of surplus countries will be overvalued to such an extend that no exports to the rest of Europe or to the Asian markets will be feasible – this means that the powerful German exporting sector will be like a giant with its hand tied behind its back – so German exports will fall considerably, thus German growth will stall. I assume there is no more need to drive my thought towards its logical conclusion, since the calamities I have already put down are already enough to make my point crystal clear.

Currency unions constitute organic connections of states and in the case of the Euro, this is quite apparent, whereas fixed exchange rates are only means of individual monetary policy that can be canceled with much less cost.

At this point I need to say that I bear no delusions whatsoever regarding the very structure of the euro. I have time and again made mention to the structural flaws of the euro, I shall not repeat them here. All I say is that I personally was against a Greek accession to the euro since the country was not economically prepared for it and since the euro did not have any stabilizing mechanism to counter for the structural trade deficits it creates. But it is one thing advocating against an accession to the euro and a wholly different to call for an exit from it, especially under the conditions Greece is now found into. The latter is parallel to a collective suicide and the above analysis proves it.