Euro zone break up intriguing, but unrealistic

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The odds of a major upheaval in the euro zone, CE believes, is now above 50 percent within the next five years.

At some point, confidence in the euro will completely break down -- indeed, the financial deterioration in Greece, Italy, Ireland and Spain have already raised a multitude of alarms about the integrity of the euro and the willingness of the wealthier euro nations to help their weaker peers.

Richard C. Kang, chief investment officer & director of research at Emerging Global Advisors in New York, notes that while there exist some contractual obligations and guidelines that might prevent the orderly dissolution of the eurozone, an acceleration of financial crises (as we have witnessed thus far this year) could indeed lead to a break up nonetheless.

Kang believes the euro zone was initially formed primarily to benefit wealthier European nations like France and Germany.

“When the Berlin Wall fell and all these poorer Eastern European nations wanted to join the western economic system, France and Germany must have wondered how they could compete with all these low-currency countries,” he said.

“Thus, they proposed a unified currency, so that instead of competing against each other, the Europeans would compete against the U.S., Japan and the rising powers of China and India.”

And that system seemed to work pretty well for a number of years – until countries like Greece and Spain realized they were spending more than they earned and required help from the 'Big Boys' and the IMF to bail them out.

The recent multi-billion euro bailout of Greece reportedly caused a serious schism between France and Germany and led to calls for the euro zone to institute fiscal integration and a common Treasury to respond to future financial problems.

“There are now definitely cracks within the euro family; it's almost like it's become every man for himself,” Kang noted.

“Perhaps France and Germany now have re-evaluated and think a common currency is not such a great idea.”

Indeed, in May, the Centre for Economics and Business Research (CEBR) recommended that Greece exit the euro as the only way the small country could survive,

“The only option for Greece is both to exit the euro and to default,” said Douglas McWilliams, chief executive of CEBR. “The European authorities did well to cobble together a rescue package for the weaker European economies. However, no matter how much sticking plaster is applied, the fundamentals remain the same.”

CEBR further noted that if Greece flunked out of the euro, Spain, Portugal and Italy would probably follow them out the door.

Andrew Balls, portfolio manager at PIMCO, recently stated that the euro zone faces a variety of possible outcomes, including the “preservation of the current eurozone, albeit as a weaker entity unless urgent progress is made on a deeper fiscal union, or one or more eurozone members restructuring their debt and also the possible exit of a current member country.”

Moreover, he said, the European sovereign debt problem has started to contaminate the European banking sector and in turn the global economy, “owing to capital market and trade links and the rise in risk aversion we have witnessed in global markets.”

Balls also indicated that one of the basic problems with the eurozone is the disparate economies among its member nations as well as a lack of fiscal integration.

“As the eurozone does not have a federal system, countries in the euro area do not benefit from automatic stabilizers to cushion the impact of asymmetric shocks,” he said.

“That said, the eurozone leaders have not done a very good job of getting ahead of the crisis, and the problem has spread, from Greece to its southern European neighbors and increasingly to the banking system and the core eurozone countries. And even though eurozone leaders did... catch up in May... with a program that was impressive in terms of its size and that suggested political commitment, the crisis has morphed from earlier concerns over liquidity and funding to questions over longer-term solvency and the structural challenges that countries face.”

Ultimately, Balls said, he thinks we may end up seeing the separation of countries from the eurozone – namely “those nations that face the greatest challenges on their debt dynamics, growth outcomes and competitiveness, thereby allowing them to restructure and take deeper steps to regain competitiveness.”

In many ways this would make sense, since it would allow the eurozone to focus its support on a smaller group of core strong countries.

“But this would be very difficult to do politically, not least since the eurozone is seen by many as a chiefly political project to promote greater unity in continental Europe,” Balls cautioned.

Kang also wonders what countries like Poland, the Czech Republic and even Turkey must be thinking – considering they have been candidates for euro zone membership.

“This crisis in Europe may serve as a good case study for the developing world to see if they really want to form a monetary union like the euro zone for their own regions,” Kang said.
“Perhaps now they now see its inherent risks and pitfalls.”

 However, other observers contend that not only is a break-up of the euro zone a practical impossibility, but were it allowed to happen could ignite another massive global financial crisis.

”The decision to join the euro area is effectively irreversible,” wrote Barry Eichengreen, professor of economics and political science at the University of California, Berkeley; and formerly Senior Policy Advisor at the IMF.

“[An] exit is effectively impossible.”

Among the reasons Eichengreen cites: once a country quits the euro, it would have to devalue its newly-reintroduced national currency, resulting in wage inflation that would neutralize any benefits derived from external competitiveness.

“Moreover, the country would be forced to pay higher interest rates on its public debt,” he wrote.

Secondly, Eichengreen argues, leaving the euro (and thereby reneging on its euro commitments), would create significant political problems with its Euro neighbors and render the nation a second-class status in all future EU activities,

But the most insurmountable obstacle, Eichengeren contends, would lie with all the procedural, legal and bureaucratic headaches it would entail.

For example, reintroducing the national currency would require essentially all contracts – including those governing wages, bank deposits, bonds, mortgages, taxes, and most everything else – to be re-denominated in the domestic currency.

“The legislature could pass a law requiring banks, firms, households and governments to re-denominate their contracts in this manner,” he wrote. “But in a democracy this decision would have to be preceded by very extensive discussion.”

Similarly, in late June 2010, Fitch Ratings also said the break-up of the euro zone was a “remote” risk.

“The sovereign commitment is irrevocable — there is no legal basis for leaving or being expelled from the euro zone — while the strength of political commitment to the euro was broad and deep,” Fitch said.

While Fitch expressed its concerns about the ongoing fiscal restructuring in various euro members, it believes that the considerable legal, financial and economic obstacles and the high costs of a breakup would make such an occurrence very unlikely.