Breakin’ Up Is Hard To Do

Don Alexander
RSD Solutions Inc.
NYU

A big question is whether the Economic and Monetary Union (EMU) will survive. Too often, analysts discuss a possible departure of one or several countries from the euro area as little more than a devaluation, any country’s exit from the euro area could have potentially adverse consequences. These are some of the issues examined by Anders Aslund in Why a Breakup of the Euro Area Must be Avoided: Lessons from Previous Breakups (Peterson Institute, August 2012).

The author suggests a breakup of a currency zone is far more serious than devaluation. When a monetary union with huge uncleared balances is broken up, the international payments mechanism within the union breaks up, impeding all economic interaction. It is easier to establish a monetary union than to break it up.  There are three potential problems to address. Firstly, the devastating event a possible collapse of the EMU with its large uncleared imbalances could be. Default need not necessarily lead to departure from the euro area. Greece has already defaulted on its official debt to reduce its total public debt to a more sustainable level, but it has not left the euro area. A risk is a Greek exit would not be merely devaluation, but would unleash a domino effect of international bank runs and disrupt payment mechanisms.

Second, the critical argument for a domino effect is that the EMU already has large uncleared interbank balances in its so-called Target2 system.  Exit of any country is likely to break this centralized EMU payments mechanism.  These rising uncleared balances are a serious concern because nobody knows how they will be treated if the EMU broke up.

Third, if the impermissible happens and the euro area breaks up, the damage will vary greatly depending on the policies pursued. All the economic problems in the current crisis can be resolved within the EMU with proper policies. Devaluation may be only a palliative or a postponement of resolution of the real problem, while the costs of the dissolution of the euro area could be truly monumental.

From the outset, many prominent economists Milton Friedman, Robert Mundell and Martin Feldstein, took the view that the euro area could never work. The original arguments are straightforward. First, the euro area did not comply with the original conditions formulated by Robert Mundell “that the optimum currency area is the region— defined in terms of internal factor mobility and external factor immobility.” Second, “all successful monetary unions have eventually been associated with a political and fiscal union”.

These arguments are valid, but supporters of the EMU have countered that the optimum currency area conditions as well as the political and fiscal union—that is, a federalization of the European Union—could evolve over time and should come to fruition in this crisis. Hopefully the fundamental problems of euro area governance are now being resolved with the formation of a stricter fiscal union, a banking union, and a sufficiently large bailout fund. The EMU has not been credible with regard to fiscal discipline and hard budget constraints, and the market has rightly presumed that all national sinners would be bailed out. The current crisis has enhanced the fiscal credibility of the EMU but has instilled new fears of sovereign defaults and currency risks.

Two major problems in the euro crisis have aroused new calls for the breakup of the euro area. One is sovereign default. Many presumed that an EMU country that defaulted would have to leave the euro area, but that is not true.  The other problem is that some peripheral countries are not sufficiently competitive to balance their current account with other members of the EMU.  In every emerging market financial crisis, growth was restored by a move to flexible exchange rates—and unavoidable—on top of official liquidity, austerity and reform, and in some cases, debt restructuring and reduction.” While beneficial in some cases, devaluation is by no means necessary for crisis resolution.

Any choice of economic policy must be based on a realistic comparison between the alternatives. The EMU was designed to be irreversible, which means that it comes with a number of very costly poison pills. By Maastricht standards, it was a mistake to let Greece into the EMU, but that is not relevant, because the decision to leave would have high costs.

The Economic and Monetary Union must be maintained at almost any cost. All the economic problems in the current crisis can be resolved within the EMU. A devaluation may be only a palliative or a postponement of resolution of the real problem, as has so often been the case, while the costs of the dissolution of the euro area could be truly monumental. There the many current questions about crisis management, financing, and governance of the EMU that are not addressed in the policy brief, but breakin’ up is hard to do.