Trends that are shaping the future
Earlier this year, European Central Bank President Mario Draghi described the euro as a bumblebee - “a mystery of nature” that shouldn’t be able to fly, but somehow had managed to stay airborne. And while it continues to be buffeted from various angles, we expect the eurozone “bumblebee” to stay airborne for four main reasons.
First, the economic costs of a eurozone breakup would be enormous. Second, the political costs - and the threat to dreams of permanent peace in Europe - could be even greater. Third, on a practical level, the enormous steps toward integration have already taken place and are difficult to undo. Finally, worries about a loss of sovereignty are a red herring; eurozone nations effectively gave up much of their economic sovereignty long ago.
The economic costs of a eurozone breakup are prohibitive. An exit of weaker countries from the currency union would quite likely lead to a massive depreciation of their new currencies, followed by possible sovereign default, the collapse of domestic financial institutions, and a mass of corporate bankruptcies. Credit markets would seize up, leading to a collapse in trade and investment. The economy of an exiting country could contract as much as 40% to 50% in the first year alone, according to UBS estimates.
Core countries also have nothing to gain from the exit of weaker members, since their financial institutions also have huge exposures to peripheral sovereign and bank debt, and would likely need to be recapitalized in the case of sovereign defaults. German banks had more than USD300bn of exposure to Spain and Ireland alone at the end of 2011, data from the Bank of International Settlements show. In the event of weaker countries exiting, the central banks of stronger countries would have massive liabilities linked to their balances in the European Union’s TARGET2 interbank payment system. The German Bundesbank's TARGET2 liability is already over EUR700bn, or more than 20% of German GDP.
An exit by stronger members such as Germany would be no easier. The seceding country would likely suffer a significant appreciation of its currency, dealing a huge blow to its export competitiveness. A German exit, for example, would likely cost the country between 25% to 30% of GDP in the first year, equivalent to EUR6,000 to EUR8,000 for every German adult and child, UBS estimates suggest.
Second, while the economic costs alone would be devastating, the political costs of a eurozone breakup could be even more damaging. A fragmentation of the euro would deal a huge blow to Europe’s international prestige and influence. More importantly, it would strike at the very heart of a 60-year project that started with the proposal of the European Coal and Steel Community in 1950 to pool coal and steel production. Former German Chancellor Helmut Kohl stated this perhaps most succinctly in 2004 during celebrations to mark 10 new EU members, saying: “We never want to wage war against each other again… that is the most important reason for a united Europe.”
Third, putting aside the enormous economic and political costs, the practical issues associated with dismantling the eurozone - and the world’s second most used currency - are mind-boggling. The external value of certain assets, liabilities and cash flows would suddenly plummet as contracts were redenominated in devalued local currencies. The mismatch between assets denominated in local currencies and liabilities denominated in foreign currencies would hit governments, companies and individuals, leading to widespread corporate and personal bankruptcies. Huge quantities of collateralized swap arrangements between global banks would need to be unwound. To avert a potential failure of the global banking system, governments would possibly have to take control of currency, equity and/or bond markets for an extended period. Simply put, any decision to abandon the eurozone is no longer a European one - it is global. And the ensuing global financial and economic chaos would be unlikely to endear the leaders of the US, China, Japan, Russia et al to the idea of agreeing to abandon the European experiment.
Finally, while peripheral countries today bristle at a loss of sovereignty to the “troika” that has forced austerity on them, it is important to remember that eurozone nations gave up much of their economic sovereignty long ago when they agreed to abandon their national currencies for the euro. Nations face what the intellectual forefather of currency unions, Robert Mundell, dubbed the “policy trilemma”. They cannot simultaneously have fixed exchange rates, open borders to capital and an independent monetary policy. By abandoning the peseta, the lira, and the escudo, Spain, Italy and Portugal gave up the ability to set their own monetary policies. The Maastricht Treaty also restricts the ability of eurozone members to use countercyclical fiscal policy, requiring them to keep budget deficits under 3% of GDP.
In conclusion, despite the eurozone being like a bumblebee - “a mystery of nature” that shouldn’t be able to fly - we expect that it will remain airborne for economic, political, practical and sovereignty reasons. As German Chancellor Angela Merkel said earlier this year: “Europe is not just a matter of the intellect - Europe is and remains above all a matter of the heart.”
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