Euro-zone collapse? Most unlikely

“It would be technically possible for a member state to leave the euro zone, but politically it is about as likely as a meteorite hitting the Eurotower in Frankfurt” – as Barry Eichengreen nicely put it.

Partly there are significant costs from monetary disintegration. These were massive in the post-socialist transition of the early 1990s, when COMECON and its transferable rouble disintegrated, the USSR and the rouble area split into 15 countries and currencies, Czech and Slovak members of the CSFR split together with the Czecho-Slovak crown and Yugoslavia splintered into more pieces and currencies than its former membership of five. A devastating deep and protracted recession followed, though in fairness this was due not only to such processes of economic and monetary disintegration but to the general move by these countries from planned trade transactions to their sudden exposure to market transactions at world prices and payment in foreign currencies.

Partly, the advantages from dividing the Euro-area would be highly questionable. The weaker countries leaving the Euro-zone and re-introducing a national currency would not lighten the burden of their national debt which would continue to be denominated and serviced in euro or other foreign currencies. They may or may not improve their trade competitiveness via devaluation of their re-introduced national currency – apart from the fact that competitiveness could be improved in many other ways if this is what a country wanted (“domestic devaluation” via wage restraint, investment in productivity increases, greater competition etcetera). Nor would there be any advantage for such stronger member countries as Germany.

In an article for the German Council on Foreign Relations Adam Posen argues that Germany has an intrinsic and direct interest in the prosperity of the eurozone. Germany benefits in terms of seigniorage, transaction cost savings, lower real interest rates available to its companies, a strengthened global influence, and improved shock absorption. These advantages increase with the size and the diversity of the Eurozone, and the German Chancellor Angela Merkel should not make a “competitiveness pact” for eurozone countries the condition for German continued support for the Euro.

All the same, over the last year, the prospect of Euro-area split has been a frequent though intermittent object of discussion. The title of a 2010 book by Hans-Olaf Henkel, formerly of IBM and ex-euro-enthusiast, expresses a widespread feeling in Germany today: Rettet Unser Geld! (Return our money!). Marshall Auerback also explores this possibility in a recent paper, “What happens if Germany exits the Euro?”, Levy Economics Institute of Bard College, 2011/1, though ending with a cautionary assessment not a recommendation.

“On the plus side, given Germany’s historic reputation for sound finances, the country would likely emerge with a strong Deutschmark, a global “safe haven” currency for currency speculators keen to find a true store of value.

But this would likely come at a huge cost: Germany would probably save its banking system at the expense of destroying its export base. The newly reconfigured DM would soar against the euro and become the ultimate safe-haven currency. This would mitigate the write-down impact of the inevitable haircuts on euro-denominated debt, because the euro (assuming it is retained by the remaining eurozone countries) would fall dramatically. Even if the euro itself vaporized, the Germans would simply pay back debt in the old currencies, likely at a fraction of their former value.

But Germany’s external sector would be wiped out. The resultant appreciation of the new Deutschmark, along with the inevitable banking crises in the periphery (which would exert significant deflationary pressures in those countries and therefore reduce consumer demand in the eurozone ex Germany), would engender a huge trade shock: Germany’s growth would slow dramatically, as exports compose such a large proportion of its GDP.

Another interesting byproduct: by accounting identity, a fall in Germany’s external surplus would mean an increase in its budget deficit (unless the private sector began to expand rapidly, which is doubtful under the scenario described above), so Germany would find itself experiencing much larger [public] deficits.”

This accounting identity is a centerpiece of Keynesian macroeconomics as popularized for instance by the late Wynne Godley, but it is or rather should be part of any macroeconomist’s education. Auerback divides the economy into three main sectors: domestic government, domestic non-government (or private), and the foreign sector. “By accounting identity, the deficits and surpluses across these three sectors must sum to zero; that is, one sector can run a deficit so long as at least one other sector runs a surplus.”

Looking at GDP accounting from the “sources” perspective, we get the identity:

(1) GDP = C + I + G + (X – M), i.e. national income must equal the sum of private consumption and investment, plus government expenditure plus net exports.

From the “uses” perspective, GDP must be taken up by private consumption plus savings plus taxation, i.e.:

(2) GDP = C + S + T. Therefore

(3) C + S + T = GDP = C + I + G + (X – M), or

(4) (I – S) + (G – T) + (X – M) = 0

As a simple matter of double-entry book-keeping, the three balances must add up to zero.

At present Germany is running a large positive external balance (X-M), matched by an even larger excess private savings over investment (S-I) minus a modest public deficit (G-T). If, as a result of the reintroduction of an overvalued DM, German external balance were to be substantially reduced or vanish, Germany would have to either contract private savings relatively to investment or run substantial public deficits or both. An abrupt change of gear, which is at odds with the wishes of the German people and leadership. Something for Chancellor Merkel to ponder.

(This is also, incidentally, why the size of a country’s government deficit does not lend itself to be targeted directly, independently of what else happens to the balance of private savings and investment as well as the external balance of the country).