Hamish McRae: Greece will leave the euro. But what then?
Sunday 20 May 2012
So what will happen to the eurozone? Let's start with three quotations from European politicians and officials at the centre of the storm.
"There is zero probability for the euro area to break up. Bond spreads today exaggerate credit risks."
"The euro area is a monetary zone of complete solidarity."
"We certainly won't see a state bankruptcy in Greece."
The first comes from Joaquin Alumina, then EU commissioner for economic and monetary affairs. The second from Christine Lagarde, when she was finance minister of France. And the third from Ewald Nowotny, European Central Bank board member and chairman of the Austrian central bank. All a bit complacent, you might think?
Well, I have cheated because as you can guess these statements were all made in 2009. But they are worth quoting, not because they make these people look silly – we all get things wrong – but rather to show how far the euro debate has moved over the past three years. The eurozone is indeed tearing itself apart, and it comes as a bit of a relief that in Britain, at least, the Government and central bank have the courage to say so.
So what on earth is going to happen? There are such an enormous range of possibilities – from the eurozone holding together to there being no euro by Christmas – that any prediction is bound to be wrong. But somewhere between these extremes there are some broadly probable outcomes and at the risk of looking as silly as those grandees, I thought it might be helpful to sketch my own most probable outcome.
The first thing that seems inevitable is that Greece will leave the eurozone. That is now the markets' odds-on view, as shown not just in opinion surveys but in bond yields. The right hand graph shows some calculations by Fathom Consulting derived from market yields that rate the chances of both a formal default by Greece on its sovereign debt and the chances of it abandoning the euro. As you can see, the first is as near as 100 per cent as makes no difference. But while euro withdrawal is less certain, the probability has risen from around a 30 per cent chance earlier this year to 75 per cent.
Timing of the exit? Well, it could be this year but since there will be huge pressure on Athens to stay in, it could well be next year or even later. If the Greek government were wise it would deny it was leaving, make secret preparations, and then leave when no one was expecting it. Either way, an exit in the next two years is going to happen.
When it does there will be huge political pressure on the rest of the eurozone to hang together. That could work for a while. The most exposed members, Portugal, Spain, Ireland and Italy, will be bullied and bribed to stay. The ECB will print more money, the eurozone authorities will provide cheap loans, Germany will be forced to underwrite the risks of the bloc.
This could succeed for another couple of years beyond the Greek exit: the so-called "firewall" would hold. But I cannot see it holding for very long for the reason set out in the main graph. These countries need a devaluation.
Calculations as to the scale of devaluations needed are rough and ready. These come from Capital Economics and differ slightly from those made by, for example, Goldman Sachs. Thus, on these numbers, Ireland needs a 15 per cent devaluation whereas on Goldman's it is about square. It is possible to live with a "wrong" exchange rate for quite a while, but there are costs. Sterling was probably 15 per cent overvalued between 1997 and 2008, which must have contributed to the decline in manufacturing exports during that period. At present levels, with the recent recovery of the pound, we are probably about right.
It is also possible to compensate for too high a rate by cutting costs, as Germany did from 2000, and as Ireland has done more recently. But it is very hard for any society to adapt quickly because it means cutting wages, perhaps by a large amount. So the scale of the cuts needed just look too big to sustain. The alternative, for Germany to inflate by 20 per cent or more, vis-à-vis the rest of Europe seems so outlandish a possibility as to be dismissed.
If this is right, then there is no other possible outcome. These countries have to leave the eurozone. I would guess this will be within five years, so let's say 2017.
It is possible they might be bound together in a new "southern euro" which would be devalued against the "northern euro", rather than going back to national currencies. But that would be difficult. There would have to be capital controls between the two and the political advantages are hard to see. In any case this would soon lead to tensions between the two biggest members of this "Club Med", Italy and Spain. But it might be less humiliating for the politicians than returning to national currencies. So while I can't see it working, they might have a try.
Either way, that would leave a core eurozone built round Germany and France, with a few small ones, the Benelux countries, Austria and so on, tagging along. The problem with that is that France in some ways resembles a southern rather than a northern European country. Support for the euro in France was very weak, when it was proposed, with only 50.6 per cent voting in favour of the Maastricht Treaty.
If the tensions continue to mount, it might be that Franco-German relations would work better were they to have their own currencies. So the outcome in another decade or so, would be a euro as a greater Deutsche Mark. In economic terms that could work very well. Politics? There will have to be a different set of politicians, who can escape from the present mindset.
A final quote. It comes from the Ifo Institute in Munich, which reported on Friday the latest twists in the euro saga. It noted the need for adjustment by the weaker members, and how hard this would be, and it dismissed the idea that northern Europe could continue to prop them up with subsidised credit. Its comment makes a nice counterpoint to the quotes at the start: "One cannot help but wonder how thoughtlessly Europe's politicians have started down this slippery slope."
Athens' shiny new airport is a warning against more EU funds
As it happened, I was in Brussels on Friday: the epicentre, you might think, of the eurozone crisis. The astounding thing is how little feel you catch for the strains the currency is under: traffic was busy, shops were full, and there were lots of Russians boozing in a top hotel.
It brought home three things to me. The first is that debt is invisible. It hangs over people, worries them, changes the way they behave and may eventually result in their losing their jobs. But it is only then that you see it.
So the plight of Greece and Spain is very evident, but the pressures on a country such as Belgium, the first core nation to go into recession and with very high sovereign debts, are not.
The second thing is that capital cities are protected. Brussels, has added status as the base for the European Commission, but the same applies to Washington or London, where national spending supports the economy. This is a huge social, as well as an economic, issue as fringe areas find it harder to have their voices heard.
And the third is that fund transfers within Europe, choreographed by the commission, are more a problem than the solution. Even when such funds have gone into physical investment rather than quasi-welfare, it is hard to feel they have been well spent.
Greece has a shiny new airport, left, and other visible signs of foreign-funded infrastructure. Ireland has too. The arguments for further European-funded investment need to be seen through the window of what has happened to past investment.
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