As I travelled around the US last week, one question cropped up more than any other: could the euro disintegrate? More specifically, might individual nation states choose to leave the euro and, if so, which ones would depart first?
That these questions are asked at all reveals a lack of credibility surrounding the euro. You don't hear many investors in Europe asking whether the dollar might disintegrate, even though it might make economic sense for California, for example, to exit stage left and choose to tie itself to the fast-growing economies of Asia rather than to the US.
We don't ask these questions of California for an obvious reason: California, like the rest of the US, is ultimately represented by federal government bodies in Washington which control a large budget, protect US interests through diplomatic and military means and set the nation's monetary policy.
Yet it wasn't always so. Between 1769 and 1821, California was a Spanish colony. It then found itself in Mexico's hands until 1848, when the US took control after the two-year Mexican-American War. America's 19th century history was one of slow and sometimes disorderly political integration. Arguably, the Union might have fallen apart at any point. Most acts of political integration have their difficulties. The European Union is no exception.
Investors, however, always like to cast doubt on political intent. The latest concerns revolve around Greece and its survival in the eurozone if it is unable to deliver the painful austerity required to put its budget back on a healthy path. For some investors, Greece should think seriously about leaving the eurozone altogether. The argument has its attractions. Arguably, the euro operates like a modern-day version of the Gold Standard, with individual countries obliged to accept occasional periods of inflation and deflation in order to adjust to the disciplines imposed by a single currency. Reading Liaquat Ahamed's excellent Lords of Finance, it's clear the Gold Standard didn't work for everyone – indeed, Winston Churchill later regarded his decision in 1925 to return Britain to the Gold Standard his biggest blunder, leaving industry having to cope with deflation, declining wages and rising unemployment. In today's Europe, many countries find themselves having to go down that path.
Yet leaving the Gold Standard was relatively easy compared with a possible departure from the eurozone today. The main difficulty is practical. Staying in might be costly but departing might be even worse. Divorce isn't always the best option.
Take Greece, for example. The only reason it might consider leaving the eurozone is to introduce new drachmas to enable a devaluation via a fall in the exchange rate rather than through constant declines in wages and prices. Imagine, however, that rumours got out that Greece was planning such a move. Surely, deposits held within Greek banks would be spirited away with remarkable speed. The money would head off to Germany, Switzerland or France. The Greek banking system would collapse, even before new drachmas had been introduced. Without a functioning banking system, a devaluation would achieve very little. To safeguard against such an eventuality, the Greek government would have to impose capital and exchange controls to prevent an exodus of bank deposits but that would be contrary to EU law.
Arguably, only one country could leave the eurozone and not put its banking system at risk, but only because its departure would likely be associated with currency appreciation, not depreciation. Plenty of Germans are becoming distinctly uneasy about the euro, regarding the activities of Greece and other countries as a threat to the single currency's underlying integrity. The reintroduction of Deutsche Marks would doubtless be a popular move for many in Germany. And, as an act of monetary castration, it would leave the euro weaker, thereby allowing a partial devaluation for the likes of Greece, Spain and Italy, all of whom otherwise would face the need for painful internal adjustment. Why, however, would the German government sign up for a plan which left Germany nursing competitive losses having worked so hard to restore competitiveness following the shocks after the reunification in the early 1990s?
It's not an appealing idea. Moreover, with the prospect of continued revaluation, deposits would surely pour into the German banking system. Domestic liquidity would then be boosted to such an extent that inflation would become more difficult to control.
Unilateral departures from the eurozone are neither easy nor credible. There are, however, other options. One which would lead to serious hypertension in Germany is to accept the need for a higher inflation target. If countries need to regain competitiveness within the eurozone, it's far easier to accept low wage increases relative to a high inflation target than it is to accept wage cuts relative to a low inflation target even if, in real terms, the outcome is much the same. However, any attempt to shift the European Central Bank's inflation target higher would surely fall on deaf ears in Germany and, even worse for the success of the system as a whole, hasten Germany's departure. Another option, which would be consistent with the spirit of European integration, is for the eurozone to move towards a federal fiscal system and to encourage more flexibility in product and labour markets. No one suggests California should leave the US dollar zone because everyone accepts that, in times of difficulty, California will either be bailed out by its fellow Americans or will adjust relatively smoothly to new market realities. To date, it's not possible to reach the same conclusions about the eurozone. Should, however, the mooted European Monetary Fund get off the ground, with its bailout carrots and exclusion sticks, this could be the next stage of European political integration, leading to further erosion of national sovereignty to make the EU work more credibly.
For some, it would be a step too far but it is surely a better bet than some of the more murderous options pursued by the US in the 19th Century or, indeed, by Europe in the 20th Century. If the people of Europe have learned anything, it's surely that jaw-jaw is better than war-war.
stephen.king@hsbcib.com
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