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Will Merkel Deep-Six the Euro?

As we noted the other day, the quickly deteriorating situation in Greece has got people speculating that the Greek exit from the eurozone (“Grexit”) is just around the corner—perhaps coming as soon as September. And contagion is spreading past the troubled countries, maybe even infecting the otherwise-robust German economy.

All this tumult has to have forced some serious contingency planning in Europe’s capitals. The Economist mapped out just what some of these plans might look like, using an imaginary memo to Angela Merkel from her staff as an expository device.

The memo offers a menu of unappetizing options. Since an open-ended commitment to bailing out the delinquent states increasingly looks unsustainable both fiscally and politically, the first option is an orderly Grexit. Greece is forced off the Euro and it defaults on its obligations by redenominating them in newly devalued Drachmas. Even by writing off the entirety of Greece’s debts and providing a reasonable aid package to help in the transition, the total cost of this is estimated at around €320 billion, with Germany shouldering €110 billion of that.

While this is superficially plausible and the least costly way forward, it contains within it the seeds of broader chaos.

If that was that, it would be a bargain compared with the likely present value of transfers from Germany to Greece over the next few years and maybe decades. But there is a sizeable risk that a Grexit could turn into a calamity, as markets reacted badly to the admission that euro membership was no longer irreversible. At worst there could be a market collapse to rival the one that took place after the Lehman bankruptcy in late 2008, which could in turn trigger a recession on the scale of the desperate downturn of 2008-09. In the panic, you would come under intense pressure (Barack Obama would be on the line immediately) to concede debt mutualisation without getting the quid pro quo of fiscal control at a European level that you have been demanding. After holding out for so long against demands that you write a blank cheque, that is what you might well end up having to do.

So what to do? Cut “well above the site of infection,” forcing Spain, Portugal, Cyprus, and Ireland off the Euro as well, and draw the line at France and Italy. The cost for this is exorbitant: €1.15 trillion, with Germany shouldering up to €500 billion, or almost 20 percent of its GDP. But with the costs of the chaos after a disorderly Grexit alone likely to exceed that, aggressive amputation might be the most reasonable way forward.

That some variant of the above contingency plan exists on European leaders’ desks is quite likely. Whether there’s the political will to see it through is not.

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  • Otiose8

    There are a few delusions at work here. One is that anyone can accurately total the costs for eventualities that are unknowable from our present.

    What can be known now is that the costs of waiting to cut loose from these drains on resources will only go up with time.

    Providing funds to give Greece the time to make reforms and / or cut costs is a complete waste of money. They can’t and won’t cut costs or undertake meaningful reforms on their own.

    The only reason for Germany to pay out funds is to buy time to manipulate the blame away from themselves for the pain that is to come in the adjustment of a number of countries for living on borrowed money at higher standard of living than they could afford/sustain.

  • Felipe Pait

    And of course there exists the mainstream Econ 101 textbook alternative of allowing a little bit of inflation in Germany so that the problem countries can become more competitive, and allowing banks that made risky loans to negotiate the terms of repayment and take a loss.

    But of course the sensible free-market is anathema because it has been defended by liberals so it cannot be even mentioned. Not invented here, not admissible. Better to risk losing the whole European Union project than to recognize that a NYTimes columnist could be right.

  • silia

    Obama’s advantage over Romney.

    Obama is an opportunist on the outside and will do anything to win.. but he does have core beliefs/ideology which is American-style leftism. Ideologically, he’s very much in league with the left, and so there is core support for him from the American Left. But there is also support from Wall Street that knows that Obama will play the game to remain president. Radicals know Obama is a radical at heart and moderates know he’ll play the game.

    With Romney, it’s reversed. He has no core beliefs. There is nothing there. What is he at heart? A liberal? A conservative? At the core, he’s nothing, and so he has no core supporters. At best, conservatives see him as the lesser of two evils. There is no love for him. Yet, on the outside, Romney acts like he has these strong set of core values, but no one believes him since he’s been all over the map.

    So, Obama has a core but plays the game of opportunism on the outside to win in politics. In contrast, Romney’s core is opportunism but dons the mask of core values on the outside which no one believes.

  • Joe Eagar

    Felipe Pait, I have wondered this myself. The Europeans have progressively rejected all the adjustment mechanisms associated with a monetary union: fiscal transfers, labor mobility, monetary-induced resource transfers via inflation, even the much more reasonable option of a banking union.

    Every option is nationalized to the point of absurdity. Even a common deposit insurance fund is seen as a de facto transfer union.

  • Snorri Godhi

    “the first option is an orderly Grexit. Greece is forced off the Euro and it defaults on its obligations by redenominating them in newly devalued Drachmas.”

    No, that’s option #2.
    Option #1 is much simpler: Greece defaults on its obligations. Period. Greece is not forced off the Euro and does not redenominate its obligations.

    The advantages of option #1 over option #2:

    a: Greek people do not see their salaries, savings, and pensions redenominated in funny money.

    b: “there is a sizeable risk that a Grexit could turn into a calamity, as markets reacted badly to the admission that euro membership was no longer irreversible.”

    No Grexit, no calamity.

    The disadvantage of option #1:
    Greek public-sector workers (PSWs) still get paid in Euros, and as long as that happens, the Greek government cannot balance its budget without firing too many of them to be reelected. But if Greece defaults (which happens in both options) then the Greek gov. won’t be able to borrow anymore, so it will have either to fire lots of PSWs or to pay them in IOUs.

    On the whole I think option #1 is the lesser evil.

  • dearieme

    The silly beggars should have grasped the nettle and done it in the spring. Then the expelled countries would have had six months to reorganise and ensure that they had fuel enough to see them through the coming winter. I fear some people are going to have a cold time of it.

  • Eurydice

    This is getting silly. There is no “well above the site of infection” – you can’t cure a blood disorder by cutting off your leg.

    And the markets aren’t going to react badly to a Grexit because euro membership is no longer irreversible and blahdy, blah, blah – they’re are going to react sensibly to the EU’s admission that the euro is not a major currency and never will be. If, in order to save it, the EU has to jettison half the membership and reduce the euro to a minor currency, there’s no point in saving it at all.

  • kate k
  • Kenny

    Yes Dearieme, the grasshoppers always have a tough time of it in winter.

  • Charles R. Williams

    What difference should it make to anyone but the Greeks what currency they use? The problem is that Europe’s banks are insolvent. They ARE NOW. All that changes with a Grexit, is that reality has to be officially recognized.

    Now you are saying the German taxpayer must rescue Italy but not Spain et al. Gangrene must be chopped off at the knee to save the torso. But why must this body be saved and why should German taxpayers agree to pick up the tab.

    The Germans will have to deal one way or another with their now insolvent banks and German prosperity is dependent on mispriced credit to the rest of the eurozone. Recession in Germany is inevitable. Why should the Germans buy time at the expense of their own long-term financial integrity? Unless the Italians and the French use that time constructively, Germany in a very few years will be where Italy is today. Do you really believe the Italians and the French are or will be ready and willing to do what it takes to put their own economies in order?

    The Germans should bite the bullet and exit the euro now.

  • Felipe Pait

    Joe Eagar #4, better people than myself are also puzzled. I suppose that when a person builds a whole career out of one point of view, it becomes difficult to realize that different situations require different actions. There is nothing really worng with Europe. Europeans should be able to do better. With luck they will. Otherwise…..

  • Jim.

    Some pain now, as excess leverage falls out of the system, or an eternity of unlimited pain as you support an impossible system forever (or until the point where every strength fails).

    Germany’s far better off protecting itself with a midsize bailout of its own banks than it would be, signing on to bail out everyone forever.

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