Bruno Colmant - Economic Insights

Ever since November 2009, the European political message is based on the intangibility of the euro. The president of the ECB has even claimed its irreversibility.. Day after day, the European economies are diverging increasingly and the Euro is falling to pieces. If a monetary readjustment was to be authorised, it would lead to a dramatic devaluation of the majority of the European currencies with respect to the reinstalled Deutsche Mark.

A monetary change becomes plausible when we make an inventory of the bias that affect real interest rates, which have become negative for some countries. Firstly, the countries from the South of the Eurozone were - thanks to the German benchmark -  able to borrow under lucrative conditions that masked their solvency’s reality. It is in this way that Greek public debts attained peaks that the drachma would not have allowed. Indeed, foreign moneylenders would have demanded a risk premium destined to protect itself against change risks. Next, by means of a waterfall effect, the interest rates of the peripheral countries remained too low, leading to asset bubbles. This is typically the case for Spain where the real estate bubble would have never occurred if the interest rates of the Spanish State would not have been deflated by the introduction of the Euro. Lastly, this low interest rate policy has allowed the European States to reinforce their weight in economy at a reduced cost. Indeed, these States have seen their loan rates lightened and their budgetary indiscipline cleared of annoying high interest rates, which they would normally have been imposed by the financial markets.

But if the creation of the euro has compromised interest rates, its rescue generates an even more profound foible, for the ECB has to adopt extremely expansionist monetary politics. Mechanically, the euro is at the basis of numerous bubbles that all end up exploding. The next explosion will undoubtedly be that of a bond bubble in the Northern European countries. 

Is there a way of escaping from monetary recession? Of course and one should hope so for the European project comes with the moral values of ideal politics. However, so as to prevent monetary recession, monetisation (i.e. permanent discounts) of the weak countries’ public debt within ECB, as well as an increase of the inflation objectives of this institution should be accepted.

In his last publication (soon to be translated in French), Paul Krugman confirms, such as all other renowned Nobel prize winners in Economics, that inflation is the exit way of a homogenous Eurozone. Even the IMF henceforth pleads for even more flexible monetary politics. Consequently, they all plead for choosing the path of monetary creation and a much weaker euro. The objectives to return to budgetary balance should also be halted, to say the least of the Southern European economies, which are already suffocating under austerity. Moreover, a true fiscal and budgetary union should be formulated. However, monetary and political authorities are not too keen on these sovereignty transfers for it’s a federal vision of Europe that prevails.

For the countries that will be expelled or that will choose to break up their monetary rooting, the rupture will be extremely chaotic. Yet, the outline of this operation is discernible. Like a drastic devaluation, it will demand change controls, urgent bank rescues, price and salary freezing so as to prevent (hyper) inflationist phenomena, restricted movement of capital and the support of international institutions, such as the IMF. Monetary conversion will first be realised with transferred money, followed by coins and bank notes. Inevitable social unrest will also have to be appeased for monetary repudiation does not come with a regime change. 

Hereunder, I will sum up some landmarks of this monetary metamorphosis that, once again, nobody wants but that could be imposed.   

Firstly, there wouldn’t exist two euros, but a euro-mark, geographically focused on the Ruhr region and peripheral currencies with managed floating. One could imagine a return to the Drachma, the Lira, the Peseta and the Escudo. With these currencies, a system in which currencies were allowed to vary from each other within a narrow band should immediately be reinstalled, comparable to the Snake in the Tunnel (1974-1978) or the European Monetary System (or EMS from 1979 to 1999) so as to stabilise intra-community trade and inflation. In other words, leaving currencies should have to evolve towards a central rate system, of which the euro-mark will be the reference axis, coupled with fluctuation margins. Moreover, the Eurozone has already returned to the EMS with sovereign spreads that replace fluctuation margins and devaluations that are being transformed in defaults.

The problem would lay in the formation of the exchange rates of these new currencies. The inhabitants of the leaving countries would indeed receive a certain amount of the national currency instead of euros for their belongings. The euro would thus not be replaced by a currency basket. This would also be applied to the active accounts that these residents have abroad.

The exchange rate of this new currency will be depreciated by 20%-30%, even more in the case of Greece, with respect to 1999. However, fixing an exchange rate is complex: leaving countries would be divided between the wish for an excessively depreciated exchange rate (to stimulate their export) and a credibility constraint (to prevent that their new currency impedes them to access foreign capital markets).

The advantage of monetary secession is that it renounces these debts. The existing debts and claims of a country that steps out of the Eurozone (and that we suppose are dominated in euros) thus have to be converted in the new national currency. Consequently, an initial exchange rate should be formulated, followed by the recognition that the debts of the leaving country - denominated in euros-  are converted, with a loss, into the new currency. The same goes for the debts of the leaving country, which will lead to a loss for foreign creditors. The Greek example is illustrative in this respect. Believing that foreign debts and claims - denominated in euros -  of a country that is stepping out would keep a parity with respect to its exchange value in euros would of course be totally naive.  

So as to minimise the losses of foreign creditors, the debts of a leaving country should, as far as possible, be domestic, i.e. being financed by national creditors. A simplified example illustrates this situation. If a country’s sovereign debt is integrally held by foreign creditors and is converted by the authorities in a national currency depreciated by 30%, this will lead to a loss of 30% that is being charged to foreign creditors. If this very same debt is 80% domestic, this only comes with a global loss for foreign creditors of 20% times 30%, this is 6%. This is exactly what the ECB has been working on over the past eight months, with the help of the banks of the weak countries. The ECB loans have essentially been used by the Spanish and Italian banks to buy back the public debts of their country.

So as to minimise the losses of monetary secession, it’s better to have a weaker euro so as to alleviate the impact of having to let go of certain currencies as well as to temper the inevitable revaluation of the euro-mark, which will have become a strong currency, and will thus be penalised in terms of foreign competitiveness. Singularly, a weaker euro also reduces the probability of a country having to let go such as Italy or Spain.

Will we escape from this threatening scenario ? The next few months will tell, but the absence of political ambition for a reorganised European structure does not rule out the issue. This would, undoubtedly, be bad news for the euro and good news for the countries that would leave the zone, knowing that - with a strong euro - the only economic perspectives that would be imposed on them would be unemployment, austerity and the contraction of their GNP. Besides, the last report of the IMF is very explicit. So as to save the Eurozone, budgetary reflation, as well as more flexible monetary politics have to be accepted.