Why A Eurozone Break-Up Won't Be So Bad

Published in Investing on 12 March 2012

Greece can look to past events for comfort.

Global financial markets were in turmoil for most of 2011, mostly because of events within the eurozone; the currency union formed by the countries that use the euro. Top of the agenda was, and still is, how to prevent Greece from defaulting and affecting the rest of the eurozone.

The big fear is that if the Greece leaves the euro, several other countries will follow, causing a wave of debt defaults that triggers a depression throughout Europe. But history tells us that when a country leaves a currency union, what usually happens that it experiences a short, sharp recession, which is followed by a swift recovery.

Many people have forgotten that Britain was unceremoniously dumped out of a currency union on "Black Wednesday", 16 September 1992, having entered it at too high an exchange rate just like the weaker eurozone members did when they adopted the euro. This turned out to be the trigger for an economic boom and I reckon that the same thing would happen to Greece if it left the eurozone.

What is a currency union?

A currency union is created when two or more countries decide to use a common currency. Historically, currency unions were imposed by empires upon nations that they had conquered, but nowadays they tend to be formed by countries that have strong trade links.

In a formal currency union, like the euro, two or more countries enter into an agreement to issue a common currency through a central bank. But in an informal currency union, there is no such agreement -- one country simply decides to use another country's money instead of its own.

Another type of currency union is a "peg", where a country retains its own currency while establishing a target exchange rate with another currency. It then adjusts its monetary policy to ensure that this rate remains fairly stable.

A few examples

One of the longest established formal currency unions is the CFA Franc, which was created in 1945, shortly after the end of the Second World War. The CFA Franc is the official currency of 12 former French colonies in Africa, and two other countries, and it is backed by the French treasury.

The vast majority of currency unions are informal and most of these involve very small countries, such as the Pacific Island nations, using American, Australian or New Zealand dollars instead of issuing their own currency. Iceland is currently deciding whether to enter an informal currency union by replacing its króna with the Canadian dollar.

"Black Wednesday" became "White Wednesday"

In October 1990 Britain joined a currency peg, the Exchange Rate Mechanism (ERM), where the pound would shadow the deutschmark. This meant that interest rates had to be set at levels that would keep the pound-mark exchange rate within a certain range.

The ERM was popular with those of us who wanted closer links with the rest of Europe, but the high interest rates that were required to keep within the ERM bands and the uncompetitive exchange rate at which we had joined the ERM were damaging British industry.

The game was up when speculators -- most notably George Soros -- increased the pressure on the pound to such an extent that, when interest rates jumped from 10% to 15% in a few hours, this didn't stop it from falling. Britain left the ERM a few hours later and, after the initial shock,the economy recovered because foreign exchange rates and interest rates fell to market levels.

Breaking up isn't so bad

Currency union break-ups are nothing new; in the last century, 69 countries have left a currency union. One of the biggest break-ups occurred when the Austrian-Hungarian Empire was dissolved after the end of the First World War. Seventy four years later, a former member of the Empire, Czechoslovakia, experienced a more peaceful dissolution when it split into the Czech Republic and Slovakia in what has become known as the 'velvet divorce'.

If Greece left the euro, and went back to the drachma, it would have a much more competitive exchange rate, which would boost its economy. It would also help if it deregulated its labour markets, attacked vested interests in the vastly overpaid public sector and abolished ridiculous laws such as the one that requires the shareholders of a company that sells food online to have a chest x-ray...

The eurozone lives beyond its means

The weaker eurozone members aren't just being damaged because they entered the euro at too high an exchange rate. Most of their governments have been spending far more than they raise through taxes for way too long, and the accumulated debts are now weighing down their economies.

In theory, a country can run a permanent budget deficit providing that its economy continues to grow. But once the growth fizzles out, the borrowing has to be cut back -- otherwise, the debt will spiral out of control as it has done in Greece.

Eventually, the markets stop lending, as happened to Greece, and when this happens a country has three courses of action: print money (eurozone members can't do this), cut public spending (voters and politicians don't like this) or default on its debts.

Countries need to live within their means and Italy, under Mario Monti's technocratic government, is currently showing the rest of the eurozone how to do this.

The losers

The most vocal defenders of any status quo tend to be those who gain the most from it. Many people, especially professional politicians and bureaucrats, have a vested interest in ensuring that the eurozone does not break up because their careers, reputations and future incomes depend upon countries continuing to remain in the eurozone.

But, in the long run, you cannot ignore the iron laws of economics and I suspect that Greece will eventually be forced to leave the eurozone. Many Greeks will lose out when this happens, particularly those who work in its public sector.

The other big losers are the owners of Greek euro-denominated debt, but they were reckless in lending money to a country that has spent almost half of its life in default ever since it won its independence from the Ottoman Empire in the early 1830s.

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theRealGrinch 12 Mar 2012 , 10:42am

without huge social change brought about through tax retribution and social acceptance, monetary unions are doomed to fail. A floating currency is one of the great economic tools which brings about greater efficiencies in the allocation of resources.

ManInTheStreet 12 Mar 2012 , 9:29pm

I think one thing that is always missing from the anglo-saxon view of how Europe should progress is the raison d'etre of the EU for mainland Europeans -- to prevent the catastrophe that has befallen then for certainly the last 100 years, and arguably much longer.

There is a lot of stomach for a currency union and the political cost of maintaining it precisely because of the fear of it collapsing. Now it is true that when many countries moved off the gold standard in the 1930s they quickly devalued and thereby boosted exports.

But there was and remains a strong *political* commitment (regardless of the views of the Daily Mail and Telegraph) within many countries in Europe to make the Euro work. After all they were affected far more adversely via the internecine wars of recent history. We, in contrast, like to wallow in our rose-tinted winners status (luckily for us America and American money bailed us out.)

It is all about Germany convincing its electorate to allow the transfer of money from North to South (a la USA). And as each cliff-edge is approached that message is slowly seeping into the German psyche.

So I'd content that there wont be a Eurozone breakup. (Greece excepted.) On the contrary, I'd suggest Poland will join the Euro within the next five to 10 years.

4spiel 13 Mar 2012 , 12:56pm

Is this the HOLY ROMAN EMPIRE or THE HOLY ALLIANCE. After all with Putin on one side and the Persians on the other don't we need one ? And should not the British Islands join too with the right fiscal measures in place so we don't ever again let a Labour Government run up our debts ?

ianaharris100 13 Mar 2012 , 1:40pm

When you vote Labour you vote for financial incontinence as they want to placate their voter base. I absolutely agree that the politicians and bureacrats are desperate to keep he EU going and paying their huge, largely tax free, salaries and expenses. It's strange how the LibDems bat on about an unelected House of Lords, but don't seem worried about an unelected EU government.
It should by now be plain to all that the costs to business of the never ending stream of EU directives, all of which we scrupulously observe, is strangling businesses of all sorts, except maybe the biggest, who can cope, and that we are tied to a sclerotic Europe when we should be concentrating on the BRICs for our future

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