A Eurozone Without Germany?

At the most fundamental level, the governments and institutions of the eurozone have three routes they can pursue to resolve the euro crisis: They can try to stick together, they can encourage weaker members to leave the currency union, or Germany alone can leave the euro.

1. Try to stick together

Holding the currency union together is what the governments of the eurozone are currently trying to do. This requires a crisis management approach that oscillates between austerity and pro-growth stimulus that is difficult to achieve. It also creates massive resentment in virtually all quarters and suffers from an uncertain outcome.

This approach also requires Germany to assume financial responsibility for the eurozone, a state of affairs not enthusiastically supported by the German population. Nor has Germany’s leadership been enthusiastically accepted by most partner governments and their populations.

Holding the eurozone together would also require a redesign of the monetary union — which is virtually impossible to achieve given the legal structure of the European Union. Despite 30 years of preparation for monetary union, the Maastricht Treaty was a completely inappropriate political compromise that produced — and ended — in great turmoil.

The other, not unrelated reason is that the composition of the eurozone’s membership is too heterogeneous. The eurozone does not remotely resemble what economists call an optimal currency area. Worse yet, its governance is dominated by countries that do need — or may need — financial support.

The South’s request for a fiscal union in the form of eurobonds, a eurozone treasury or financing by the European Central Bank (which in the end would need to be backed by some kind of fiscal authority) is not the way to get out of the problem. The North would only dig itself into a deeper hole.

A good warning is provided by Italy, a country that featured its own historic North-South divide – but which had its own currency, a central government and a fiscal union. Did those things provide the country with monetary stability? Did it provide convergence between the South and the North as a result of massive transfers for 50 years? The answer is a resounding no.

Why, then, should Europe be more successful, given national jealousies and the refusal of external interferences? What keeps any future monetary union from resembling the North-South divide of Italy?

And should a middle-income country in the EU (Germany ranks 9th in the EU by per capita GDP) take on the risks of that enterprise and be the ultimate payer?

The moment Germany offers any guarantees for the debt of the other countries, it will put its AAA bond rating at stake. The worst that can happen to the eurozone is that Germany overburdens itself.

Its potential ratings downgrade will also be costly for other members as the debtor quality of the supposed ultimate payer is reduced. And such a development would not be greeted gladly by the German population.

The risk of the “stick together” strategy backfiring is very high. Disillusionment in the South, bitterness in the North, haggling over transfers, laxity in reforming the institutions in the South, insistence on wrong policies from the North, the moral hazard problems from the assistance provided, emergence of nationalistic attitudes — does anyone really want that?

2. Induce problem members to leave

The composition of the eurozone membership was faulted from the beginning. By the criteria set out in the Maastricht Treaty, neither Italy nor Belgium should have been admitted on the basis of their excessive public debt.

For political reasons, these rules were ignored from the beginning, leading many critics to have serious doubts about the validity of the Maastricht Treaty.

Could the eurozone become stronger with strong new members? This seems doubtful. In light of the crisis, strong countries like Denmark, Great Britain and Sweden seem content to congratulate themselves for being outside the euro.

And it does not make any sense to say yes to countries such as Iceland, Bulgaria or Romania that do not fit and would only increase the existing problems? Even for a country like Romania, it may well be better not to join in order to retain more flexibility in managing its economy.

Similarly, an exit from the euro would make crisis management easier for Greece. Unlike a dark night operation, a well-prepared exit plan will not have epidemic repercussions on other countries that is feared by decision makers.

The political problem is which countries should leave, and the only strong case is Greece. However, if Europe’s monetary union was started anew, and without political constraints, the optimal membership would obviously be smaller.

A monetary union without Greece — and without the future entry of other problem countries — would, however, only be marginally better than the present configuration.

3. Germany leaving the Euro

On the basis of the above arguments, Germany would be better off outside the euro.

It would obviously trade, just as it did before, with the eurozone. But it would make a much bigger contribution to redressing the competitive positions necessary to readjust the external accounts and to generate growth in the South.

Since the eurozone’s southern countries had higher inflation rates than the North, the real exchange rate of the South appreciated, while the real exchange rate of the North depreciated. As a result, the South’s deficits increased over time and the North’s surpluses increased. It was an instable equilibrium.

Now wages in the South are falling to contribute to the required adjustment. But the economic pain felt by the population is high and the fall in wages may not be enough.

If Germany left the euro, its new currency would in all likelihood appreciate and the competitive position of the South would improve. Its current account surplus would fall, a fact that is desirable for Germany as well as the South.

Appreciation would dampen inflation in Germany. Meanwhile, depreciation in the South would tend to increase inflation, helping these countries lower their debt-to-GDP ratios.

Would it be expensive for Germany to exit? Yes, but not more expensive than to stay.

All the claims that Germany has accumulated in the euro will be the same with Germany in or out. These claims may be paid back, or they may not.

The probability of default will increase with Germany out, but accumulating further claims while staying in may make the loss for Germany even higher in the end.

What about financial market reactions? An orderly pull-out by Germany (probably followed by other Northern states) will create two blocs that fit together better.

The Southern currency may strongly depreciate due to financial speculation, but doing so would help the adjustment process and growth. Financial markets do understand how the economy works and will see that greater freedom of choice in the South (accepting higher inflation, currency depreciation) will make it easier to get out of the crisis than receiving handouts under the Northern macro constraints.

From a long-term perspective, Germany has to compare the present value of financial obligations over the infinite future with the high present cost of getting out. Nobody knows which is higher.

Remaining in is certainly a severe and increasing constraint, not to mention a permanent source of conflict. The alternative, a euro divorce, might be very costly — but it would buy peace and tranquility.