“Why a collapse of the Eurozone must be avoided”

A Swedish economist Anders Aslund (senior fellow at the Peterson Institute in Washington) wrote an excellent article a few weeks ago on why a collapse of the Eurozone must be avoided under all costs. I recommend you read the whole thing

His point is partially based on a historical comparison of what happened with the break-up of three previous multi-nation currency zones, namely the ones of the Austro-Hungarian Empire, Soviet Union, and Yugoslavia. The structure of these economies differed to a great extent to the structure of the EU today, but some lessons can certainly be applicable.

His view is, and I agree, that too many economists think of a euro break-up as a mere devaluation that would benefit the exiting states. But not too many recognize the possible dire consequences this could bring to exiting countries (mostly everyone is preoccupied with what the effects will be on countries that remain in the Eurozone, or provided there is a full break-up, what will the effects be on the global economy – these predictions are usually very pessimistic). Exiting a currency peg (Argentina) and abandoning a currency are two very different things. Almost every nation that left the Austro-Hungarian, Soviet or Yugoslav currency unions experienced a rapid hyperinflation. In addition, losses of output were even more devastating: 
"The output falls were horrendous and long lasting. The statistics are flimsy, but officially the average output fall in the former Soviet Union was 52%, and in the Baltics it amounted to 42% (Åslund 2007, 60). Five out of twelve post-Soviet countries – Ukraine, Moldova, Georgia, Kyrgyzstan, and Tajikistan – had not reached their 1990 GDP per capita levels in purchasing power parities by 2010. Similarly, out of seven Yugoslav successor states, at least Serbia and Montenegro, and probably Kosovo and Bosnia-Herzegovina, had not exceeded their 1990 GDP per capita levels in purchasing power parities two decades later (World Bank 2011). Arguably, Austria and Hungary did not recover from their hyperinflations in the early 1920s until the mid-1950s. Thus half the countries in a currency zone that broke up experienced hyperinflation and did not reach their prior GDP per capita in purchasing power parities until about a quarter of a century later."
Now some may say that this was in most cases due to recovering from (Austro-Hungary) or engaging into wars (Yugoslavia), or the fact that a hard and painful transition to a market economy characterized by corruption and cronyism took its toll. However, in neither of the cases had exiting the currency union resulted in increasing exports due to a cheaper currency. In fact, exits were surrounded by huge uncertainty, very high borrowing costs, and a painful drop in output and employment. Not the kind of environment that would attract foreign investors, is it? 

Cronyism which characterized the transition made things worse after the initial stabilization. One can arguably say that hyperinflation at the time played a big role in exacerbating corruptive activities. Although the main culprit for that would probably be the inefficient institutions, initialized by the new governments. Nevertheless hyperinflation ate up a huge proportion of the newly formed nations’ wealth, similar to the effect of currency devaluation done in Argentina in 2001

For these reasons (and in fact many more) abandoning a currency is much harder than it appears to be, particularly for an anchor currency like the euro: 
"If one country (Greece) departs from the Eurozone or if its Target2 balances are capped, the current slow bank run from the south will accelerate quickly and become a massive bank run from most banks in southern Europe, and the banking system would stop working. The Eurozone payments system would stop functioning because it is centralized to the ECB. To re-establish a payments system is both politically and technically difficult. In the former Soviet Union, it took three years to do so. Currency controls would arise and a liquidity freeze would occur. If the drachma were reintroduced in the midst of a severe financial crisis, its exchange rate would plummet like a stone by probably 75%-80%. High inflation would result and mass bankruptcies ensue because of currency mismatches. Output would plunge and unemployment soar. Greece would experience a new default and other countries would follow."
Source: Andres, Domenech: "A solution to the euro debt 
crisis:  Back from the future",  VoxEU.org,  26 June 2012.
Their view is that higher bond yields and worse-off
Target2 balances reinforce each other.  
He addresses the Target2 balance (an inter-bank measurement of the net flows of money across borders in the Eurozone), which was signaled as a rising concern for the German Bundesbank, and some German economists (see the graph below). Aslund's text was essentially a response to the text from Hans-Werner Sinn who proposed capping the Target2 balances in order to end the 'hidden bailout' the Bundesbank has been issuing to peripheral Eurozone members. Aslund made a comparison to the Soviet example where a similar cap put an even quicker end to the currency zone. Note that these large imbalances arose primarily from the current account deficits of the Southern Eurozone countries. For a more interesting analysis, FT's Money Supply blog has a good overview (and a great graph showing the net balances within the Eurosystem): 
Source: Financial Times blogs, Money Supply: "Keeping track of those
Target2 balances"
, 25 May 2012
In conclusion: 
"...the Eurozone should be maintained at almost any cost. All the economic problems in the current crisis can be resolved within the Eurozone...the Eurozone-wide clearing must be maintained in full. The Target2 balances should be resolved by reforms, not by capping national balances. The only reasons for a breakup of the Eurozone would be that Eurozone governance fails completely or that one nation decides to leave. If the breakup starts, it would be better to agree on a complete and speedy dissolution into the old national currencies."


  1. Let me say I completely disagree with this. You cannot compare a command economy with a more or less free market one.

    The Soviet Union,(and Yugoslavia) of course had a fall in output since their output was mostly of inferior, unwanted products, many produced for the state or military.

    The old empire happened long ago, and who knows what part of that economy was also state run.

    That is not to say there will not be some pain, but what will cause more pain? Continuing this impossible debt accumulation until the whole thing falls like a house of cards?

    1. That is true, but think about the institutional system in Greece, Portugal or Italy today? None of them were a command economy, that's true, but all of them were characterized by an unsustainable welfare state model and crony capitalism and corruption that sustained that model.
      The comparison isn't a direct one, but it does tell us what can happen if some countries continue on the road to stabilization on their own, i.e. after experiencing a huge external shock to their economies. They are highly unlikely to become another Iceland, Latvia or Estonia, primarily due to a significantly different institutional environment.

      The socialist transition is a perfect example, as it was purely led by corruption and cronyism, which would, in my opinion, characterize the exiting countries as well. Unless of course, a dictatorship doesn't arise amid the public anger, which would be an even worse option, at least in the longer run.

      as for the more or less pain, I have argued many times before for a set of irreversible structural reforms which would liberalize the labour market, deregulate the economy, and gradually restore public finances and investor confidence in the economy (look no further than Sweden or Germany for good examples of how to do so)

  2. I think they're right about the Target2 balances; if I understood it right, Germany has a net credit of 650bn or so, which was the money used to finance Italy, Spain and Greece's imports, through the central bank clearing system, or something like that? It's basically a huge liability for Germany, and a risky one as well.

    If that's the case, than I perfectly understand the German position that this can't be allowed to go on any further.

    1. Something like that, yes, here's the excerpt form the Bloomberg article I linked to in the post (it offers a pretty good description of how the system works):

      "The Target2 system, named for the Trans-European Automated Real-Time Gross Settlement System, is part of the common currency’s plumbing system to settle transactions.
      A Greek importer, for example, might place an order with a German company. Payments to and from the accounts of the buyer and seller are channeled via central banks, so the German exporter’s bank gets a credit with the Bundesbank, which in turn has a claim on the ECB. The Greek importer’s bank owes its local central bank, leaving the Bank of Greece with a debit at the ECB.
      Transactions across the 17-member euro region produce a net surplus or deficit between countries at the ECB, and the system depends on each country being able to meet its obligations. The less willing commercial banks are to deal with each other, the more lopsided the balances between central banks become. The Dutch central bank has claims on its peers of 153 billion euros, while Luxembourg is owed 110 billion euros, according to Whittaker."

      They also say:
      "The Target2 liabilities are just as risky and just as real as holding the government bonds of Greece and other peripherals"
      So you're right on that point, it is a risky liability for Germany to hold.


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