Student NameChin Pey PhuahFergus ColleranSamuel Cronin

Student Number(in order)

102869421027532110276297

Assessment Title The breakup of Eurozone

Course Fin 40990 Capital Markets and Instruments

Lecturer Dr. Elaine Hutson

Date Submitted 28th October 2010

OFFICE USE ONLYDate ReceivedOFFICE USE ONLYGrade/Mark

Declaration of AuthorshipI / We declare that all material included in this project is the end result of my/our own work and that due acknowledgement has been given in the bibliography and references to all sources be they printed, electronic or personal.

…………………. …………………. …………………..Signed: Chin Pey Phuah Fergus Colleran Sam CroninDate: 28th October 2010

Table of Contents

Page

Executive Summary ............................................................................................................i

1.0 Introduction ........................................................................................................................1

2.0 Findings and Discussion

2.1 Scenario 1: Departure of Germany from the Eurozone..............................................2

2.2 Scenario 2: Departure of Struggling economies from the Eurozone..........................5

2.3 Obstacles to Exit ….…...............................................................................................8

2.3.1 Economic Obstacles

2.3.2 Political Obstacles

2.3.3 Technical and Legal Obstacles

3.0 Conclusion .........................................................................................................................12

4.0 Appendices ........................................................................................................................13

5.0 References ..........................................................................................................................14

Executive Summary:

This paper examines the possibility of the breakup of the EMU in three main sections.

Firstly the incentives and disincentives are examined for Germany to leave the Eurozone and

reintroduce the Deutschmark. Then the weaker economies or so-called “Pigs” are considered

with particular emphasis on Greece. Finally a closer look is taken at the various obstacles to

exit and why there may be more incentives to stay within the EMU than the obvious

economic implications.

If Germany decided to exit the Eurozone they would regain control of their monetary

policy. They would then increase interest rates to target their problematic rate of inflation.

This would result in an increase in the value of the Deutschmark relative to the Euro. In

Germany's absence the remaining members of the EMU would be able to increase interest

rates to combat the more widespread problem of slow growth. Germany would also no longer

be responsible for a Greek bail out, something that is very unpopular with the German

taxpayer who ultimately would have to cover the cost. On the other hand the cost of German

labour per unit economic output would likely shift back to historic highs. This would lead to

a loss of competitiveness in international markets. If Germany (or any other Eurozone

country for that matter) reintroduced their national currency they would also have to

undertake the large costs associated with printing and distributing the new currency. Another

negative effect for the remaining members of the EMU would be the swift decrease in price

stability in the Eurozone after losing close to a quarter of its monetary base.

Like the German example, there are many pros and cons for a weaker member state to

abandon the Euro. The main economies in question are that of Portugal, Ireland, Greece and

Spain or the “Pigs” as they have become known. These member states all have significant

budget deficits and little or no growth. They are consequently meeting with great difficulty

raising much needed funds on the international bond markets. They are facing the

implementation of tough austerity measures over the foreseeable future and resulting

stagnation. If however Greece (for example) was to abandon the Euro and reintroduce the

Drachma there would be a number of theoretical positive results. If Greece regained its

monetary policy they could devalue the Drachma in order to increase competitiveness

through exporting and tourism. On the other hand, as with the German example, there would

be large procedural costs associated with the changeover. It would also take a significant

period to plan and implement the changeover. The greatest disincentive would probably be

the relative increase in public debt as the Drachma devalues relative to the Euro. The Greek

public, as well as international economic agents would have a disincentive to hold Drachma

with impending devaluation a certainty. This would potentially lead to a bank run which

would cripple the Greek economy. There is also a high risk of speculative attack in the

reintroduction of a national currency with the view to devalue.

As well as the aforementioned negative effects of leaving the EMU there are also

several other “costs” associated with such action. The economic costs include wage inflation,

credit rating downgrades and the possibility of the reintroduction of export duty for devalued

currencies. In terms of political costs, a country that chose to leave the EMU may

subsequently be forced to leave the EU due to pressure from member states. There would

also be the issue of legality to consider before action could be taken. The Maastricht Treaty

clearly has no provision for exit.

In considering the material contained in this report, focusing on the advantages and

disadvantages for individual countries to exit the Eurozone, it is apparent that there is little

chance of the Eurozone disbanding in the near future.

1.0 Introduction

The on-going debate of Eurozone breakup has caught global attention. Even before the

formation of single currency, many world renowned economists and researchers have

questioned the sustainability of having the Euro as the single currency of 16 nations with

varying macroeconomic performance. The idea behind the adoption of Euro is to have a

centralized monetary policy to maintain price stability. Price stability is a crucial element in

the effort of increasing economic welfare and growth of an economy (European Central

Bank, 2010). In order to join the Eurozone, a country must meet the convergence criteria set

out by the European Central Bank (ECB). Up to 2007, it was a success and the level of

Eurozone as a whole as the ECB managed to keep both inflation and growth in line with the

targeted rate (Baldwin, Gros and Laeven, 2010).

However, a closer look suggested the one-size-fits-all monetary policy seems to exhibit

problems. The absence of deficits and debt discipline in some of the countries resulted in

violation of the criteria. According to (Baldwin et al., 2010), from 2000 to 2007 Greece

violated the budget deficit of less than 3% of gross domestic product (GDP) rule eight out of

eight years; Italy five out of eight years; Portugal and Germany four out of eight years and

France three out of eight years (see table 1). This created huge current account imbalances in

the Eurozone. It started with Greece’s standard fiscal crisis in early 2010 and swiftly led up

to the Eurozone crisis. Many economics and financial analysts, including leading economics

consultancy Capital Economics reportedly discussed the possibility that one or more member

might depart from the European Economic and Monetary Union (EMU) (Donovon, 2010).

This paper seeks to discuss the possibility of Eurozone breakup by looking at two

scenarios. The first scenario considers the advantages and disadvantages of countries with

trade surplus like Germany departing from EMU, and the second scenario considers

countries with trade deficits like Portugal, Ireland, Greece and Spain. Following that, the

paper will run through the obstacles to abandon the euro and readopting the national currency

of one country. It is argued that there are three main obstacles, which are the 1:Economic,

2:Political and 3:Technical and Legal barriers.

2.0 Findings and Discussion

2.1 Scenario 1: Departure of Germany from the Eurozone

The defection of Germany brings both advantages and disadvantages to the country and

also the EU zone as a whole. The most obvious advantage to Germany by reintroducing their

national currency which is the Deutschmarks would be that they will have total control over

their own monetary policy. This will enable Germany to correct the asymmetry in interest

rates that existed during the adoption of one-size-fits-all policy and also maintain a low

inflation by pursuing a tighter policy (Thygesen, 2003). Germany who favors high interest

rate would then be able to attract more investment capital.

In addition, departure from the Economic and Monetary Union (EMU) would also help

Germany to appreciate the restored Deutschmarks (Elliott, 2010). Donovon (2010) suggest

that the appreciation of Deutschmarks will help push domestic demand to maintain jobs and

growth that in turn will increase the German’s standard of living. As Germany would be

replacing Euro with a stronger and more stable currency, this may leave the residual

countries in EMU especially those with a weak economy such as Portugal, Italy, Ireland and

Greece with an enhanced competitiveness that would assist them to boost growth and

subsequently climb out of recession. Zeihan (2010) suggested that Germany don’t mind a

strong currency because what they are producing is high on the value-added scale that gives

them the competitive edge.

Apart from that, Germany’s defection would also release them from the financial burden

of supporting weaker countries’ economy. Graydon (2010) reports that the proposed Greek

bail-out receives little support from the public in April 2010, where the survey shows only 16

percent of German supported the idea. Also noted in his report, a large amount of the Greek

debt held by German banks is being held by banks which have previously been bailed out

and are now owned by the German state. Therefore if these banks failed as a consequence of

bailing out Greece, the aftereffect would be at German taxpayers’ expense. To use taxpayers’

money to back the struggling finances of another country will never leave the taxpayers

happy with the German government.

It is undeniable that the deutschmark had a well-grounded reputation for being a store of

value as the renowned Bundesbank directed Germany’s monetary policy. Papic, Reinfrank

and Zeihan (2010) forecast that it is most likely that deutschmark regain credibility in a short

period if Germany were to reintroduce its national currency. According to Elliott (2010),

defection of Germany would also prevent other core members in the euro area such as France

to suffer from the deflationary bias in German’s economy policy.

In the early 1990s, Germany recorded the highest cost of labor per unit of economic

output produced relative to other countries when the reunification upsurge wages and labor

taxes. However after Germany joined the euro zone in 1999, they recorded a decrease in

labor cost due to fierce competition (see table 2) (The economist, 2005). The emergence of

single currency can be described as putting all countries in the euro area in one fighting ring

competing for pretty much everything. In order for Germany to compete with others cost

effectively, workers at several large companies are forced to put in additional hours without

extra pay or take a pay cut to avoid the threat that firms will move factories to a cheaper cost

country. Therefore if Germany leaves the euro zone now and reintroduces its revalued

national currency or other country in the euro zone abandon euro and reintroduce its

devalued national currency, German companies might see themselves in the same situation as

they were in the early 1990s- a loss of competitiveness relative to other countries.

To reinstitute the deutschmark, Germany would have to first reinstate its renowned

central bank, and then withdraw its reserves from the European Central Bank, follow by

printing its own currency and re-denominate the country’s assets and liabilities to the

national currency. Not limited to the above, Germany would have to go through a long tiring

process to again use the deutschmark. Therefore, it can be deduced that Germany will incur a

high conversion cost. The barriers to exit EMU will be discussed more in depth later in the

paper.

Eichengreen (2007) demonstrated the effect of departure according to country size. He

claims that bigger countries are more likely to affect the incentives of other members to

maintain a monetary union for the prospects of corollary benefits. Hence, if Germany

defected, it would significantly diminish the price stability benefit of euro and the driving

force for financial deepening ascribed to the single currency as the size of the euro area

would decrease by more than a quarter. He also proposed that departure of a few big

countries could result in general disintegration in the euro area. Therefore, it can be deduced

from the above disadvantages that Germany or another big economy with trade surplus are

most unlikely to depart from the Eurozone or a total breakup of the Eurozone abide there

may be immediate benefits considering there may exist bigger and longer term consequences.

2.2 Scenario 2: Departure of struggling economies from the Eurozone

In the recent international crisis the strength of the Eurozone has and continues to be

tested. The majority of this is due to four or five of the weaker Eurozone economies, namely

that of Portugal, Ireland, Italy, Greece and Spain. The media has given the collective name

“P.I.I.G.S” to these member states. The thing these economies have in common is that they

are all running substantial budget deficits and are experiencing trouble in the international

sovereign bond markets. When the Euro was introduced these countries found themselves

with a much stronger currency than their previous domestic currencies. This allowed them to

borrow money (issue bonds) at much lower rates then before. This cheap money gave way to

overspending during the period between the introduction of the Euro and the international

financial crisis. This is now evident by their large budget deficits. It now seems that these

countries are left with two options, either to maintain tough austerity measures by drastically

cutting spending/increasing taxation or quitting the Eurozone altogether. With either of these

strategies comes several pros and cons that would have to be carefully considered before any

action was taken.

The main reason these countries would exit the Eurozone would be to regain control over

domestic monetary policy. The ECB's objective is to maintain inflation below but close to

2%. Because of this the current interest rate set by the ECB is more suited to Germany and its

concerns over inflation rather than say Greece's debt problem. Taking Greece as the best

example, if the Greek government were to do away with the Euro and reintroduce the

Drachma they would be able to devalue their currency in order to become more competitive.

It would become possible for them to print more money in order to buy domestic government

debt and bypass the international credit markets (Zeihan 2010). Once the domestic currency

was sufficiently devalued Greece's exports would become more attractive and there would be

an increase in tourism. This increased economic activity would in theory yield higher growth

and thus lead the way for economic recovery. On the other hand if Greece stay in the

Eurozone they can look forward to years of stagnation as they continue to implement tough

austerity measures dictated by the ECB and the IMF.

As well as these seemingly positive consequences of leaving the Eurozone, there are

many potential drawbacks. The procedural cost of reintroducing the Drachma would be

enormous. Notes & coins would have to be printed/minted and dispersed, ATMs would have

to be reconfigured and computer code would have to be rewritten (Eichengreen, 2007) This

process, as well as the lengthy political talks and preparation that would have to take place

for such action would ensure that this could not happen over night. The whole process may

take up to two years! Another concern would be the unpredictability of the state of the

Eurozone after this lengthy preparation. If Greece decided tomorrow, based on current

information, that they would like to reintroduce the Drachma, it would inevitably go into

circulation at a time in the future when things could be drastically different.

As well as logistical problems, perhaps the biggest problem with devaluation would be

the relative increase in already existing public debt. As the Drachma decreased in value

relative to the Euro, the budget deficit would become increasingly difficult to manage. It

would also be detrimental to hold Drachma because of its decreasing value. The Greek public

would have a strong incentive to keep their holdings denominated in Euro. This would

inevitably cause panic and the Greek people would shift funds from Greek bank accounts to

overseas banks in the rest of the Eurozone. This could well lead to a nationwide bank run and

cripple the Greek economy. To combat this the Greek government would have to implement

emergency laws in order to force the Greek public to hold on to their Drachma. Any such

system would be a nightmare to operate and would lead to other problems such as a black

market in Euro.

The Drachma would also be prone to speculative attack on international markets from

economic agents hoping to profit from it's demise. This may be similar to “Black

Wednesday” where the Bank of England had to withdraw the British Pound from the

European Exchange Rate Mechanism (ERM) due to the short selling of speculators.

From a Greek point of view (or any of the other “Pigs” economies for that matter)

reverting to their national currency and devaluing would more than likely be detrimental to

the recovery of the economy. The theoretical advantages from such action would be grossly

outweighed by the negative consequences mentioned above. I therefore conclude that it is

quite unlikely that these nations will take this action.

2.3 Obstacles to Exit

There are many obstacles to exiting the Euro. Eichengreen (2007) mentioned the three

main barriers to exiting the Euro currency, these are ‘Economic Reasons’, ‘Political Reasons’

and ‘Technical and Legal Reasons’. These are the three obstacles we will be discussing here.

2.3.1 Economic Obstacles:

The theory behind a country, whether it be a larger, stable country like our example,

Germany, or be it a smaller less stable country like Ireland for example, wanting to leave the

Euro is varied. As mentioned above, a country like Ireland may want to leave and de-value it’s

currency to try and encourage growth through exports and increased tourism for example.

However this would lead to significant wage inflation, as workers react and anticipate this move,

which may contribute to negating any external benefits. Joining the Euro has been proven to

reduce debt servicing costs, so leaving would have the inverse effect. There would also be the

possibility of credit rating downgrades, higher sovereign spreads and an increase in interest

costs, as, again, investors anticipate and react to this move.

For a country like Germany, if they left the EMU they may have a problem with

companies moving to neighbouring countries that will have cheaper labour, in comparison with

the now appreciated Deutschemark.

Eichengreen also mentions the fact that countries that leave and depreciate their

currencies may be forced to pay an export duty if dealing with other EU countries, as defecting

country may have be seen as unfairly manipulating its currency and attempting to solve its

problems at the expense of it neighbours. This would also bring about some unprecedented

border controls, which would add to the transaction costs. More severely again, such actions may

eventually lead to the restriction on the freedom of travel that Europeans have enjoyed in recent

times.

2.3.2 Political Obstacles:

Jacques Delors once said “Obsession about budgetary constraints means that the people

forget too often about the political objectives of European construction. The argument in favour

of the single currency should be based on the desire to live together in peace” Prior-

Wandesforde, Robert (2005). Indeed, this is how many people still see the European Union, and

if a country were to try and leave the EMU they would more than likely have to bare significant

political costs. For one, leaving the EMU may mean leaving the EU, this may be dependent on

the terms of separation, whether amicable or not. ‘True’ Europeans would see that a country

wishing to leave does not hold to a high level the larger process of political integration. They

may therefore be ‘demoted’ to a second tier European country. They would not hold a strong

voice in EU parliamentary discussions, in fact they may be made leave the EU altogether.

For a country like Italy, which was initially amongst the main countries to set up the

European Union, defecting from the EMU would have detrimental effects on its political powers.

Some even believe that Italy was elevated to a premier tier country by this alone and that if they

defected they would do irreparable damage to their European position.

Germany has an almost unique reason for staying. Though almost 70 years ago at this

stage, Germany is still bearing the long dark shadow cast by WW2. Indeed the only way

Germany may see the European Union as a way to regain a voice in foreign policy. Eichengreen

(2007) believes that Germany will choose voice and loyalty over exit. The fact that Germany was

a founding member of the EU and still firmly believes in the idea of European political

integration leads Eichengreen to believe that they will invest more in seeking to fix the perceived

problems than another member state with weaker commitment to the larger European process.

Germany would see a failure of the monetary union as a failure of the European Union as a

whole and will therefore suffer the monetary policy that doesn’t currently suit it and lobby for

changes for the better rather that just leaving.

2.3.3 Technical and Legal Barriers:

The fact that the country will have to re-denominate all its money to its new domestic

currency brings about a whole new set of challenges. Everything from wages and pensions to

credit-card debt and mortgages will have to be redenominated. This would have to be

comprehensive and fast, going on the example set by Argentina’s exit from convertibility in

2001 (VOX 353 Blejer, Levy-Yeyati 2010). However the redenomination and subsequent

devaluation may evoke strong political and social reaction as it will benefit bank debtors and hurt

bank deposit holders. This may also lead to people moving their savings out of national banks

and into other European banks, much like what happened in Argentina, which may cause the

banking system, already in a weakened position in many EU countries, to collapse. To prevent

this, Argentina imposed a ‘deposit freeze’, a policy which eventually led to governmental

collapse.

Technically, nothing stops the legislature to pass a law requiring banks, firms and

households to redenominated their contracts, however this will inevitability require a lengthy

debate and planning and will not be an immediate solution. Everything from computers to tolls

bridges will have to be adjusted for the new domestic currency, which in turn will have to be

distributed, all of this coming at a large expense.

There is also the issue of debt and bond contracts and the legality of switching them to a

new domestic currency. This is further complicated by the grey area of what exactly constitutes a

certain country’s debt, as not all of the country’s debt is issued by nationals of that country, to

nationals of the same country. A country can issue bonds abroad, foreigners can hold bonds of

that country, etc. There is basically no precedent on this to guide courts. This would lead to a

lengthier process again, possibility of litigation and of further uncertainty for the defecting

country. As the defecting country would be dealing with its European neighbours, this would

again lead to increased tension between the countries.

However even given all of these points, it is hard to know exactly how other European

countries would react to a member of the EMU wanting to leave. Denmark, Sweden and the UK

have all enjoyed the benefits of the single market without taking part in the Euro currency.

3.0 Conclusion

After weighting the potential advantages and disadvantages for a country to leave or stay

in the Eurozone and also by taking into conisderation the obstacles to exit, we conculue that it is

much more likely that one or two members leave as opposed to a complete breakup in the next 5

years. However, it is still realistically unlikely that any country will leave at all. Even though

some countries are protesting against current austerity measures and Eurozone confidence is at a

particular low, yet they have not yet call for a unilateral exit from the euro. I think that they will

ultimately see that this as the way forward economically for Europe as a whole.

No matter how you look at it, countries like Germany have better managed their

economies than countries like the ‘P.I.IG.S.’. Whether this is a cultural, historical or traditional

thing that cannot be easily changed, for example a relatively high tax evasion in Italy or low

productivity in hotter countries like Spain. However, people still recognise the great benefit of

the Eurozone and also the European union in both economically and politically.

Ireland has no reason to worry about Eurozone break up, but we must appreciate that (and

I think we are generally realisitic about the coming years) the recovery will be slow and

economically painful. However, we must realise that sacrafices have to be made. The public

service needs to be overhauled and the bonus culture of financial institutions needs to be reined

in. But there are even obstacles in our path to recovery. For example, trade union power has

meant that budget cuts to the health service can’t be made through wage cuts, but now will have

to be through spending cuts for key equipment and job cuts. The country has to realise that

unless we are willing to sacrafice that the road to recovery will be much longer than many people

anticipate.

4.0 Appendices

Table 1: Euro zone policy framework in practice, 2000- 2007

Source: Baldwin, Gros and Laeven (2010)

Table 2: Eurozone labor cost

Source: Zeihan (2010)

5.0 References

Baldwin, R., Gros, D., Laeven, L. (2010). Completing the Eurozone Rescue: What More

Needs to Be Done?. Retrieved from Centre for Economic Policy Research: www,cepr.org

Barry, C. Associated Press (May 18 2010). European Break Up No Longer Unthinkable.

Retrieved from http://www.thestar.com/business/article/811062--Eurozone-breakup-no-longer-

unthinkable

Blejer, M.I., Levy-Yevati, E. (2010, 21 July). Leaving the Euro: What’s in the box? Retrieved

from VOX.EU

Donovon, J. (2010, July 10). Euro-area breakup may boost economies from Greece to

Germany, Report says. Bloomberg. Retrieved from http://www.bloomberg.com/news/2010-07-

10/euro-area-breakup-may-boost-economies-from-greece-to-germany-report-says.html

Eichengreen, B. (2007). The breakup of the euro area (Working Paper 13393). Department of

Economics, University of California, National Bureau of Economic Research.

Elliott, L. (2010, July 11). Break-up of Eurozone would speed up recovery, thinktank says.

Guardian.co.uk. Retrieved from http://www.guardian.co.uk/business/2010/jul/11/european-debt-

crisis-germany-euro

European Central Bank (2010, October 26). Monetary Policy. Retrieved from

http://www.ecb.europa.eu/mopo/html/index.en.html

Graydon, E. (2010, April 29). Germany finds bailing out is hard to do. BBC News. Retrieved

from http://www.bbc.co.uk/news/10090578

Prior-Wandesforde , Robert (2005), “European Meltdown? Europe Fiddles as Rome

Burns,” Macro: European Economics, HSBC Global Research, London: HSBC (July).

Papic, M., Reinfrank, R., and Zeihan, P. (2010, May 18). Germany, Greece and exiting the

Eurozone. Retrieved October 19, 2010, from

http://www.stratfor.com/weekly/20100517_germany_greece_and_exiting_Eurozone

The economist. (2005, February 15). The real picture. The Economist. Retrieved from

http://www.economist.com/node/3666544

Thygesen, N. (2003). A “One-Size-Fits-All” Monetary Policy. Retrieved from

http://www.europarl.europa.eu/comparl/econ/pdf/emu/speeches/20030910/thygesen.pdf

Zeihan, P. (2010, May 16). Germany: Mittleleuropa Redux. Retrieved October 19, 2010, from

http://www.stratfor.com/weekly/20100315_germany_mitteleuropa_redux