A monetary union of 17 countries with little in common (beyond geographic proximity and a history of invading each other) was never likely to work. This crisis seems to have been inevitable. I, and most of the rest of the economics profession, have argued against the Euro (in its current form, with its current membership) for 16 years.
So the Euro should not exist. However, the cost of breaking it up is hideous. Rough calculations suggest the Greek economy would halve in size if Greece were to exit the Euro zone. That is a far greater cost than anything Asia experienced in the 1997-98 crisis.
If Germany were to try to exit, it would cost it a quarter of the German economy.
There are also political costs. The economic damage (and unemployment) would be the worst since the 1930s. In extremis, that economic pain could provoke anything from widespread social unrest to military government or even civil war.
This leaves Europe trying to work out how to make the Euro work. The solution must involve some kind of fiscal confederation. No monetary union has ever survived without a fiscal union alongside it.
Unfortunately, the politics of fiscal integration are not playing out smoothly. Euro-area politics sometimes seems akin to the politics of the playground. Politicians seem inclined to yell “shan’t” whenever economists ask them to play nicely with one another.
The Euro will develop in time. Unfortunately the process is unlikely to be rapid or easy. The Euro area seems set to experience a series of crises in the coming years. Each crisis will be accompanied by uncertainty, market volatility, and consequences for Asia.
Why should Asia care about the crisis of the Euro area? For two reasons: the current account and the capital account.
Asia does a lot of trade with Europe. The European Union _ the larger grouping of 27 countries, to which the Euro group belongs is the largest single economy in the world, accounting for 27% of GDP. In comparison, the United States is 23% of global GDP. Asia excluding Japan and Australia, but including China and India _ is 18% of the world economy. Asia exported US$541 billion to the EU in 2010. Europe swallows 16% of Asia’s exports directly before accounting for the intra-Asian trade that ultimately feeds European demand (for instance, South Korea exporting components to Thailand which then exports a finished product to Europe).
If the Euro is hit by a series of crises, then weak Euro zone economic growth seems likely. The Euro area will be a less dependable source of demand for Asian exports. Which means Asian demand will have to substitute for Euro area demand.
Under the current structure and with the current membership, the Euro does notwork. Either the current structure will have to change, or the current membership will have to change.
Fiscal confederation, not break-up
Our base case with an overwhelming probability is that the Euro moves slowly (and painfully) towards some kind of fiscal integration. The risk case, of break-up, is considerably more costly and close to zero probability. Countries can not be expelled, but sovereign states could choose to secede. However, popular discussion of the break-up option considerably underestimates the consequences of such amove.
The economic cost (part 1)
The cost of a weak country leaving the Euro is significant. Consequences include sovereign default, corporate default, collapse of the banking system and collapse of international trade. There is little prospect of devaluation offering much assistance. We estimate that a weak Euro country leaving the Euro would incur a cost of around EUR9,500 to EUR11,500 per person in the exiting country during the firstyear. That cost would then probably amount to EUR3,000 to EUR4,000 per person per year over subsequent years. That equates to a range of 40% to 50% of GDP in the first year.
The economic cost (part 2)
Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year,and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over EUR1,000 per person, in a single hit.
The political cost
The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without someform of authoritarian or military government, or civil war.
“I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.” Romano Prodi, EU Commission President, December 2001.
The Euro should not exist
More specifically, the Euro as it is currently constituted – with its current structure and current membership – should not exist. This Euro creates more economic costs than benefits for at least some of its members – a fact that has become painfully obvious to some of its participants in recent years. The Global Economic Perspectives draws on the research UBS has published over the past fifteen years looking at the issues surrounding the Euro and its existence. If the Euro does not work (and it does not), then either the current structure needs to change, or the current membership needs to change. Rather than go through the options for keeping the Euro together (fiscal confederationbeing the central idea, and our base case), we look at the consequences of attempting to break up the Euro.
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