Sunday, February 21, 2010

What If Germany Exited The Euro Area ?

A Swedish reader asked with regard to my post on the practical difficulties surrounding Greece or some other country with high deficits leaving the euro area for the purpose of competitive devaluation/depreciation, about a hypothetical scenario I didn't discuss, namely if Germany instead exited the euro area so that Greece and the others could lower the value of their currency without exiting the euro area.

I was well aware of this idea, as Ambrose Evans-Pritchard recently advocated it. I didn't address it because for one thing I thought that the post was on the verge of becoming too long, and because it is completely unrealistic, in many ways even more so than the scenario of the weak countries leaving.

First of all, the practical difficulties would be virtually as large. Assuming German deposits and bonds would be converted into New Marks, then this too would create a run against the financial systems in the rest of Europe. Why would anyone want to hold accounts or bonds in the rest of Europe if they're practically guaranteed high returns (the whole purpose if this operation is to raise the value of German currency) if they hold German accounts or bonds?

This problem could be eliminated if German accounts and bonds remained denominated in euros even after the introduction of a "New Mark" (or whatever the new currency would be called). But that would create other disruptions. Just as domestic currency depreciation is bad for borrowers with foreign currency debts, domestic currency appreciation is bad for creditors with foreign currency debts. German savers and banks would suddenly lose much of their assets as they drop in value along with the euro. And this wouldn't be limited to just assets in Germany, their holdings elsewhere in Europe would also lose value. The effect for German savers and banks would be a partial default on all of their fixed income assets, creating much more trouble for them than if Greece or some other state had a partial default.

The second big problem is that there is absolutely no reason why Germany would want to do so. Germany is not under any market pressure, quite to the contrary as their bonds have gained "safe haven" status within the euro area. While they could possibly maintain such a status, some of the safety for other euro area residents consists in the lack of exchange rate risk, something which would go lost if Germany had a separate currency. And with an independent currency, "safe haven" status will mean that the value of your currency will be driven up, causing disruptions and problems for your exporters. This could partly be compensated in the short term by the reduced debt burden for the German government, but because the value of the safe haven status would be significantly reduced, and because of the losses for German investors in other parts of the euro area, this gain will be much smaller than the losses for German investors.

Furthermore, this scheme would greatly damage the German export industry, both because of lost exchange rate stability and because of the higher value, causing great job losses in Germany. The 43% of German exports goes to and 46% of German imports comes from the rest of the euro area (with a few more percentage points being with Denmark and others with fixed exchange rates to the euro)would suffer the most, but as the "New Mark" would probably appreciate against other currencies as well (though probably by less than against the euro as the euro would presumably depreciate), exports to other parts of the world would also decline.

Why should Germany even consider such a scheme given the damage it would inflict on both its financial sector and its foreign trade? There is no way Germans would want to make such large sacrifices just because it would allegedly help foreigners with fiscally irresponsible governments.

Some might say that they would do so because they don't want to bail out these other governments. But that doesn't hold. First, because the proposed scheme would itself be a form of bail-out, and a very costly one for Germany. And secondly, there is nothing in EU treaties that compels Germany to bail out the governments of other euro area countries. EU treaty in fact explicitly forbids the ECB or the EU from doing so, and any bail-out would therefore have to carried out directly by other national governments and that would be voluntary for them.

Germany is unlikely to agree to any hand-outs (as in gifts) to Greece or others. And any loans would likely come only if Germany felt it would be beneficial to them, for example if they got paid say two percentage points in premium compared to Germany's own cost of borrowing (under such a "bail-out", Germany would thus actually earn money) and were also coupled with increased external supervision and the implementation of further fiscal austerity measures.

In short, the idea that Germany would exit is even more unrealistic than Greece exiting, because it would be more obviously damaging to the country that is supposed to leave.