Eurozone break-up will be traumatic but is now inevitable
IT is good to see Sir Mervyn King and David Cameron both being a little more open about the possibility of a Greek default. We need realism, not delusion, from our central bankers and politicians; and it is looking more likely by the day that Greece will elect a rabidly anti-austerity government next month, default on its debts and exit the euro. Yesterday’s inflation report from the Bank of England was inevitably a damp squib: even approximate forecasts are impossible until we gain greater visibility on the Eurozone’s great unravelling. Even the reduced UK growth forecast of 0.8 per cent for 2012 could end up being over-optimistic.
Will a Grexit be containable – or will it be a Bear Stearns, a dry run which ends up precipitating a new Lehman Brothers that takes down the whole EU economy? The realistic best-case scenario is somewhere in between – but nobody really has a clue, so fancy forecasts are useless. The fact that the Bank of England has assigned, somewhat ludicrously, a tiny but non-zero probability of UK growth hitting nearly six per cent by 2014 and 2015 shows that there is something very wrong with its fan chart forecasts.
But while the short-run pain from countries exiting could be immense, the consequences for them of staying in would be worse long run. The main reason why the euro needs to break up is because many of its current members allowed their competitiveness to deteriorate disastrously both before and after they joined the single currency. Prices and costs rocketed in some countries; in the past, this might have triggered a drop in their exchange rate. Tragically, they don’t have the internal political strength to slash their costs and regain their competitiveness the hard way. Politicians told their electorates so often that they would be able to have their cake and eat it that reforms have now become politically impossible.
The result is that the euro helped create a huge current account surplus in parts of the region and a huge current account deficit in other parts, with capital flowing in the opposite direction. An analysis by Doug McWilliams of the Centre for Economics and Business Research (CEBR) reveals that since 2000 Greece has lost 24 per cent of its export market share (from an already low base), France 20 per cent and Italy 18 per cent. Germany’s share has risen by 23 per cent. The German current account surplus this year is likely to be about $180bn. It has been the great winner from the euro; the single currency’s collapse against the dollar in recent days is giving its exporters yet another boost.
The euro fuelled another problem that is now unravelling. The yield premium to compensate for the risk of investing in euro-denominated bonds issued by a weak country compared with those issued by a strong country kept on narrowing. Investors started to believe that there was a single European government, and that this meant than any debt denominated in euros was safe. It was thus claimed that the single currency had achieved a free lunch: lower interest rates for all countries, without damaging the credit of strong countries. But the low rates in periphery countries, including Spain and Ireland, helped fuel property bubbles.
The cost of euro break-up will range from 2 to 5 per cent of Eurozone GDP, the CEBR estimates, and could even reach $1 trillion at worst, depending on whether it is orderly and on how many countries leave. But whatever the cost, growth will be faster afterwards than it would be under the current set of policies. Intense disruption could be imminent – it’s time to fasten your seatbelts.