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We read so you don’t have to: UBS on the break-up of the Eurozone

By Ezra Klein,

In early-September, UBS published an analysis (pdf) of what would happen if any countries decided to actually try and leave the Eurozone. Their basic argument is that however bad you think that would be for Europe, it’s likely to actually be much, much worse, with consequences that are both further reaching and more chaotic than a cursory assessment of the situation would suggest. It is, unfortunately, a very convincing paper. Here are the parts I found particularly interesting.

-- “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).”

-- “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.”

“Inevitably, as the Euro today does not work and the crisis has assumed greater magnitude than perhaps it needed to, the argument is often heard that it would be better to break up the monetary union (either completely fragmenting the monetary union, or having one or more states leave). The political and popular debate about break-up frequently misrepresents the position. Because of the misperception of the Euro as some sort of super Exchange Rate Mechanism, its break-up is often presented as having few more severe consequences than the ERM crises and partial fragmentations of 1992-93. Popular misconceptions include the idea that a country will be able to stimulate growth by simply leaving the Euro, that a country can be expelled from the Euro by other member states, or that a strong economy could leave the Euro without significant consequences. All of these arguments are wrong.

-- “For the time being there is no provision in the relevant European treaties for a country to exit the Euro. There is certainly no provision for a country to be expelled from the Euro. Those who casually suggest that a weak country could be forced to leave either have not read the relevant legislation, or do not understand its implications. The objections that the economics profession so clearly raised against the Euro in the 1990s owed much to this irrevocable aspect of the union. Any mistake in membership is permanent.

-- “The only way for a country to leave the EMU in a legal manner is to negotiate an amendment of the treaty that creates an opt-out clause. Having negotiated the right to exit, the Member State could then, and only then, exercise its newly granted right. While this superficially seems a viable exit process, there are in fact some major obstacles. Negotiating an exit is likely to take an extended period of time.

Bear in mind the exiting country is not negotiating with the Euro area, but with the entire European Union. All of the legislation and treaties governing the Euro are European Union treaties (and, indeed, form the constitution of the European Union). Several of the 27 countries that make up the European Union require referenda to be held on treaty changes, and several others may chose to hold a referendum. While enduring the protracted process of negotiation, which may be vetoed by any single government or electorate, the potential secessionist will experience most or all of the problems we highlight in the next section (bank runs, sovereign default, corporate default, and what may be euphemistically termed ‘civil unrest’).”

-- “If one country left, then speculation about other weak economies choosing to leave could then generate costs that are very similar to these. This means that it is very unlikely that a single country (or part of a country) leaves the Euro. If one country believes that the costs of membership exceed the benefits, then the act of crossing the Rubicon and leaving the Euro will then raise the relative costs of membership for other similarly positioned countries (or parts of countries). This would incentivise further departures.”

-- “If a country chooses to leave the Euro, it has essentially two choices with regards to its domestic sovereign debt. The first is to leave the sovereign debt as it is – that is to say, Euro denominated. The problem with this approach is that the entire debt is then denominated in a foreign currency, over which the NNC country has no power of taxation. The only way of earning Euros would be through trade, which is likely to be significantly disrupted – and so default on the Euro denominated national debt is almost certain. The second and more probable option is the forced conversion of Euro denominated debt into NNC debt. This would constitute a default in the eyes of most investors... What makes Euro exit more costly is the fact that as well as the sovereign default, there is also likely to be a corporate default.”

-- “Exiting the Euro is not going to take place with a small depreciation of the NNC [new national currency]. The idea that a 10% or 20% adjustment is all that is required is fantasy (why on earth would any country go through this much trauma for so small an adjustment?).”

-- “Confronted with the obvious uncertainties surrounding the establishment of a NNC, the obvious response of anyone with exposure to the secessionist banking system is to withdraw money from the bank as quickly as possible...The only real way to prevent a run on the domestic banking system would be the introduction of the NNC as a “shock” event, which was entirely unanticipated by the world at large. Given the enormous complexity involved in introducing a NNC, this is not a practical possibility. Indeed, sudden deposit withdrawals have already been observed in parts of the Euro area on even vague suggestions of secession...Bank runs could spread before the actual act of secession, therefore, and become a catalyst for a more widespread crisis in the Euro financial system.

-- “The idea that a seceding state would immediately have a competitive advantage through devaluing the NNC against the Euro is not likely to hold in reality. The rest of the Euro area (indeed the rest of the European Union) is unlikely to regard secession with tranquil indifference. In the event that a NNC were to depreciate 60% against the Euro, it seems highly plausible that the Euro area would impose a 60% tariff (or even higher) against the exports of the seceding country. The European Commission explicitly alludes to this issue, saying that if a country was to leave the Euro it would “compensate” for any undue movement in the NNC.”

-- ”If a country has gone to the extreme of reversing the introduction of the Euro, it is at least plausible that centrifugal forces will seek to break the country apart. If some geographic regions or ethnic or linguistic groups wish to remain within the Euro, demands for a break-up of the country may ensue. It is certainly worth noting that several countries of the Euro area have histories of internal division – Belgium, Italy and Spain being amongst the most obvious. It is also true that monetary union break-ups in history are nearly always accompanied by extremes of civil disorder or civil war.”

-- “Past instances of monetary union break-ups have tended to produce one of two results. Either there was a more authoritarian government response to contain or repress the social disorder (a scenario that tended to require a change from democratic to authoritarian or military government), or alternatively, the social disorder worked with existing fault lines in society to divide the country, spilling over into civil war. These are not inevitable conclusions, but indicate that monetary union break-up is not something that can be treated as a casual issue of exchange rate policy.”

“In 1994, no less a person than Helmut Schlesinger (former Bundesbank head) declared ‘the final goal…is a political one in which the economic union is an important vehicle to reach this target. Since 1952, the beginning of the creation of the European Community, the final goal was and is to reach any type of political unification in Europe, a federation of states, an association of states or even a stronger form of union. The political target has been guiding Germany since the beginning and will certainly continue to do so in the future.’ The economic costs of breaking up the Euro are high, and extremely damaging. The political costs of breaking up the Euro, even in part, are too great to quantify in bald cash terms.”

-- “How can investors invest if they believe in a break-up, however low the probability? The simple answer is that they cannot. Investing for a break-up scenario has not guaranteed winners within the Euro area. The growth consequences are awful in any break-up scenario. The risk of civil disorder questions the rule of law, and as such basic issues such as property rights. Even those countries that avoid internal strife and divisions will likely have to use administrative controls to avoid extreme positions in their markets. The only way to hedge against a Euro break-up scenario is to own no Euro assets at all.”

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