An often publicly heard policy recommendation is that weaker euro zone members should right themselves through austerity or leave the currency union. In any case, reform---not exit---is the right medicine.
The adjustment program implemented in Greece, Portugal, and Ireland are trying to strike a difficult balance between the necessary and the possible to turn around the economies. Orderly adjustment needs time and solidarity, just as it needed more than a decade and two trillion euros for former East Germany to get close to Western Germany's levels. German reunification like Europe's integration is, then and now, a political challenge and a historical chance. All the economic discipline can contribute is pointing out pitfalls and making good proposals to maximize welfare. The rest hinges on hearts and souls in Europe.
In my previous post, I discussed ways to tackle the debt problem through growth, inflation, transfers or default. In conclusion, I warned about the hidden costs and distributional effects when politicians fish for solutions that are popular with the electorate. In what follows, I argue that the same applies to an exit from the currency union.
Imagine again three countries that form a currency union: A large and strong country, called Oak, whose currency enjoys high credibility. The credibility has lead to internal exchange rate stability (another word for low inflation) as well as external exchange rate stability (another word for a strong currency). Then there is small Olive with a weak currency and inflation, and a large Pepperoni with a likewise weak currency and inflation. These three join into a currency union at reasonably competitive exchange rates, largely adopting Oak's stern monetary policy. What's next?
Only if the currency union is a credible construct will the benefits materialize. Only then will interest rates drop to Oak's level, as does inflation. Why is that? Olive and Pepperoni inhabitants start to believe that the central bank in the currency union is now guarded by oaky officials destined to fight inflation. Instead of expecting an endless spiral of higher prices and a depreciating exchange rates, internal and external price stability become engrained in the people's expectations. No longer do they need to ask for high interest rates on their savings to protect their savings against inflation, no longer do they need to flee their country and deposit their financial savings in Oak. No longer are interest rates high on investment loans. In response to the currency union, capital inflows and investment pick up, in turn creating demand for Oak's exports. This is what happened after the creation of the euro zone to the mutual benefit of all member countries.
If the currency union is not a credible construct, these benefits will not materialize. There is no point in having a currency union (or other fixed exchange rate regime) that is not believed to be lasting. Imagine Olive is being hit by a shock, whether it is self-inflicted (laziness to maintain the orchards until the olive trees are beyond recovery) or not (discovery of better tasting olives in another country). After the shock, the country would suffer from lower demand for their output (dead trees in orchards don't yield a harvest or traditional olives rot on the shelves while imported better tasting ones sell like, well, hotcakes). Banks across the currency union with loans to Olive would suffer losses because farmers are unable to repay their loans. If in this situation, the credibility of the currency union is called into question, the situation would get worse: Olive farmers would shift their savings out of the country, the banks in Olive would become illiquid, and there would be no credit for those farmers who are willing to invest in orchards. (Tendering their existing trees, or planting those with the better taste.)
This is why the integrity of the currency union is crucial. Even worse, the confidence effects are not limited to Olive. Once inhabitants of Pepperoni notice that Olive's exit from the currency union is considered, they would also empty their bank accounts given Pepperoni is known to be a weaker economy than Oak. Pepperoni's inhabitants would anticipate their exit from the currency union in expectation that every country is eventually hit by a shock. With Pepperoni being larger, the currency union would unravel in its entirety. The benefits of the currency union would get lost whether or not the currency union is formally ended or not.
Is it possible to operate a currency union in which there is not full trust? Many countries continue to do so, yet, mostly against the advice of economists. Heavy-handed regulations and ensuing distortions can maintain an exchange rate regime that lacks credibility. However, this usually leads to repeated crises and deadweight losses. Measuring these economic losses is often impossible. Thus, it is probably possible to manufacture an exit of Olive (while preserving the membership of Pepperoni) while curtailing the visible costs through regulations and the like. But, once again, the costs will be high yet hidden. Hence, let's not get fooled that exit is a costless solution, neither to Oak nor to Olive. Those who call for the disintegration of the euro zone should be aware of the political and economic damage they are inflicting on all.
Finally, a note on the benefit of devaluation to Olive upon exiting the currency union. Besides the direct costs to Olive (currency losses of savers, rescue of the banking system, etc.), the question is whether the devaluation does the trick. Given the economic and social pain of an internal devaluation (i.e., lowering domestic prices and wages), the external valuation (i.e., currency devaluation) is indeed an instant pain relief. That is why most countries enjoy high growth rates after a devaluation. Yet, many of them suffered repeated crises with repeated devaluations, and all the unpleasant things that happen during crises. Why does pain relief not do the trick? Because the pain relief treats a symptom, not the cause. The cause are usually inflexible labor markets, inefficiently large public sectors, lack of contract and law enforcement, limited competition, and the like. These must be addressed by reforms.
Structural reform is the right medicine for Olive. Exiting the currency union is not.
