Euro breakup: Who cares about accounting losses?

With the "Merkel memorandum", The Economist has joined the rows of other commentators on the cost of a euro breakup. The costs are quantified as accounting losses on bailout loans, ECB's bond holdings and Target2 balances, and possibly bank bailouts. Is this all the euro crisis is about? Hardly. The numbers the Economist bases its argument on are accounting losses and fall short of the cost-benefit analysis it claims to be. Here are a few arguments why Frau Merkel will not be impressed by accounting losses:

Losses on bailout loans. It is correct that the paid-out loans may not be repaid as scheduled, prompting Eurostat to reassess their recording as financial investment by creditor countries. But creditor countries could find ways to avoid taking an accounting losses, such as by rescheduling the loans. As the paid-out loans are already funded, a breakup does not increase creditors' gross debt. With debt and deficit not heavily affected, what to fret about these accounting losses? 

SMP losses. It is correct that exiting countries may restructure their government bonds, reducing their face value. But ECB has bought most bonds at prices below their face value, making it unlikely that the accounting loss is as large as the full exposure.

Target2 losses. It is correct that the central banks of exiting countries are likely to become insolvent and may trigger an accounting loss to ECB. But, as with accounting losses on bailout loans, why to fret about it? ECB has large reserves and considerable earning power, and---like other central banks---could remain effective despite being balance sheet insolvent.

Therefore, Frau Merkel will not take interest in accounting losses. She will look at accounting losses in the same way as in other policy areas. And so may her electorate. Who cried out about EUR200 billion or so in subsidies spent on nuclear energy since 1950 when Frau Merkel decided to accelerate the phase-out of nuclear power generation?

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Will Germany become Spain?

This great collection of quotes, comprised by an analyst at Fairfax, an investment bank, has made rounds on the Internet:

"Spain is not Greece." - Elena Salgado, Spanish Finance minister, February 2010.
"Portugal is not Greece." - The Economist, April 2010.
"Greece is not Ireland." - George Papaconstantinou, Greek Finance Minister, November 2010.
"Spain is neither Ireland nor Portugal." - Elena Salgado, Spanish Finance Minister, November 2010.
"Ireland is not in ‘Greek Territory.’" - Brian Lenihan, Irish Finance Minister, November 2010.
"Neither Spain nor Portugal is Ireland." - Angel Gurria, Secretary General OECD, November 2010.
"Spain is not Uganda." - Mariano Rajoy, Spanish Prime Minister, June 2012.
"Uganda does not want to be Spain." - Henry Okelo Oryem, Unganda Foreign Minister, June 2012.

And what is Germany?

Let's step back. European integration and the euro created a new economic union, enlarging the market for the German export-driven economy. German surpluses, nourished by higher external demand, were channeled back into deficit countries. The crisis has put an end to this virtuous cycle of self-financing export demand. ECB liquidity provision and international bailouts are helping deficit countries to repay German loans, in addition to financing capital flight to Germany. These flows, together with largely unchanged high German savings, cause a flood of liquidity in Germany which is no longer channeled back into foreign countries. High and increasing risk aversion limits the choice for investments that are deemed safe, such as Bunds and real estate.

Where could this lead Germany to? After decades of stagnation, real estate prices have started to climb. Demand for real estate assets may stimulate construction, pushing Germany's output above its potential. Ensuing increases in wages and prices may erode the real value of savings and reduce Germany's international competitiveness, slowing external demand. In consequence, safe haven flows may reverse, a real estate bubble may burst, and bad loans may cripple the banking system. And someone may say: "Germany is Spain."

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Why Germany wants to keep Greece in the euro area

Germany had a good crisis---this is how the commentator Satyajit Das, Roubini's fellow blogger and author of "Traders, Guns, and Money"---nicely puts it. Since the subprime crisis spilled over the Atlantic, Germany's output took a leap forward above pre-crisis levels, unemployment plummeted, the budget deficit vanished, and household net wealth grew to about EUR225,000 per household. Today, ECB's monetary policy gives an additional stimulus with interest rates at 1 percent whereas the Taylor rule suggests 4.5 percent would be more appropriate (compared to 2009 when ECB first dropped rates to that level). Recently, the euro started depreciating, giving German exports some extra boost. The crisis works phenomenally for Germany! Why stopping it?

But the current sentiment is overshadowed by tendencies of disintegration. The economic Diktat has stoked popular resentment in the crisis countries, toppling the political leadership and sometimes leaving the necessary political reforms in limbo. This is pretty bad. Unless there are second thoughts on both sides, the alternative is the disintegration of the euro area. While Greece may be the first and obvious candidate to exit, it is hard to imagine how to contain further disintegration. Preventing contagion that will trigger the exit of others (described here) will only be contained through large and unconditional commitments from Germany. These commitments may dwarf the cost of keeping Greece in the euro area in the first place. Let's run some numbers. Below table composes direct breakup costs, losses from German investments in the crisis countries, and the drag on annual export demand. 

The direct breakup losses to Germany from the default of exiting countries on official debts, assistance, and ECB claims are estimated at around EUR75 billion (EUR1,875 per German household). This number would increase to around EUR170 billion (EUR4,100 per German household) if Ireland and Portugal are included, and more than triple if Italy and Spain were added.

The new currencies in the exit countries are likely to depreciate vis-a-vis global currencies, resembling previous currency crises that very often bankrupt the corporate sector given the extent of their foreign liabilities. This would pose a risk for banks and other investors in Germany (and elsewhere) which have significant exposure to those countries. Given the slim capital buffer in banks nowadays, their recapitalization is likely to fall again into taxpayers' laps. Assuming the depreciation in the exit countries and their economic collapse causes losses on German investments of 50 percent in Greece and Portugal, and 25 percent in Italy and Spain, the potential damage on Germany's wealth would amount to EUR0.5 trillion (EUR13,000 per household).

These first two types of losses are a one-time hit, maybe still considered worth the bang compared to annual transfers of about EUR47 billion (EUR1,175 per German household) to plug the fiscal deficits of Greece, Ireland, and Portugal. Adding Spain and Italy would of course increases the annual bill significantly to EUR180 billion (EUR4,500 per German household), all assuming that deficits don't slim down.

In addition to the one-time hit, lower exports may at least temporarily put a drag on Germany's Wirtschaftswunder. Export demand from Greece, Italy and Spain---making up about 10 percent of German exports---would collapse, although there may be some offsetting effects. The appreciation of the neue deutsche Mark would reduce demand for German exports from other countries. In combination, there could be an annual loss in export demand of some EUR100 billion (EUR2,500 per household). 

The crisis is like a good party for Germany, but the next morning will arrive soon. While stakes are high, the situation is not lost. According to a recent survey, the majority of European economists continue to think that fiscal integration is needed to save the euro area. The dominating opinion in Germany is more sceptical. Let's just be aware how costly it is to pull the plug!

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