Jens Nordvig: The eurozone break-up debate - Uncertainty still reigns

06 November 2012

Conversations about the break-up of the eurozone are changing. This column argues that an 'avoid break-up at all costs' dogmatism may not be a prudent view.

There is still limited consensus on the implications of various forms of breakup and on the preferred path for the eurozone. European policymakers remain stubbornly adamant that the euro is irrevocable. Meanwhile, academic economists and market strategists continue to disagree about both the merits of keeping the eurozone together and about the costs of any break-up scenario.

No historical precedent

Despite several years of debate, little progress towards reaching an informed consensus has been achieved. But why? And what can be done to more objectively evaluate the implications of various breakup scenarios?

If we look back through history far enough, there are plenty of examples of currency unions that have broken apart. Despite such evidence, there really is no historical precedent for the breakup of a currency union as unique as the eurozone. This is because:

• The eurozone is large in economic terms. Its size differs from past currency unions that have split, typically involving much smaller countries. The eurozone accounts for roughly 20 per cent of global GDP; Greece, Italy, Ireland, Portugal and Spain alone accounting for 6.7 per cent. By comparison, the Soviet Union’s ‘ruble zone’ - a recently disintegrated currency union - accounted for only 2.5 per cent of global GDP.
• Eurozone financial markets and institutions play a disproportionately large role in the global financial system. Indeed, eurozone banks account for 35 per cent of global bank assets and for 34 per cent of global cross-border lending. No currency union break-up in history comes close in relation to its importance for the global financial system.
• Eurozone countries are substantially wealthier than other countries that have experienced a break-up in the past.
• The euro serves a unique role both as a reserve asset and as a currency widely used in international capital markets. The euro’s truly international features raise new problems that were not features of earlier periods of currency union disintegration.

No one truth about eurozone breakup

Over the past few years, we have seen a flurry of statements about the near-infinite cost of eurozone break-up. However, conditions change. Statements that were true in the past may no longer apply. The analysis of a Greek exit scenario is a case in point; foreign investors have dramatically reduced their exposure to Greece over the past few years and, in particular, eurozone banks have only a fraction of the exposure they had in early 2009.

Additionally, the eurozone’s backstop infrastructure has been dramatically expanded, providing a better chance of limiting contagion effects in the eurozone and avoiding an uncontrolled systemic crisis. These changing circumstances are now reflected in officials’ recognition that the cost-benefit analysis of a Greek exit has changed.

The break-up scenarios now being debated, that involve strong countries exiting, also change the analysis. Problems associated with extreme capital flight that have, in the past, been used to argue that the cost of a break-up would be prohibitively costly, would be smaller in a situation where a strong country leaves. For instance, it is conceivable that a Finnish exit could be managed without devastating disruption to financial markets. Thus, 'avoid break-up by all means' is not a universal truth.

We ought also to consider the costs of the status quo; how much would non-break-up cost? Often, the cost of break-up is analysed in isolation. The cost of the current policy path is not explicitly accounted for. Quantifying the cost of the status quo is a dynamic exercise and most would agree that the current path has been more costly than was predicted a few years ago. It is not analytically objective to a priori exclude the possibility that the cost associated with non-breakup could exceed the cost of breakup.

Conclusion

Economists still have a lot of work to do. We need a robust cost-benefit analysis that includes specific eurozone break-up scenarios versus the costs of the current path of gradual eurozone integration. Many different eurozone break-up scenarios have been debated but without being able to properly quantify the effects of break-up scenarios, uncertainty still reigns.

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