November 21, 2007
The euro: like it or lump it
Barry Eichengreen has a post on Voxeu about how difficult it would be for a country to make an orderly exit from the euro. (The column draws on a longer NBER working paper.) The strength of the euro is squeezing Europe, and especially Italy, very hard. There is some talk of pulling out of the euro system. If only. Italy would surely benefit if it could. But, as Eichengreen explains, it literally cannot without precipitating a really fearsome financial crisis.
In 1998, the founding members of the euro-area agreed to lock their exchange rates at the then-prevailing levels. This effectively ruled out depressing national currencies in order to steal a competitive advantage in the interval prior to the move to full monetary union in 1999. In contrast, if a participating member state now decided to leave the euro area, no such precommitment would be possible. The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.
Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises.
What government invested in its own survival would contemplate this option? The implication is that as soon as discussions of leaving the euro area become serious, it is those discussions, and not the area itself, that will end.
A cynic’s instinct would be to say that scholarly articles explaining why the euro system cannot break up mark the beginning of the end–but Eichengreen’s logic seems impeccable. Italy would surely have been better off if it had never joined the system (an isssue Eichengreen does not go into here), but it is too late for regrets now. The title of the column is the only mistake I can see. "The euro: love it or leave it?" That surely ought to be: "The euro: like it or lump it [no question mark]."
