Investors in euro assets will have realised the currency is at a crisis point. The question now is whether it can survive and, if so, in what form.
The European Central Bank (ECB) has lost its battle with markets over indebted governments on the eurozone periphery, in particular Greece, Ireland, Portugal and Spain.
After the European Union (EU) and the International Monetary Fund (IMF) bailed out Greece in the spring, the ECB stalled the crisis by printing money and buying peripheral eurozone debt. However, it has realised a repeat would devalue the euro and stoke international currency wars.
Instead, the ECB has settled for lending to peripheral eurozone banks to avoid them tapping the markets, particularly in Spain and Portugal, where they constitute the governments’ largest private sector liability.
Nevertheless, the ECB has effectively turned the peripheral sovereign debt markets over to national governments, the EU, the EU’s new European Financial Stability Fund (EFSF) and the international community – in other words, the IMF.
In the first category, Spain and Portugal can weather the markets if politicians follow the example of Italy and tackle deficits, ensuring supply of government bonds is lower than demand. They must also raise retirement ages and radically liberalise the private sector to make up for state spending cuts.
“If it wishes to avoid this type of contagion, the eurozone must sacrifice another of its core mantras: no bail-out, no exit and no default”
Greece and Ireland have missed that chance, however. Liabilities in their state and banking sectors have spiralled out of control, faster than their governments’ ability to stimulate the private sector. Neither the EU nor the IMF have turned confidence around.
Within the euro as it stands, Greece and Ireland can only avoid restructuring their debt by appealing to the EFSF, a makeshift mechanism to transfer fiscal clout or state revenues from the stronger areas of the eurozone to weaker ones.
However, neither the EFSF nor any wider fiscal union is acceptable in the long term for voters, who did not sign up for fiscal transfers, nor for some of the stronger economies. France in particular risks a downgrade if it allocates too much of its revenue abroad. (article continues below)
If it wishes to avoid this type of contagion, the eurozone must sacrifice another of its core mantras: no bail-out, no exit and no default.
In the absence of long-term bailouts, defaults and debt restructurings are the least acceptable option. In the case of Greece, a debt restructuring would cause contagion by punishing stronger economies who bailed out the country. In the case of Ireland, restructuring would be impossible without incurring a bailout or a default, and creditors have already indicated they would not accept a voluntary discount on repayments.
In conjunction with a shorter-term bailout, the least contemplated but most palatable option is an orderly Greek and Irish exit from the euro, which for the rest of the eurozone would also be the cheapest alternative.
As other structural reforms are not working, Greece and Ireland should resurrect the drachma and the punt with the ECB’s help and use them domestically alongside the single currency.
The plan has three advantages. First, Greece and Ireland have already executed a successful transition between their local currencies and the euro, albeit in the opposite direction.
Second, the plan would still allow them to sell assets in bulk in exchange for hard currency and then use them to pay off their euro-based debts.
Third, the drachma and the punt would most likely decline against the euro, making Greek and Irish exports cheaper and more competitive. The domestic economy would also be able to use euros if the buying power of the local currencies declined.
In the unlikely event the local currency appreciated, exports would worsen, but the domestic economy would celebrate.
Such behaviour is unlikely to stir rhetoric about currency wars as neither Greece nor Ireland are globally significant. The rest of the world, on the contrary, will be relieved to see the euro appreciating against anyone, although the euro might initially decline on news of an exit.
Whatever the outcome, an orderly exit would liberate the eurozone from less radical but far more intolerable alternatives. Despite inevitable volatility in the short term, long-term investors in euro assets should treat it as a blessing.