EZ break-up stands to benefit the core

I’ve argued elsewhere on this blog that the weaker countries in the EZ stand to benefit from abandoning the euro. Rather than undergo an endless process of retrenchment inside the single currency, they could grow much faster following a nominal devaluation outside the euro area. This would not just benefit the peripheral countries, however. The core countries stand to gain from weaker countries abandoning the common currency as well.

The core countries have two main courses of action they could pursue instead of the current approach of buying time with bailouts, LTROs and firewalls for the periphery. The first option would be to pull the plug on the weaker countries, cutting off their funding and letting them fend for themselves. This would be a disaster for all parties, causing the crisis to spread like wildfire to the core. It is clearly not on the table. The second alternative would be for the core countries to keep the peripheral countries on life support indefinitely, effectively turning the core-periphery relationship into an endless unhappy marriage.

To maintain such an unhappy marriage, the EZ’s core countries would need to agree either to unlimited fiscal subsidies for the weaker countries through joint and several liabilities (such as Eurobonds) or to fiscal transfers. But Eurobonds can only emerge once political union and a pooling of assets have been achieved in the EZ. This is a long-term process, and there is very little chance that EZ leaders could achieve this in the timeframe necessary to keep the weaker countries in the common currency area. More likely, the EZ’s unhappy marriage of core and periphery would involve creating a fiscal transfer union. This is an extremely risky and expensive venture, however.

Weaker countries would be disincentivised to undergo the difficult and painful task of rebalancing their economies if they knew they could turn to the wealthier EZ countries for hand-outs instead. Transfers to the weaker countries are already vehemently opposed in the stronger, wealthier countries of the core. Furthermore, if the core countries were to provide all of the weaker EZ countries with unlimited fiscal transfers, the core countries’ own balance sheets would become impaired and they would end up requiring bailouts themselves.

While the introduction of Eurobonds is too long-term a project to be completed in time to prevent the exit of some weaker countries from the EZ, such exits from the periphery would make it easier for the remaining core countries to create joint and several liabilities.

The EZ’s core countries do not trust in the fiscal responsibility of their peripheral counterparts. This was highlighted by the agreement of the fiscal compact, an initiative spearheaded by Germany to impose limits on the fiscal imbalances EZ member states are allowed to accrue. EZ leaders touted the fiscal compact as an early step towards fiscal union, but at the time of its agreement it represented nothing of the sort. It was an attempt to get the weaker EZ countries to mimic Germany’s fiscal dynamic, thereby placing the entire onus for adjustment onto the periphery and ensuring that drastic fiscal adjustment would drive the EZ’s weaker countries deeper into recession.

Given Germany’s obsessive insistence on fiscal responsibility as a pillar of the EZ, the exit of weaker countries from the common currency area could provide the impetus for the stronger countries to move towards creating a true fiscal union. Currently the core countries are unwilling to pool liabilities with the weaker countries because of concerns that they will be subsidizing those countries forever and will therefore see their borrowing costs rise. But if the EZ loses its weaker members, the smaller EZ that would result would consist of countries with a greater reputation for fiscal responsibility. Such a change in the profile of the membership might lead the strongest, wealthiest countries to become less opposed to issuing Eurobonds and to finally take the necessary steps to establish a fiscal union. The result could be a smaller but much stronger currency area.