Saturday, December 11, 2010

Is Greece Leaving the Euro Good for the Euro?

As Europe continues to cope with a crisis that seems to grow bigger by day, the debate is shifting from “what will Europe do” to be “who will abandon the euro first?” Will the periphery be forced out by the core; or will the center decide that the currency marriage with the profligate and the undisciplined is not worth the hassle?

The case for change is seen daily on newspapers across the world. In crisis, markets buy the currencies they trust and sell those they do not. If the exchange rate is the daily poll on the euro, what a disappointment these two years have been. Against the major currencies, the euro has done poorly. Using the pre-Lehman rate of August 2008 as a basis, by November the euro lost 18.5% versus the Australian dollar, 17% versus the Swiss Franc, 31% versus the Japanese Yen, and 8.8% versus the US dollar. Only versus the British Pound has the euro fared better.

What does this tell us? Obviously, markets do not have faith in the euro, but what is “faith?” In theory, the exchange rate links one currency’s supply and demand for money to another’s. In reality, exchange rates move in response to anything, whether rational or whimsical, hard news or gossip. And of course, there are meddling governments as well who distort currencies. In that randomness, however, there is logic. Logic that says exchange rates track the market’s gut feeling about an economy’s prospects.

The market’s perspective on the euro is really a bet on Germany, France, Italy and Spain – herein lies 77% of the Eurozone’s GDP. Strictly speaking, what happens to Greece (2.6% of GDP), Ireland (1.8%) or Portugal (1.9%) is no big deal. Of course, looking at a country’s share of GDP is not enough. Collapsing countries drag with them banks and financial institutions that are tied to them. Ireland’s gross external position, for example, is greater than Japan’s, although the latter’s economy is 23 times the size of the former’s. Big troubles can come from small countries.

In this context, therefore, the task that Europe faces is only incidentally a currency one. The problem is not that Germany and France and Greece and Ireland share the same currency but that they are interlinked through their banking systems. If the peripheral countries fall, the core will not be able to hold not because there is one currency but because the losses triggered on the core’s banks will have to be offset through a sale of assets or through support from governments.

There are, of course, many other intricacies. Governance to avoid profligacy, the periphery’s ability to grow within a fixed exchange rate system, and the fact that membership in the currency union allowed the periphery to spend in ways it would not have been allowed to with an independent currency. These are all important. But for now, life would hardly be easier for the euro if Greece and a few others left the euro.

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