A Euro Breakup: Cardiac Arrest for Europe

Mohamed El-Erian is CEO of PIMCO, the global investment management firm. Nouriel Roubini teaches at New York University and heads Roubini Global Associates. Both are members of the Nicolas Berggruen Institute’s Council on the Future of Europe.

BERLIN—In theory, most agree that the Eurozone integration project is worth saving. Yet, at every important decision point during the euro-crisis over the past two years the commitment of politicians has appeared too partial and too conditional. The longer the Eurozone stays in a no man’s land with the periphery accumulating more debt at high interest rates just to buy time, the more costly and painful future adjustments will be and greater the risks of a break-up.

This has become so clear that some respectable voices within mainstream opinion are now concluding that, already, the Eurozone may no longer be sustainable and, therefore, it would be better for it to split up now instead of later when the costs would be much higher. But this view goes too far.

Let us leave no doubt: If the eurozone totally fragments, Europe also fails as the single market and European Union may also collapse. So, if one believes in the sustainability of the Eurozone, there is absolutely no more time to waste.

The only alternative to letting the euro unravel over the coming months is for Europe’s leaders to gather the political will now to move quickly toward greater integration—starting with a much clearer and more actionable roadmap towards fiscal and banking unions that stops and reverses the balkanization of banks and public debt markets; an economic union that restores growth and competitiveness; and a political union that provides democratic legitimacy for the transfer of large chunks of fiscal, banking and economic sovereignty to the center of the EU. And all this may only be feasible—indeed desirable—if it is proceeded by a revamping of eurozone membership so it is more in line with current realities and likely prospects.

Eurozone fragmentation—which we define as the return to national currencies by a significant portion of the current 17 members of the eurozone, and particularly one or more of the big four (Germany, France, Italy and Spain)—would be so destabilizing and chaotic that Europe would face a lost decade. In addition to destroying the Eurozone, the larger, 27 member European Union would be exposed to enormous strain.

In the short run, fragmentation would be the economic and financial equivalent of a cardiac arrest for Europe. Cross-border flows of goods, services and capital would be disrupted as currency denomination concerns overwhelm the normal valuation calculus. Large currency mismatches would fuel corporate financial stress and give rise to multiple defaults. Unemployment would surge. And the provision of basic financial services, from banking to insurance, would be curtailed along with a high probability of bank runs in the most vulnerable Eurozone members.

Controls would proliferate—as the weak economies sought to limit the surge in capital outflows, and as the strong economies resisted excessive inflows. In the process, the very functioning of the common market that underpins the European integration project would be undermined. Balkanization of banks, financial markets and public debt markets that is already ongoing would be followed by balkanization of trade in goods, services, labor and capital, and a return to trade and financial protectionism.

Those countries that have been buffeted now by several years of crisis management have limited, if any, internal cushions to absorb new blows. As a result, the economic and financial disruptions would likely fuel social unrest and political dysfunction—further undermining national support for European integration.

While the brunt of the catastrophe would be felt primarily by the weak (formerly peripheral) economies, the stronger (formerly core) countries would also take a substantial hit.
 
Let us look at each in turn.

In returning to their national currencies, the weaker Eurozone economies would stand to regain control of a broader set of policy instruments. As such, they would have greater means to pursue the competitive gains that are essential to restoring their growth dynamics and generating jobs.

But to do so effectively would require deft management of a major currency devaluation. They would thus have to counter significant inflationary pressures and the higher costs of imports, disrupted banking and monetary transmission channels, and soaring risk premia. And with the whole of Europe disrupted, they would find that the price advantages gained via devaluation risked being eroded by a collapse in regional demand. Moreover, given currency mismatches, a widescale return to national currencies would involve a string of payment defaults. Along with some coercive restructurings and a forced conversion of euro assets into new depreciated national currencies

The issues of regional demand and defaults are also of significance to the stronger economies. Notwithstanding the gains they have made in trade diversification, including a greater reorientation towards emerging countries, a significant amount of their exports are still sold in Europe. This market collapse would come on top of the losses on account of rapidly eroding financial claims on the weaker economies defaulting on their euro debts, both direct and via the likely need to recapitalize regional institutions. Debtor restructuring, and surely outright defaults, would impair the balance sheets of creditor institutions, increasing their own debt (because they will have the same assets but greater liabilities) and costs of capital. And the AAA rating of Germany and other core Eurozone members would also be put at risk.

Then there is the rest of the world. Europe is still the globe’s largest economic area, and the most inter-linked financially. As such, disruptions would inevitably be transmitted to the rest of the world. And with the United States already struggling to maintain meaningful economic growth and job creation, a global recession would materialize.

All this speaks, of course, to why the political narratives have repeatedly sought to rule out a fragmentation of the Eurozone; it is also why leaders of other countries have put pressure on their European counterparts to address the regional crisis in a more determined and holistic manner.

  But words and moral suasion are grossly insufficient to stop the forces of fragmentation that have been enabled by important design flaws and fueled by years of policy responses that have been tactical rather than strategic, sequential rather than simultaneous, and partial rather than comprehensive.
 
Only by understanding the enormity of the risks that they face do the leaders of Europe stand a chance of overcoming persistent internal tensions and converge on a potentially game-changing response.

And only then would they be able to convince a skeptical citizenry of the necessity of taking truly unprecedented steps—first to reform the Eurozone into a more coherent union that is smaller, less imperfect and more robustly designed and operated; second to ensure that this reformulated Eurozone can move forward in generating growth and jobs; and third, to safeguard the broader functioning of the EU.

Having bickered and dithered for too long, European leaders no longer have at their disposal a neat, relatively costless and highly certain solution for the regional crisis.

What they do have is some time—though not much—to attempt to defend the integrity of the regional integration project by taking bold steps now starting with an economic, fiscal and banking union, and moving toward a political union.

Yes the outcome is far from guaranteed and, inevitably, there would be immediate disruptions. But all this pales in comparison to the catastrophe that Europe and the world would experience if it continues with an approach that remains too little and too soon.

Germany and the core need to decide boldly whether they believe that the Eurozone can survive and in what format. If the answer is yes, then the pursuit of a less imperfect union would need to be accompanied by massive official financing—both fiscal and from the ECB—to the periphery to smooth the painful adjustment through austerity, reforms and internal devaluation. If, instead, they were to decide both that the Eurozone is not viable as is and that a smaller union is not achievable, the costs of breaking up disorderly later rather than breaking up now would be much larger. What should not, and must not, happen is for the Eurozone to remain in its current muddled middle.