Euro Zone: Size Matters

Currency in Crisis

The German Christian Democrats hold a party congress next weekend. There are a number of proposals that members are trying to get incorporate into the party position and platform. Many observers seem to be exaggerating the significance of some of the proposals that have been reported in the press.

One such proposal is to give the national central banks weighted votes on the ECB. The proposal calls for weighting the votes by GDP. This would of course give large countries more influence, and Germany in particular.

This seems to be in reaction to the fact that many had expected Germany's Weber to replace Trichet, but of course he did not. There is also concern in some circles in Germany, as reflected by the resignations of Weber and Stark, that the ECB is violating its trust by blurring the distinction of fiscal and monetary policies by buying sovereign bonds and by putting at risk the ECB's independence. It is not clear that this proposal would be acceptable to the majority of EMU members.

One seeks a voluntary (if that word is not too abused these days) exit for members who are unwilling or unable to comply with EMU rules. They could leave EMU without leaving the EU.

Another set of proposals that sparked even more interest is the allow for countries to leave the euro zone.

Currently a country could leave the EMU if it chose, but the balance of legal opinion seems to be that a exit from EMU requires an exit from the EU. This is seen as part of the high barrier to exit. The proposal would lower that bar.

A separate proposal in this space seeks a mechanism by which a country can be forced out of the euro zone.

Talking about contingency plans and base cases are two different things. When Greece was going to have a referendum and possibly reconsider joining EMU, it makes sense for European officials to consider the consequences. It does not mean that is their objective. Similarly the US may, as reported some time back, have a contingency plan to move troops into Canada--it doesn't mean it will or that it plans on it.

European officials, including Germany and France, in word and deed recognize the importance of preserving the euro zone as currently constituted.

Imagine a situation where a country like Greece drops out of the euro zone, but not out of the EU. The country tries to reintroduce Drachma 2.0 and devalue it. Investors anticipating run on the banks to withdraw their euros before confiscated. Because the drachma 2.0 is purposefully weak, it cannot serve the function of money as a store of value. The drachma 2.0 depreciates sharply. Greece defaults on its sovereign debt.

A deep economic contraction and high inflation results. The supply of goods, even for export, is terribly compromised. Unemployment which jumped the most on record in August to 18.4%, rises much further. As members of the EU, Greek workers leave and to look for jobs in Northern Europe, while those countries are also experiencing an economic downturn or higher unemployment.

Some have argued that if Greece were to leave EMU, the euro would appreciate. This claim seems to be based on a couple of questionable assumptions.

Second,European officials have indicated that Greece is an exception. A haircut for private holders of Greek sovereign bonds will not be repeated. Investors cannot be confident that this is really the case. And if Greece leaves, won't that increase the risks of another exit? European officials say Greece is an exception, but investors will likely see it as an example.

For about 50 years Europe was divided. European integration and a broadening of EU membership and monetary union has united the continent in a way past generations could only dream of. A smaller euro zone implies a new division in Europe and a defeat for the elite project. That elite project was driven in large measure by the desire to pacify Germany by tying to the future of Europe.

The CDU party congress proposals also reflect a struggle within Germany. The crisis has brought out into relief Germany economic and financial prowess. The struggle is whether Germany should seek the political power that is commensurate with its economic and financial power.

In our view, rather than break up in, the solution for Europe's crisis will be more integration rather than less.

And this means more erosion of sovereignty. More promising and telling than the CDU committee proposals is Merkel's push for EU treaty changes that will give allow monitoring of budgets including the right of the EC and members to seek enforcement of fiscal agreements before the European Court of Justice. First, it assumes that Greece is the main weight on the euro and like a tumor, it can be cut out to return to health. Yet the problems in the euro zone seem much larger than just Greece and sometimes, to keep to the tumor analogy, when a smaller tumor is removed, a larger one grows. While the former proposal could be acceptable to many members of the euro zone, the second one seems much less so. However, it does touch a raw nerve in the market, especially following reports suggesting that Germany and France had discussed a more integrated and smaller euro zone.