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Binds and Bonds: Why the EU Should Break Up

Friday, February 10, 2012

Europe’s core countries should take preemptive action to form a smaller and more enduring currency union.

German and French policymakers have yet to face up to Europe’s real policy choice. They could choose to continue the pretense that the euro can be preserved in its present form. This would run the real risk of a costly and disorderly unraveling of the euro that could embroil a still-solvent country like Italy. Alternately, they could choose to recognize that several euro member countries will, in time, be forced to default on their sovereign debts and leave the euro. This recognition could allow them to plan for the creation of a new, well-functioning currency union among those core European members best suited to belong to such a union.

Sadly, the recent European Summit provides strong evidence that European policymakers are still making the wrong choice. Rather than recognizing that the internal and external imbalances of countries like Greece, Portugal, Ireland, and Spain have reached such large proportions that it is almost inevitable that these countries will be forced to default on their sovereign debts and to exit the euro, European policymakers are striving to preserve the euro, unchanged in its present form.

European policymakers are proposing that all countries should adopt constitutional balanced budget amendments and sign up to legally binding budget deficit reduction programs that are to be externally monitored.

They are doing so by proposing that all countries should adopt constitutional balanced budget amendments and sign up to legally binding budget deficit reduction programs that are to be externally monitored. It is assumed that after several years, once the desired degree of deficit reduction is attained, the present monetary union could move towards a full fiscal union that would provide the firmest of underpinnings to the existing currency union.

The fly in the ointment is that successful correction of the still very large public sector imbalances in the European periphery would require the early restoration of economic growth in those countries. However, the policy approach of severe public sector belt tightening across all euro member countries is a sure recipe for a deep and prolonged European recession. This is because euro membership acts as a policy straightjacket by precluding currency devaluation as a way to boost exports. And as Greece’s experience over the past 18 months would attest, a deepening economic recession puts deficit reduction targets well out of reach, increases a country’s public debt service burden, and heightens political opposition to staying the austerity course.

The futility of excessive budget austerity in a fixed exchange rate system is especially the case when one considers that the overall European economy is already showing signs of considerable weakness, and the envisaged degree of budget tightening is extraordinarily large. It is, for example, being proposed that Italy undertake a budget adjustment of close to 2 percentage points of GDP per year in each of the next two years, while for Greece, Ireland, Portugal, and Spain the proposed budget adjustment is more on the order of 3 percentage points of GDP per year in 2012 and 2013.

Even in the best of times, attempting to apply multi-year budget adjustments of such a large scale would run the risk of a prolonged and deep economic recession. However, these are far from the best of times in Europe, given a currently weak external economic environment and the likelihood of a European credit crunch over the next year as European banks sell assets and restrict credit in an attempt to strengthen their balance sheet positions.

As Greece’s experience over the past 18 months would attest, a deepening economic recession puts deficit reduction targets well out of reach, increases a country’s public debt service burden, and heightens political opposition to staying the austerity course.

As if to underline the futility of severe budget tightening in a fixed exchange rate system, the IMF is now forecasting a serious deepening in the European periphery’s recession in the year ahead. The most disturbing aspect of the IMF’s latest economic forecast is that Italy and Spain, Europe’s third and fourth largest economies, are now both expected to contract by around 2 percent in 2012. This is almost certain to cause large budget deficit overruns in both of these countries and to raise questions anew in the markets about these two countries’ debt sustainability.

Rather than passively reacting to a series of peripheral country defaults as they occur, Europe’s core countries should take preemptive action to form a smaller and more enduring currency union comprised of those countries best suited to be in a currency union. They should do so by availing themselves of those provisions in the Lisbon Treaty that allow countries to voluntarily exit the union. Doing so in unison would allow them to bind themselves in a new currency union with stronger underpinnings than the current one, including an early move to a true fiscal union that might involve the joint issuance of euro bonds.

A significant though not insurmountable legal obstacle to the formation of a new, smaller currency union among the stronger northern European economies is posed by the existing Lisbon Treaty. While the treaty provides that countries can exit the present currency union either individually or in unison, doing so would require them to leave the European Union as well. For that reason, should the core countries decide to leave, they would also need to rapidly approve a parallel treaty, which would provide for the maintenance among themselves of the present trade arrangements that they have within the European Union. Such a course of preemptive action would certainly be preferable to a disorderly breakup of the current monetary union.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

FURTHER READING: Lachman also writes “It’s Europe’s Economic Growth, Stupid,” “A Tale of a Euro Exit Foretold,” “No Lehman on the Aegean” and “Will Greece Destroy the Eurozone?” Michael Auslin contributes “Europe whole or divided (or 1648 and all that)” and John Makin asks “How did Europe's debt crisis get so bad?

Image by Rob Green / Bergman Group

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