Can the Euro Be Saved?
To speak to Professor David Beim or to receive the paper, please contact Sona Rai at firstname.lastname@example.org or (212) 854—5955.
NEW YORK—October 13, 2011—Columbia Business School Professor David Beim, Professor of Professional Practice, Finance and Economics, and Bernstein Faculty Leader, Sanford C. Bernstein & Co. Center for Leadership and Ethics, recently issued a report that explains why only radical action can save the eurozone’s common currency.
Professor Beim’s paper first explores three deep flaws in the euro’s design that have combined to undermine the common currency.
The first flaw is that the euro includes too many countries whose economies are not similar. For example, Germany and Greece cannot realistically use the same currency. If they try to do so, a payments problem soon arises: trade no longer clears between them, Germany over–exports and Greece over–imports. The relatively cheap imports drive down local Greek producers. The country will inevitably fall into depression, just as Argentina did a decade after locking its currency to the dollar.
The second flaw is that the euro area has no effective governance system to resolve the payment problems it has created. Decisions require the separate consent of 17 sovereign governments. This precludes taking timely and decisive action, so the system seems adrift.
The third flaw is the most serious. The European Central Bank (ECB), on a consolidated basis, holds over €1 trillion of bonds and loans to eurozone member governments and banks. These are risky assets. A very substantial portion is surely derived from stressed countries. If these were to default, who would bail out the ECB? Since this prospect is so frightening, the ECB has for two years prevented the economically rational solution of default and restructuring from even being debated. They have maintained the illusion that all such debt is risk–free, however, as the report poses, a system built on an illusion cannot last.
Given these vulnerabilities, policy is pointed in exactly the wrong direction. As Professor Beim’s paper emphasizes, when any borrower has borrowed too much he needs to have his debt reduced, as Mexico and Brazil had their debt reduced in 1989–91 under the Brady Plan. Lending an over–indebted borrower more only digs him in further and makes the ultimate default more costly. Greece needs to have its debt reduced, yet the euro leadership keeps raising ever larger funds to lend it more. This is completely unsustainable. If an orderly Greek default is not arranged a disorderly one will surely happen.
The paper suggests a way the ECB might be able to limit contagion from a Greek default to Portugal and others: by accepting default but requiring that any defaulting country should be required to leave the euro area. Indeed Greece would quickly end its economic misery if it had its debt forgiven and re–established the drachma, just as Argentina quickly recovered after is default and new currency after 2001.
Professor Beim indicates possible ways in which the eurozone’s flaws could be addressed. However, all recommendations would require euro area leadership to take drastic action, and there is not much time left to implement policy before a potential downturn. Cracks are showing in both the north and the south. One or more northern countries could simply refuse to support the next round of bailouts. Or Greece could explode: street riots could get out of hand, and parliament could vote no confidence in the government and its cooperation with the “troika” of inspectors from the European Union, the ECB, and the IMF. This could quickly lead to bank runs.
If this occurred, either some countries would begin withdrawing, and/or or the ECB would agree to save the system by printing euros. Inflation would serve as a stealth tax to address imbalances — rising prices lower everyone’s living standards. Prof. Beim’s paper concludes that in extremis, inflation will likely appear to be the best option. This would be an ironic end, since the euro was deliberately set up to try to avoid inflation.
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