By William L. Watts
In 2010, the once unthinkable prospect of a euro-zone breakup became increasingly thinkable.
The coming year will likely determine whether the euro in its present form falls apart or finds a way to overcome its flaws. Neither outcome is inevitable.
Of course, the idea of a euro breakup was never all that unthinkable. Economist Martin Feldstein wasn’t alone when he predicted long before the euro’s 1999 launch that a single-currency project driven more by politics than economic necessity would likely be doomed. Read archived story about Feldstein’s long-held euro-skeptic views.
For those in the breakup camp, the most talked-about notion at the moment is the potential creation of a two-tiered euro zone. See recent David Marsh column on potential euro fragmentation.
The concept holds that the euro zone essentially splits in two, most likely in a divide engineered by Germany as politicians heed taxpayer disgust over the cost of bailing out the nation’s profligate neighbors.
The split would end the troublesome mismatch between prudent core countries and the high-debt periphery that has made the European Central Bank’s one-size-fits-all monetary policy so problematic.
The scenario typically envisions a stronger euro that includes Germany, the Netherlands, Austria, Finland and a handful of smaller players, while the weaker version is made up of Spain, Portugal, Ireland and Greece.
Which way France goes would be up for grabs.
Economists Peter Boone and Simon Johnson contend in a post on the Baseline Scenario blog that the weaker countries, while damaged, would at least rediscover the positive effects of a cheaper exchange-rate. Meanwhile, those in the stronger euro group would do well and would probably look to raise interest rates in the short term.
But while a growing number of experts seem to be pondering ways a breakup could be accommodated, there are plenty of skeptics.
Keep it or ditch it completely
“Europe has two options. Keep the euro or ditch it completely,” said Jessica Hoversen, foreign-exchange and fixed income analyst at MF Global in Chicago.
A two-tier euro would simply be too difficult — and costly — to implement, she argues.
Indeed, skeptics have argued that weak nations that leave the single currency or are placed outside the strong euro would potentially see soaring external debt costs if their liabilities aren’t re-denominated in the weaker currency — a daunting task.
And life could also prove difficult for Germany and other countries in the strong version of the euro. They would likely find themselves with the world’s strongest currency, which would be unwelcome for the nation’s dominant export sector, Hoversen said.
The more likely outcome is for the euro zone to push through the crisis, but with much tougher oversight of toughened fiscal criteria, she said.
Meanwhile, Germany is likely to decide the euro’s fate.
And those betting on the survival of the euro say that while German leaders are wary of political backlash, they remain committed to the euro project.
The price for that will likely prove to be increased German influence over the euro zone, including a guarantee of German leadership of the ECB, said Stephen Gallo, head of market analysis at Schneider Foreign Exchange.
“It’s going to work, but it has to be under German terms,” he said.