The end of the euro? Five reasons why we think not.

June 11 2020

Giovanni ZanniChief Euro area Economist

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Every so often, talk about the end of the euro area resurfaces. Here, Giovanni Zanni explains why we don’t expect any countries to leave the euro, and that a strengthening of the bloc is in fact more likely.

Speculation about a break-up of the euro area has flared up again recently, this time due to the coronavirus-induced recession and a ruling by the German constitutional court against the ECB’s bond-buying policy.  Here’s five reasons we don’t expect it to happen.

1. Leaving the euro would lead to some major problems before the departure…

Even if any country wished to leave the euro, it would face some major obstacles to doing so.

A country can’t just leave the euro when it wants

Leaving the euro would lead to endless legal challenges on international contracts, and the process would certainly take time. Establishing a parallel currency – apart from being against EU rules if carried out while still using the euro – would also be fraught with problems.

“You don’t leave the euro: the euro leaves you”.

What’s the immediate consequence if a country is expected to depart the euro area, or it’s even suggested that it might do so? Major capital outflows. This is what we saw when Greece discussed the mere possibility of a referendum on euro membership in 2015 – banks had to close and capital controls were enforced. This is not an attractive proposition for any country considering leaving.

Exiting could prompt an economic shock

Expectations that a country could leave the euro would impact its rates and the sustainability of its debt, leading to a higher chance of its sovereign bonds defaulting. The banking and broad corporate sectors would also be affected in many ways even before the departure takes place, resulting in a major financial and economic shock that would probably lead to a political U-turn. Again, this is arguably what happened with Greece in 2015.

The euro is not a currency peg

Previous currencies cannot be recovered. That has important consequences for any desire to, for example, “return to the lira”, as joining is a true irreversible process.

2. There would be problems after the event too

Leaving the euro is seen as a way of gaining economic advantage through a competitiveness-increasing devaluation, but there’s no guarantee it would play out like that. Let’s consider some of the reasons why.

Your biggest trading partner would retaliate

If carried out in bad spirit, an exit and devaluation would in all likelihood result in the leaving country’s biggest trading partner by far – the remaining euro bloc – retaliate. And even if the separation were achieved amicably, the benefits of a managed devaluation may be negligible compared with the drawbacks of leaving the euro.

A new currency would probably face problems in asserting itself

This could lead to “euroisation” – effectively still having the single currency, but without the advantages of shared sovereignty over it.

Currency devaluation rarely works in practice

For example, sterling’s 30%+ depreciation after the financial crisis didn’t do much for the UK’s current account deficit problem. And as the ECB has stated, due to the increasing fragmentation of production processes, imports are widely used to produce exports. This overrides conventional exchange rate assumptions based on the premise that countries compete to sell products using only domestic inputs.

3. There’s nowhere else to go

The countries forming the euro area aren’t just irreversibly linked by a common currency – they’re also bound together by tight trade linkages. The EU / euro area is a highly integrated economy, with intra-euro-area commerce accounting for around half of total trade. This even applies to countries like Germany, which has higher exposure to Eastern European countries and Asia: recent geopolitical events have led it to refocus on Europe.

What’s more, a weaker country than Germany would also find it hard to remove itself from the ties of geographical proximity and related economic and political linkages. In particular, it’s hard to imagine, in the event of a country unilaterally leaving and devaluing, that other euro area members would not retaliate and raise barriers to trade. Given the size of the Single Market, the trade it lost would be difficult to replace.

4. There are positive reasons to stay in the euro

One of the biggest reasons for staying in the euro is the security that being part of a large group of nations confers upon individual members. This can be clearly seen in the response to the coronavirus crisis. The EU has undergone many crises over the years, so it has built up significant lines of defence in response – and it shows: the economy will contract by an unprecedented amount this year due to coronavirus lockdowns, but the financial impact has been muted so far thanks to the measures taken in response, notably by the ECB.

The ECB’s toolbox is now comparable to that of other major central banks, so it’s able to deal with liquidity concerns, finance the economy on extremely favourable terms, and much reduce the risk of sovereign defaults through quantitative easing and other means. Countries choosing to go it alone would miss the kind of protection that euro area membership provides.

5. The euro area remains committed to deeper integration

Mario Draghi, former President of the ECB, recently reminded us of how many influential figures within the EU see the future when he stated that doubts about the viability of the euro area will only be fully removed when there is banking, capital-market, economic and fiscal union. He went on to add that sharing a single currency is political union.

Recent developments, such as the French-German "Recovery Fund" initiative in response to the coronavirus outbreak, show the ongoing political commitment to the European project of its key founders, especially in times of crisis. We’re confident that deeper integration is only a matter of time. At present we’re just seeing the green shoots of the final euro area supranational structure, and it will take years to complete, but in our eyes it’s much more likely than the demise of the euro.

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