All eyes on Germany as eurozone crisis rumbles on

5th October 2010

In an updated version of his book on the credit crunch, Freefall, Nobel Prize winner Joseph Stiglitz says that Germany's exit from the distressed eurozone might be a powerful means by which to avoid the economic crisis in Greece and Spain triggering a complete break-up of the currency and sending Europe's weakest countries back into recession.

Stiglitz believes the future of the euro as it stands is "bleak" and that the austerity measures being undertaken across the eurozone and being demanded by markets could be irreparably damaged.

He reckons Germany's exit might offer a long-term solution to the sovereign debt crisis as it would allow the euro to fall, thereby helping to boost exports from eurozome members.

Economists' focus on Germany's role in the eurozone saga is due to the very different complexion of its economy, running as it does very high trade surpluses compared to countries like Ireland, Greece and Portugal, which are running big deficits.

This variance during a time of economic crisis is creating massive strain on the single currency and is precisely what many economists opposed to the euro warned of at its inception.

Stiglitz's stance on Germany has support among other economists including Alan Brown, Schroder's group chief investment officer.

Slow motion train wreck

Brown, who has been warning about the future of the euro for some time now, and indeed raised the prospect of Germany leaving the currency himself earlier this year, says:  "Watching events unfold in Euroland is like watching a slow motion train wreck. There is a ghastly inevitability to what is happening even if it could all have been so different.

"The inevitability comes quite simply from the maths and German insistence on austerity everywhere coupled with its unwillingness to contemplate stimulating its own economy."

Germany can of course point to its own fiscal resolve in times of strife, not least during the hard re-unification years, when its own real effective exchange rate rose by some 25%.

"It took its own medicine and suffered a decade of weak growth, 10% unemployment and static labour costs to regain competitiveness," points out Brown. "Hardly surprising then that it prescribes the same medicine for Southern Europe."

And Germany's medicine for what ails Portugal Italy Ireland, Greece and Spain (the so-called PIIGS bloc) is very strong indeed. All Eurozone members must cut their budget deficits to below 3% and structural weaknesses addressed by a long, painful process of adjustment.

Furthermore, according the German prescription, if a Eurozone member finds itself unable to consolidate its budgets then it should, as a last resort, exit monetary union but be allowed to remain a member of the EU.

Bitter medicine

Brown says: "Germany's prescription would put the whole of Southern Europe on the "naughty step" for a decade or more, condemning the whole Eurozone area, and particularly the PIIGS, to sub-par growth…. it would be a Herculean task, especially so for Greece, which under the circumstances may well decide it best to restructure and withdraw from the euro."

Arguments that so much political capital has been invested in the euro that it is simply inconceivable that it could break do not wash with Brown.

Neither is he impressed by suggestions that a weak member coming out of the euro would be bankrupted over-night with much of its liabilities denominated in euros and its assets suddenly denominated in a depreciating ‘new currency'.

There are two reasons for this, says Brown, the first being that in the event of a member country wishing to withdraw from the euro, everything becomes negotiable as happens after every sovereign default. 

Secondly, like Stiglitz, Brown also believes it conceivable that the euro could break up by way of the strong currencies rising out of the euro leaving the weaker Portugal, Italy, Ireland, Greece and Spain within the euro.

The currencies that left the euro would have assets denominated in an appreciating ‘new currency'. It is certainly a move that might please the German people, who are becoming increasingly resistant to helping to underwrite bailouts of the profligate neighbours. 

As Brown says: "How about New Deutschemarks? Could anything be more populist? Almost anything is possible from a single country withdrawing, to one or more new currency zones being created, to a return to all the pre-existing national currencies."

Saving the PIIGS

"The bottom line however is that almost all options would lead to a material realignment of exchange rates between the PIIGS and the Deutschemark bloc, leading to a reduction in today's chronic imbalances and a much earlier restoration of growth.

Will that damage Germany's export sector? Yes it would, but ultimately rebalancing Germany's growth more towards domestic demand is a key element of getting Europe back on to a sounder footing."

If history offers any lesson for the euro crisis it is, Brown says, that currency regimes come and go. In the last century alone there was the Bretton Woods agreement, which lasted from 1944 to 1971. And between the 1880s and the late 1930s the Gold Standard was the most common currency arrangement for most countries.

There was also Latin Monetary Union of 1865 in which four countries linked their currencies: France, Belgium, Italy and Switzerland, with other countries, including Spain, Greece, Romania, Austria, Bulgaria, Venezuela and the Papal State joining up at various times. The strains of World War One put paid to that particular effort in 1927.

It is not certain the euro faces a big shakeout but, like Stiglitz, Brown reckons the numbers coupled with Germany's role in the eurozone and its demands on fiscal discipline mean it is highly likely in the medium term.

"This tragedy (or pantomime) has many more acts to come yet," he says.

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