How to Break Up a Monetary Union – UBS
The Euro stays
We do not believe that European Monetary Union will break up. The costs of breaking up the Euro, at this stage, far exceed the benefits. Far better, in our view, to default within the Euro than to incur the political, economic and possibly social costs of trying to survive outside.
Monetary unions do break up
Notwithstanding the fact that we think the Euro survives intact, it is relatively clear that (in economic terms) the Euro does not work. That is to say, parts of the Euro area would have been better off (economically) if they had never joined. This is not an argument for departing, but it raises questions about the factors that make monetary unions economically successful, and what happens when those factors are absent.
Two monetary union fractures
Looking at the historical precedents of the US monetary union seizing up in 1933, and the collapse of the Czech-Slovak monetary union in 1993, may be helpful in considering what the Euro area will have to do over time if it is to become a more efficient monetary union.
The US precedent
There are some tempting parallels between the US situation in the 1930s and the position of the Euro today. The US monetary union, though it effectively ceased in early 1933, was able to re-establish itself by adapting its institutions. In particular, labor market mobility and fiscal transfers across borders were ultimately important in generating a more smoothly operating monetary area.
Germans should pay for Greek pensions
The concept of fiscal transfers across different regions within a monetary union normally suggests a degree of political union, though this does not have to be the case. What it does suggest, at least for now, is that popular complaints in Germany (and elsewhere) about paying for social security in other parts of the Euro area appear misguided. Monetary unions entail sense of economic community. This means that wealthier areas should, indeed must subsidize those parts of the monetary union that are at an economic disadvantage. Fiscal transfers are the price that has to be paid for a monetary union of any meaningful size.
With the background of the current economic and monetary problems that certain member states are having it is interesting to reflect upon how UBS viewed the applicants to the EMU in 1996. The Venn diagram below was put together by UBS as the EMU was being established.
- Today Greece is under the severe stress and is struggling to implement austerity measures in order to get its annual deficit to GDP figure down to 8.7% this year and below the EU’s limit of 3% by 2012. Greece needs to borrow around 54 billion Euro’s this year and to date in 2010 has raised 13 billion Euro. The cost of issuance has been increasing by the week as off the run yields of Greek debt have stretched to 339 basis points above the more stable German Bund. Both Standard & Poors and Moody’s are watching Greece and are warning that they could downgrade Greece’s debt to as low as BBB-, the last investment grade rating possible.
For more on the Greek situation see the Wall Street Journal article, “Greece to Issue Bond Next Week.”
- Other countries with severe budgetary and real economy issues include Portugal, Italy, Ireland and Spain round out the “PIIGS” acronym. With Italy, Spain and Portugal the economies did not lend themselves to a monetary union according to UBS. Rather the countries only had the political will to proceed to the EMU. In fact Italy and Belgium did not even meet one of the key criteria for entry, which stated that a nation could not have a deficit greater than 60% to GDP. With Ireland, UBS believed that the country was financially close to the Maastricht criteria in addition to having the political will to enter the union.
- The Maastricht Treaty specified qualifying criteria for entry into the European Monetary Union:
- Annual deficits not to exceed 3% of a nations GDP
- Public debt not to exceed 60% of GDP
- Inflation rates within 1.5% of the three lowest inflation rates in the EU
- Exchange rate stability
Background on the European Union:
- The integration of markets in Europe has been a long process which dates back to the Treaty of Paris in 1951. This agreement established the European Coal and Steel Community between Belgium, Luxembourg and the Netherlands.
- By 1967 three treaties were merged and the European Communities were established. In addition to Belgium, Luxembourg and the Netherlands the community now included France, West Germany and Italy.
- By 1973, Ireland, Denmark and the U.K. were added to the community.
- During the 1980’s Greece (1981), Spain (1986) and Portugal (1986) joined.
- The Maastricht Treaty was signed on February 7, 1992 and created the European Union. From the EU’s formation in 1992 to 2007 another 15 countries have joined.
- The Economic and Monetary Union structure was defined during the Maastricht Treaty and eventually led to the creation of the Euro. EMU membership is a three step process that starts with coordinating economic policy, followed by achieving economic convergence and finally ending with the adoption of the Euro.
- The economic and monetary union of the European Union is the currency union of some of the European Union members. The following countries have adopted the Euro as the single currency. Conversion to the Euro began on December 31, 1998 with 11 countries adopting the Euro. Since then five additional countries have adopted the Euro.
Blue = EMU members Green= EMU II members Red= Other EU Members
Market Reactions to Debt Levels Differ
The first chart below, demonstrates how markets view the risk associated with holding the sovereign debt of a PIIG country by using the Credit Default Swap spreads. With this risk in mind it the second and third charts illustrate just how much debt countries are projected to add in 2010, Fig.3, and the level of gross public debt as a percentage of GDP in 2010.