A Break From the Euro

In an article on these pages on Friday (“Let Europe borrow”), Jacques Attali, the founding president of the European Bank for Reconstruction and Development, and Haris Pamboukis, Greece’s minister of state to the prime minister, argued that the key to a long-term solution for Europe’s economic troubles lies in the establishment of a European treasury and federal budget. Mr. Benink joins the debate.

It is entirely possible to stabilize euro bond markets and save the euro with a large increase of the European Financial Stability Facility and/or a substantial increase of the European Central Bank’s purchase of government bonds. In essence, this would mean a bailout of bond holders.

However, there is a real danger that the European Union’s government leaders, ministers of finance and central bank governors would not be able to bridge their differences and present a coherent and credible strategy to financial markets in the near future.

Such a strategy of “muddling through” is not without risks. Without a clear and coherent strategy, bond holders may, at some point, lose confidence and start selling bonds of some of the Union’s larger countries as well. This may explode into a full-blown euro-zone crisis, which may be hard to resolve and may risk the very existence of the euro.

In the event that Europe’s leadership remains divided, there is an alternative to muddling through, and its associated risks to the euro.

Last weekend, my colleague Jacques Sijben, emeritus professor of economics at Tilburg University, and I published a proposal in the Netherlands which consists of the following elements:

First, weak euro zone countries in Europe’s periphery, such as Greece, Ireland and Portugal, take a euro zone “holiday” and exit the euro for the next 10 years.

During these 10 years they will have to implement structural reforms in their economy, reduce government deficits and debt, and show that they can maintain a stable exchange rate to the euro. If they succeed, they can rejoin the euro.

Second, their new national currency would have to devalue substantially compared to the exchange rate at which the country entered the euro zone. This would enhance and restore the country’s competitiveness and its ability to service debt and interest payments.

Third, the government debt in euros of these countries would have to be restructured substantially in order to prevent debt levels, measured in the new local currency, from exploding and becoming unsustainable. The prospect of debt restructuring may prove to be an important incentive for countries to accept a temporary exit from the euro (which according to the Maastricht Treaty cannot be imposed upon them).

Fourth, bond holders, including banks, will face losses associated with the haircut imposed on the bonds.

Fortunately, most banks have returned to substantial levels of profitability, which should allow them to absorb these losses.

Insofar as some banks would fall short of equity, they would have to be recapitalized by their national governments.

Fifth, the overall majority of countries would remain in the euro zone and continue using the euro. This is a big advantage over proposals which advocate a split-up of the euro into a strong and a weak euro, which would involve an expensive conversion in all countries.

The proposal outlined above would be comparable to a surgical act in which countries with an unsustainable mix of debt and competitiveness would be, temporarily, cut out of the euro zone, thereby preventing contagion to the other euro-zone countries.

Such an approach is likely to be less costly and risky than muddling through.

Harald Benink, professor of banking and finance at Tilburg University in the Netherlands and chairman of the European Shadow Financial Regulatory Committee.

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