What the end of the Euro looks like

Large devaluations and debt write-downs will open up fiscal space and boost growth

This week I’m writing about why the Euro needs to end. I’m not doing that because I’m anti this or anti that. The end of the Euro is a matter of economic necessity. The reason for this is that Europe faces many external threats, from Russia’s invasion of Ukraine to Chinese mercantilism and US tariffs. Fiscal space is desperately needed to counter these, but many countries are overindebted and have none. The way Europe has dealt with this so far - in its typical kick-the-can manner - is to pretend there’s no problem. It’s done that by using the ECB to cap government bond yields periodically, creating the illusion that fiscal space exists, something I wrote about on Monday. The problem with this is that it’s just an illusion. As I laid out yesterday, neither Spain nor Italy are able to give meaningful assistance to Ukraine because they’ve run out of fiscal space. When illusion meets reality, reality wins.

The way to regain fiscal space is to cut spending and raise taxes, but neither Spain nor Italy have an incentive to do that due to the ECB’s backstop. So the Euro zone is stuck in a bad equilibrium, which - over time - will only make it weaker, not stronger. That’s why the best way forward is for Germany to exit the Euro, which will spark a reversion to the national currencies of old.

The biggest pushback against this is that a dissolution of the Euro will cause market chaos. There’s two considerations here. First, if the current equilibrium is bad, there’s an unambiguous case for switching to something better. That should hold no matter how costly the end of the Euro is. Second, the cost of transitioning back to national currencies and the scale of market turbulence are endogenous to how policy makers behave. Italy and Spain currently have every incentive to paint apocalyptic scenarios for a transition. That’s because they’re currently extracting rents from Germany and want the status quo to continue. That’ll change once Germany pulls the plug. At that point, Italy and Spain will work with Germany for their own sakes to minimize market turbulence. Current prognostications of market turbulence are therefore really just a form of negotiation and should be - largely - ignored.

So what happens when the Euro ends? I use the rest of this post to lay out what I see as key market moves.

• There’ll be large devaluations for the high-debt periphery. Emerging markets (EM) experience “sudden stops” in capital flows - a reversal in capital inflows - all the time. When this happens, their currencies devalue sharply, which sets the stage for recovery by boosting exports. The Euro periphery experienced exactly this kind of sudden stop in 2010/11, but was unable to devalue because it was locked into the Euro. The left chart below shows the scale of this problem. The black line shows the median real exchange rate across a bunch of EM crises. On average, this falls around 30 percent and stays at a substantially devalued level for many years. The Euro periphery had none of that, especially not the kind of front-loaded devaluation that boosts exports when it’s most needed. The inevitable consequence is that the periphery stagnated, as the right chart below shows. The end of the Euro will see markets fix this instantly. There’ll be large devaluations (my best guess is 30 - 40 percent) to rectify what should have happened more than a decade ago.

• There’ll be periphery bond market crises and debt write downs. No one knows how much periphery bond yields will spike, because the ECB has played such a massive role in keeping yields low artificially. But we do have one episode that provides some clues. In March 2020, at the height of the COVID shock, ECB President Lagarde mis-spoke and said: “The ECB isn’t here to close spreads.” For just an instant, markets thought the ECB would no longer cap yields. That comment sparked a huge rise in spreads over Bunds, as the chart below shows. Based on that episode, it’s reasonable to think that Italian and Spanish yields would go back up to seven or eight percent, which is where they were at the height of the 2010/11 debt crisis. Three points are worth noting. First, of course Italy and Spain could use their central banks to buy bonds, thereby capping yields. But they’d be printing money to do that, which would only make the devaluation of their currencies worse, so they’d only be able to do this in very limited fashion. Second, bond yields would thus rise materially, making large debt burdens unsustainable and causing debt write downs. These debt write downs would bail in households who - up to this point - were unwilling to pitch in and make debt sustainable. By bailing in households, fiscal space would be created. Third, higher interest rates and debt write downs would substantially shrink the periphery financial sector, which is overinflated due to artificially low interest rates. There’ll be no more bids by Unicredit for Commerzbank in this world, but more likely a consolidation wave across European banks that’d be lead by Northern institutions.

• Germany will have to write down its TARGET2 claims. As I note above, the 2010/11 debt crisis was a sudden stop in capital flows to the periphery. The Euro zone dealt with this by replacing private flows with official ones, which were extended mostly by the Bundesbank to periphery central banks. Resulting claims are called TARGET2 and - as the chart below shows - are around €1 trillion (German GDP is around €4 trillion). These claims will have to be written down and additional financial assistance will likely have to be given to the periphery. That sounds costly, but it’s better than the status quo, which is an open-ended transfer from North to South. Germany and other Northern countries will see large appreciations of their currencies, but their central banks will be able to offset some of that via QE. In effect, the Bundesbank and its peers in Northern Europe will follow down the path of the SNB, which has had to deal with appreciation pressure on the Swiss Franc for many years.

If all this sounds daunting, it isn’t. The scary part is only the transition. Once that’s over, devalued real exchange rates will shift the Euro periphery into a higher growth equilibrium, while debt write downs will allow the periphery to carry its weight in the defense of Europe against external threats. The endpoint is unambiguously better than the current “pretend” equilibrium.

A positive side effect is that abandoning the Euro will also offer populists one less angle of attack. The political center in Europe has enough on its plate without also having to defend the Euro against populist diatribes.