The world economy is continually changing, but one constant is dissatisfaction with the euro. Toward the beginning of the decade, the main complaint was that the euro was too weak for booming economies like Ireland. Now the complaint is that it is too strong for growth-challenged countries like Italy.
To be sure, the source of the current problem is external. It stems from the fall of the dollar, reflecting a combination of economic and financial problems in the United States, and the insistence of the Chinese authorities that the renminbi should follow the greenback. But that does nothing to defuse the complaints.
The negative impact is being felt by all Eurozone members. But some countries where growth was already stagnant, such as Italy, are least able to cope. Already in June 2005, following two years of euro appreciation, then-Italian welfare minister Roberto Maroni declared that “the euro has to go.” Then-prime minister Silvio Berlusconi followed by calling the euro “a disaster.” But this earlier episode of appreciation pales in comparison with what has happened since. And if the dollar depreciates further and the US falls into a full-blown recession – both of which are more likely than not – calls like these will be back.
So is the euro doomed? After seeing the number of Eurozone countries rise from 10 in 1999 to 15 at the beginning of 2008, will the process shift into reverse? If one country leaves the Eurozone by reintroducing its national currency, will others follow? Will the entire enterprise collapse?
The answer is no. The decision to join the Eurozone is effectively irreversible.1 However attractive the rhetoric of defection is for populist politicians, exit is effectively impossible – although not for the reasons suggested in earlier discussions.
A first reason why members will not exit, it is argued, is the economic costs. A country that leaves the euro because of problems of competitiveness would be expected to devalue its newly-reintroduced national currency. But workers would know this, and the resulting wage inflation would neutralise any benefits in terms of external competitiveness. Moreover, the country would be forced to pay higher interest rates on its public debt. Those old enough to recall the high costs of servicing the Italian debt in the 1980s will appreciate that this can be a serious problem.
But for each such argument about economic costs, there is a counterargument. If reintroduction of the national currency is accompanied by labour market reform, real wages will adjust. If exit from the Eurozone is accompanied by the reform of fiscal institutions so that investors can look forward to smaller future deficits, there is no reason for interest rates to go up. Empirical studies show that joining the Eurozone does result in a modest reduction in debt service costs; by implication, leaving would raise them. But this increase could be offset by a modest institutional reform, say, by increasing the finance minister’s fiscal powers from Portuguese to Austrian levels. Even populist politicians know that abandoning the euro will not solve all problems. They will want to combine it with structural reforms.
A second reason why members will not exit, it is argued, is the political costs. A country that reneges on its euro commitments will antagonise its partners. It will not be welcomed at the table where other EU-related decisions were made. It will be treated as a second class member of the EU to the extent that it remains a member at all.
Political costs there would be, but there would also be benefits for politicians who could claim that they were putting the interests of their domestic constituents first. And politics have not rendered countries like Denmark and Sweden that have steadfastly refused to adopt the euro second-class EU member states.
The insurmountable obstacle to exit is neither economic nor political, then, but procedural. Reintroducing the national currency would require essential