Cost of Eurozone break-up too high

Then it appeared in economic commentary as a “worst case scenario”. Some now firmly believe that a break-up, while not imminent, is unavoidable in the longer term

Now all this has taken a quantum leap forward with the call from a Eurozone prime minister for euro member countries to be expelled if they do not stay within the limits laid down by a central commissioner.

Writing in the Financial Times last week, Marke Rutte, the Dutch prime minister and Jan Kees de Jager, his finance minister, said the euro crisis merited a budget tsar with powers to dictate taxes and spending in Eurozone countries and who could ultimately adjudicate whether countries should be kicked out of the euro.

The article followed news of pressure applied on Italy to ensure austerity budget proposals were being followed through, and an unexpectedly early departure of international lenders from Athens following disagreements over whether Greece was implementing the measures demanded by the European Union and International Monetary Fund. Last week yields on Greek 10-year bonds shot up again as markets suffered another anxiety attack.

Rutte argued that if euro countries continued to flout demands for spending restraint, they would be forced to submit their budget plans to a commissioner who would have power of veto. And it should be possible to force countries to leave the euro if they did not abide by the commissioner’s ruling. “Countries that do not want to submit to this regime can choose to leave the euro…In the future the ultimate sanction can be to force countries out of the euro”.

The call was broadly welcomed in Germany where there is a growing backlash against proposals to expand the Eurozone’s emergency bail-out kitty – the European Financial Stabilisation Fund – and deep unease over the resort to Eurobonds. Many Germans fear these would saddle them with Greek, Italian and Spanish debt and with the borrowing and fiscal policies of these governments outwith their control.

Germany and other northern European countries are likely to insist on a common fiscal discipline and fiscal oversight before it will ever agree to the issuing of Eurobonds.

While the approach of the Dutch prime minister has been rejected by the European Commission, the Dutch call is broadly similar to the position of Angela Merkel in Germany, though she would express it rather less starkly for fear of being thought (crime of crimes) anti-euro.

Fiscal integration, however unpopular, is likely to proceed, however bumpily in political terms, for the single reason that it is the least worst option. This does not mean that the future of the Eurozone is in any way guaranteed – indeed politically matters are likely to take a sharp turn for the worse – but the alternative would prove massively disruptive and costly.

Just how costly was the subject of a paper last week from UBS economist Stephane Deo. His base case is an “overwhelming probability” that the Euro moves “slowly (and painfully) towards some kind of fiscal integration”.

But there has been widespread speculation that a euro split-up may come to pass sooner or later, with little appreciation of how expensive it could prove.

Were a stronger country such as Germany to leave the euro, the consequences, he writes, would “include sovereign default, corporate default, collapse of the banking system and collapse of world trade”. He estimates that a weak euro country leaving the single currency would incur a cost of around ¤9,500-¤11,500 per person each year, falling to ¤3,000-¤4,000 per person per year in subsequent years. This equates to a range of 40-50 per cent of GDP in the first year.

Were a stronger country such as Germany to leave the euro, the wider consequences would be similar. UBS estimates the cost at around ¤6,000-¤8,000 for every German adult and child in the first year, and a range of ¤3,500-¤4,500 per person a year thereafter. This would be equivalent to 20 per cent-30 per cent of GDP in the first year.

In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over ¤1,000 per person in a single hit.

But the economic cost of a euro exit could prove the least of Europe’s problems. Well in advance of the fact would be a period of killer volatility in financial markets and panic withdrawals of deposits from banks in the countries suspected of a Euro exit. And if the economic outlook deteriorates further – as ECB governor Jean Claude Trichet warned at the end of last week – the impact would be worse.

Fragmentation of the euro would also incur political costs. There would be trauma and disruption across all major financial centres. And Europe’s “soft power” internationally would effectively cease as her membership, unity and credibility would be severely hit. Once one member had departed, the question would immediately arise, “Who next?”.

Meanwhile the latest summit of Group of Seven finance ministers and central bankers in Marseilles over the weekend is unlikely to provide any easing of the tensions now building in the Eurozone. There are the usual calls for “global action” and a co-ordinated response yet at the same time for countries to stick with their budget deficit reduction plans.

But many Eurozone finance ministers will be looking to America and President Barack Obama’s announcement of a $450bn (£282bn) stimulus to help create and sustain jobs. If debt-laden America can get dispensation from the IMF for that, why not other countries?

Short of a major reconfiguration of the Eurozone – or a complete chaotic break-up – the likelihood is a Eurozone with a centralised ministry of finance, with the rules determined by Germany and the northern states, severe curtailment of the economic sovereignty of southern countries, and, through Eurobonds, fiscal transfers from the rich north to the uncompetitive south.

If that is the “best case scenario”, little wonder markets are jittery.