Scenarios
Different countries could abandon the euro for different reasons. One can imagine a country like Portugal, suffering from high labor costs and chronic slow growth, reintroducing the escudo in an effort to engineer a sharp real depreciation and to export its way back to full employment. Alternatively, one can imagine a country like Germany, upset that the ECB has come under pressure from governments to relax its commitment to price stability, reintroducing the deutschemark in order to avoid excessive inflation.
These different scenarios would have different implications for whether defection implies breakup-that is, for whether one country’s leaving reduces the incentive for others to remain. In the case of Portuguese defection, the residual members might suffer a further loss of export competitiveness, while in the event of German exit, they might find their competitiveness enhanced.
Specifically, if other countries are similarly experiencing high unemployment associated with inadequate international competitiveness, then Portugal’s leaving will aggravate the pain felt by the others and may lead them to follow suit-but Germany’s leaving may have no, or even the opposite, effect. Similarly, if discomfort with the inflationary stance of ECB policy is shared by other countries, then Germany’s leaving, by removing one voice and vote for price stability, may heighten the incentive for others to do likewise.
More generally, if the country that leaves is an outlier in terms of its preferences over central bank policy, then its defection might better enable the remaining participants to secure an ECB policy more to their liking, in which case the likelihood of further defection and general breakup would be reduced. Disagreements over the stance of policy being an obvious reason why a participating member state would be disaffected, one might think that the defector would automatically be an outlier in terms of its preferences over central bank policy. But this is by no means certain: countries whose preferences differ insignificantly from those of other members could choose to defect for other reasons-for example, in response to an exceptionally severe asymmetric shock, or because of disagreements over noneconomic issues.
And if the country that leaves is small, this would be unlikely to much affect the incentives of other members to continue operating a monetary union that is valued primarily for its corollary benefits. The contribution of the euro to enhancing price stability would not be significantly diminished by the defection of one small member. The impetus for financial deepening ascribed to the single currency would not be significantly diminished.
If Portugal left the euro area, would the other members notice? Even if it used its monetary autonomy to engineer a substantial real depreciation, would its euro area neighbors experience a significant loss of competitiveness and feel serious pain?
On the other hand, if Germany defected, the size of the euro area would decline by more than a quarter. This would imply significant diminution of the scale of the market over which the benefits of the euro were felt in terms of increased price transparency and financial deepening. Countries balancing these benefits against the costs of being denied their optimal national monetary policy might find themselves tipped against membership. Defection by a few could then result in general disintegration.
In practice, a variety of asymmetric shocks could slow growth and raise unemployment in a euro area member state and create pressure for a real depreciation. The shocks that have attracted the most attention are those highlighted in Blanchard’s model of rotating slumps (Blanchard 2006). The advent of the euro has brought credibility benefits to members whose commitment to price stability was previously least firm and whose interest rates were previously high.9 Enhanced expectations of price stability have brought down domestic interest rates, bidding up bond, stock, and housing prices.
Foreign capital has flooded in to take advantage of this convergence play. The cost of capital having declined, investment rises in the short run, and as households feel positive wealth effects, consumption rises as well. The capital inflow has as its counterpart a current account deficit. In the short run, the result is an economic boom, driven first and foremost by residential construction, with falling unemployment and rising wages.
But once the capital stock adjusts to the higher levels implied by the lower cost of capital, the boom comes to an end.
Unless the increase in capital stock significantly raises labor productivity (which is unlikely insofar as much of the preceding period’s investment took the form of residential construction), the result is a loss of cost competitiveness. The country then faces slow growth, chronic high unemployment, and grinding deflation, as weak labor market conditions force wages to fall relative to those prevailing elsewhere in the euro area. The temptation, then, is to leave the euro zone so that monetary policy can be used to reverse the erosion of competitiveness with a “healthy” dose of inflation.
This particular scenario has attracted attention, because it suggests that the tensions that could eventually result in defections from the euro area are intrinsic to the operation of the European Monetary Union (EMU). It suggests that the intra-euro-area divergences that are their source are direct consequences of the monetary union’s operation.
This story tracks the experience of Portugal since the mid-1990s-first boom, then overvaluation, and finally slump. There are signs of similar problems in Italy, where the difficulties caused by slow growth are compounded by the existence of a heavy public debt, and in Spain, which experienced many of the same dynamics as Portugal. The implication is that Greece and Slovenia (and future EMU members such as Estonia and Latvia) will then follow.