The Breakup of the Euro Area: Comment

October 2008


(PDF Version)

I’m pleased to be a discussant of Barry Eichengreen’s  paper about whether the euro and the European Economic and Monetary Union (EMU) will survive.

Before turning to the substance of this interesting paper I should say something about the views about the euro that I expressed a decade ago before its launch (The Economist, 1992; Journal of Economic Perspectives, Fall 1997, and Foreign Affairs, November-December 2007).  Contrary to what many people think, I did not express doubts about whether the EMU could be launched or whether it could survive. My concern in those papers was that the single currency would have undesirable long-term economic and political effects, including higher average unemployment in the euro zone and a weakening of the political alliance between Europe and the United States. I shall not pursue those ideas here.

Barry has given us a careful and balanced analysis of the possibility that one or more members of the EMU will leave the monetary  union in the coming decade. He concludes that one country leaving in the next 10 years is unlikely and a complete breakdown of the EMU during that period is even less likely. He notes that it is difficult to predict beyond 10 years but suggests that a political marriage that lasts 10 years is likely to keep on going.

I will begin by discussing Barry’s analysis and then to go beyond his framework to consider two other reasons why one or more members of the EMU might chose to abandon the euro.

The draft that Barry circulated to the conference was dated May 2008, indicating that he prepared these remarks well in advance of the meeting.  But as he noted in his presentation, the current financial and economic crisis may provide a severe test of the strength of the monetary union.  But nothing that Barry said in his presentation makes me think he changed his mind because of the current situation.  I’ll return to that at the end of my remarks.

The potential exit of an EMU member is not just a hypothetical question.  The interest rate differentials among the 10 year government bonds of the EMU countries shows that financial markets consider it  a real possibility.  The interest rate on the German bond is the lowest.  But the 10-year government bonds of Greece and Portugal pay more than 100 basis points more than German bonds and even Italian bonds pay nearly  100 basis points more – indicating that the markets think that there is a risk that during the next decade those countries will not be able to pay in euros – either because they are insolvent or because they have left the EMU.

Barry’s analysis proceeds along two basic tracks.  First he considers whether it could be in a country’s rational self interest to leave the EMU.  Second he considers the barriers – technical, legal and political – that might cause it to stay in the EMU even if the  government of that country thought it would be desirable to leave.


I will start with the latter issues. Barry notes that many previous currency unions or single currency states have broken up (the Austro-Hungarian empire, the Soviet Union, the Czech-Slovak split).  But he then goes on to argue that those splits occurred either at a much earlier time in history when financial systems were simpler or in countries with simpler financial systems.  He also notes that the exit by one EMU country might not be by mutual agreement, adding treaty complications.  But in the end he concludes that splitting a country out of the EMU would be possible although the leaver would have a diminished political status in the EU.


Having set those issues aside I can focus on why a country might decide to leave the EMU.  Of course, countries don’t decide.  Political leaders decide.  I  will come back to that important distinction. 



I will start as Barry does by asking whether it could be in a country’s interest to leave the EMU.  Barry focuses on the desire of a country to pursue a different monetary policy. He notes that a country with slow growth, high unemployment and a large trade deficit --  he gives Greece,  Italy and or Portugal as current examples -- might be tempted to leave in order to ease monetary conditions and devalue its currency.  Barry explains why that might be a foolish decision because leaving the euro zone might lead to higher real interest rates and higher inflation.

Conversely, a country that wants a tougher monetary policy – that could be Germany if some future majority in the ECB is less concerned about inflatation than Germany is at that time – could leave the EMU in order to pursue a tighter policy.  Barry explains the risks of that strategy, particularly the capital inflow that might occur, but recognizes that the economic consequences for a strong country leaving the EMU would be less adverse than for a weak currency country.

Although the problem of a one-size-fits-all monetary policy is the most obvious reason for a country to want to leave the EMU, it is not the only one. 

The Stability and Growth Pact that limits fiscal deficits might be another reason why a country might want to leave the EMU.  In a serious downturn, a country may wish to pursue a traditional Keynesian policy of fiscal stimulus.  Although the Stability and Growth Pact may be elastic enough to permit some of that stimulus, a country may feel constrained from acting as aggressively as it wants.  It is certainly possible that the current downturn – especially if it becomes very deep and very long – will provide a fiscal challenge to EMU solidarity that has not occurred during the past decade.

It is of course also possible that a substantial number of countries will decide at some future tome to pursue a very expansionary fiscal policy and that the ECOFIN will choose to allow that because of a significant economic downturn.  A country that is opposed to such large fiscal deficits and that sees itself hurt by the resulting rise in euro interest rates and by the induced change in the value of the euro might feel that it would rather pursue a tighter fiscal policy in order to avoid  those exchange rate and interest rate consequences and would leave the EMU in order to do that. 

The current financial crisis raises another problem – the lack of a clear national lender of last resort.  It remains to be seen how willing the ECB will be to provide national central banks with the volume of euros needed to be a full lender of last resort.  If a country sees its banks failing because the national bank cannot create as much currency as it would have been able to do before the EMU, that would be a further reason for a country to consider leaving the EMU.

There is one further reason that might apply to leaving the European Union (EU)  as well as the EMU.  As of now,  taxation is a national responsibility within the EU.  Income redistribution among the EU countries is thus relatively limited.  But there is frequent discussion in some circles that this should be a matter for the EU, opening the way to substantial income redistribution.  High income countries might find this reason enough to want out.

Although each of these four reasons – monetary, fiscal, lender-of-last-resort and taxation -- might be enough to cause a country to want to leave the EMU, Barry might of course be able to explain in each case that doing so would be a mistake.  But the economic officials in the EMU countries might not understand the economy as well as Barry does or may have a quite different view of what drives inflation, exchange rates and other key variables.  We certainly know that thinking about those key relations has changed substantially even in the United States during the past few decades.  So officials might be provoked by any of these four reasons to believe that withdrawing from the EMU would be helpful even if the majority of economists at this conference would disagree.



But let’s for a moment assume that the government officials fully understand the adverse consequences of leaving the EMU and do not want to do so.  These officials may nevertheless not like the way policy is going in the EMU – monetary policy at the ECB or fiscal policy because of an inadequately (or excessively)  permissive ECOFIN.  That may cause the country to threaten that it will leave the EMU if policy is not changed.  That is clearly a substantial risk if the country is Germany or France.  But even if it is one of the smaller countries it might be a serious threat because it could be seen as the beginning of an unraveling of the EMU.  So either type of country could make the threat in the hope that the threat would be enough to cause their EMU colleagues to agree to their desired change in policy. 

The risk of course is that the other countries may not be intimidated.  The threatening country would then have to choose between accepting a humiliating defeat or leaving the EMU.  




I want finally to return to the idea that policy decisions are made by individual politicians or groups of politicians who are motivated by the own self interest rather than by a pure interest in the national well being.  Democratic procedures are of course supposed to align the self-interest of politicians and the well being of at least a majority of the public.  But that only works in a complex area like economic policy if the public is sufficiently wise, technically sophisticated, and far sighted.

If not, and this is certainly a more reasonable description, a  politician could make the case for a policy that will help him or his party to get elected even if it is not in the long run national interest.

Here’s an example of how self-interested politicians could lead to an EMU withdrawal by building on existing voter attitudes. A recent official Eurobarometer survey indicated that 95 percent  of respondents in the Euro 12 coungtries believe that the EMU has raised prices (Lane, Journal of Economic Perspectives, Fall 2006) . In Italy it was 97 percent and in Germany 91 percent. If at some future time  inflation is rising rapidly, it might occur to some political group to argue that if they are elected they will bring down prices or  inflation by taking the country in question out of the EMU . 

Or, to take a different example, what if the current economic downturn and financial crisis becomes very severe, producing very high unemployment. It is certainly possible that some politicians will argue out of a mixture of conviction and self interest that, if elected to a position of control,  they would take their country out of the EMU, permitting the combination of easy money, fiscal deficits and lender-of-last resort assistance to banks to revive the economy.

It is important in this context that the support for the EMU and even for the EU is generally very weak.  For example, when the Eurobarometer  recently asked French respondents how attached they are to the European Union, only 16 percent said that they are “very attached.” In contrast, 56 percent of that group said they were very attached to France as a nation.

Barry’s paper reports similar lack of support for the EMU among respondents in many countries.  When asked in the 2006 Eurobarometer survey whether they thought EMU membership had been to the advantage of their country, only 40 percent of Italians said yes.  The proportion was similar in Portugal and even smaller in the Netherlands and Greece. In Germany it was only about 45 percent.  Only four countries showed really substantial belief – more than 60 percent --  that EMU membership had been advantageous: Ireland, Luxembourg,  Austria and Finland.

Similarly,  when asked whether they had confidence in the ECB, only 44 percent of Italians said yes.


In short, after a decade of experience with membership in the EMU, the public support for EMU is weak at best.  A political leader or political party could use this weak support to promote its political power by promising to withdraw the country from the EMU or by saying that they will threaten to withdraw the country from the EMU if the other member countries do not agree to their proposed policy changes.

The currently developing  economic crisis may provide a significant test of these temptations.


October 2008









[1] This is a comment on a paper with the same title presented by Barry Eichengreen at an NBER Conference in Milan, Italy on 17 October 2008. (Revised November 2008)