ANGELA MERKEL, the German chancellor—and also, in effect, the
euro area’s boss—has always insisted that she wants to preserve the euro
area in its current form. But as the euro crisis intensifies and the
potential bills for Germany mount, she would be imprudent not to be
considering a Plan B. Drafted in utmost secrecy by a few trusted
officials for the chancellor’s eyes only, this is what the memorandum
outlining a contingency plan might say.
TO: Angela MerkelFROM: ???SUBJECT: Plan B
THE CURRENT IMPASSE
I. Since the euro crisis started over two years ago you have said
that Germany will defend the single currency, based on your conviction,
shared by business and the political class, that its survival is in our
national interest. To that end Germany has pledged large amounts of
public money, both in our contributions to various rescue funds and
through the Bundesbank’s share of risks taken by the European Central
Bank (ECB). At the same time you have tried to minimise the bill for
German taxpayers by insisting that bailed-out states implement strict
austerity programmes and, more generally, by resisting calls for debt
mutualisation—code for Germany underwriting the euro area—while
demanding greater central control over all national budgets.
II. Bluntly, the plan isn’t working. Greece is a disaster zone.
Ireland and Portugal are making some progress (it was encouraging that
Ireland was able to raise some money from the markets in July) but they
still have a long way to go and could easily be knocked off course.
Worse, Spain looks as if it may need a full bail-out rather than the
partial one for its banks you had hoped would suffice. And Spanish
sickness is infecting Italy, undermining all the good work that Mario
Monti has been doing since the Italians saw sense and got rid of Silvio
Berlusconi, as you had been urging behind the scenes. Meanwhile François
Hollande isn’t doing enough to get France into shape and is playing the
usual French game of calling for Germany to do more while resisting
your attempts to centralise control at the European level. Mario Draghi,
the ECB’s president, has calmed things down for the moment, but his
plan could easily come unstuck.
III. The position is dangerously unstable. If capital flight from the
peripheral economies gathers pace, it could trigger runs on entire
banking systems. That would put the ECB—and thus, indirectly, the
Bundesbank and Germany—on the hook for deposits worth trillions of
euros. The domestic politics are already ugly in several countries,
notably Greece. This is poisoning our position in southern Europe, where
our help is increasingly seen as a new form of German tutelage. The
situation is deteriorating in Germany, too, where your ability to act is
being limited by a backlash against bail-outs and against the euro
itself. If anything, the backlash in Finland and the Netherlands is even
more vicious.
THE CASE FOR PLAN B
IV. Hence the need to consider an alternative strategy. The aim of
this contingency plan is not the complete break-up of the 17-country
euro area. That would be against the German national interest,
destroying the hard-won respect we have achieved since the second world
war by embracing European integration. And it would needlessly damage
our economy by bringing back currency risk for trade with countries such
as Austria and the Netherlands, which have adapted perfectly well to
the euro. Plan B seeks to save the euro by surgery, excising states that
cannot cope rather than clinging to the vain hope that they can regain
their health within the euro zone.
V. We propose two options. First, the one that may be forced on you
anyway: an exit by Greece arising from gross dereliction of its duties
under the various bail-out agreements. We have taken as a given that MPs
in the Bundestag will not sanction a single euro more in bail-out money
to Athens. If that forces the Greeks out, so be it. Second, we also
consider a wider exit of other countries that have failed the euro test.
We think this should include all the states that have already been
rescued, or are requesting bail-outs, because those countries share with
Greece a fundamental loss of competitiveness and vulnerability to
foreign capital flight. This means that they cannot be cured within a
reasonable period of time while staying within the euro.
VI. In assessing the two options we have relied mainly on a
cost-benefit analysis. That has been informed, where relevant, by
historical precedents and the legal position (we are well aware of your
concern that Germany must at all times be seen as law-abiding). We also
look briefly at some of the practical issues involved in an exit.
Naturally, we have taken into account the political constraints you face
both at home and among your fellow European leaders. Caution is your
watchword, so we’ve highlighted the risks of things going wrong if you
adopt Plan B.
CAN AN EXIT HAPPEN IN THE FIRST PLACE?
VII. We start with the most basic question of all: can one or more
countries leave (or be forced out of) the euro, both legally and
practically? As a matter of legal principle, the answer is no, because
when countries joined the euro the conversion of their former currencies
was supposed to be “irrevocable”: a Hotel California that you can never
leave. Indeed, a legal opinion published by the ECB in 2009 argued that
because European treaties did not conceive of the possibility of a
country leaving the euro, an exit would require them to leave the
European Union (EU) as well. That would exacerbate the economic pain
because the departing state would lose access to both the single market
and valuable regional-support funds.
VIII. But we think this argument of legal impossibility is
overstated. European laws are in constant flux because of the ease with
which new agreements can supersede old ones. The Maastricht treaty of
1992 banned bail-outs, but you have yourself authorised two agreements
allowing them: the temporary rescue fund and the permanent European
Stability Mechanism, whose legality our constitutional court is
considering at the moment. Similarly, we think that it will be possible
to find a way round the supposedly binding rule that a country exiting
the euro would also have to leave the EU.
IX. What about the practical obstacles to an exit? There are two main
ones. First, it would take several months to design, print and
distribute an entirely new currency, leaving a departing country bereft
of new cash. Second, news of a country leaving or being ejected would
almost certainly leak, prompting bank runs so massive that they would
overwhelm even the ECB’s ability to counter them. That would lead to a
total (and chaotic) break-up rather than a controlled one.
X. We think it will be possible to deal with both these practical
difficulties. Yes, it took six months to launch a new currency when, for
example, the Czech-Slovak monetary union broke up in 1993. And yes,
they were able to overstamp existing notes as either Czech or
Slovak—something that would not work for a country like Greece, which
relies so heavily on euros spent by tourists. But modern economies have
become much less reliant on cash than they used to be. We think a
country could get by for a few months through enhanced use of electronic
payments (which might also flush out more of the black economy) and by
using existing euro notes and coins for small transactions, as proposed
by Roger Bootle, the head of Capital Economics, a consultancy, who
recently won a competition set by Lord Wolfson, a British businessman,
on how one or more countries might leave the euro.
XI. The worry about bank runs is more justified, but we think it too
can be overcome. The most obvious way would be to keep the exit decision
completely secret until the weekend it was implemented. That is tricky,
because you would need to convince other European leaders ahead of a
council meeting, and news would be bound to leak. But if the news did
get out, then a state leaving the euro could immediately impose an
extended bank holiday and implement capital controls (normally illegal
under European law, but there is a get-out clause for up to six months
in exceptional circumstances). That should deal with the problem.
AN EXIT OF GREECE ALONE
XII. Assuming the legal and practical hurdles to an exit by any state
can be surmounted, then the first option is for Greece to leave, which
on the face of it looks less risky than a bigger break-up. One immediate
difficulty is that the Greeks don’t want to go, so they would have to
be expelled. There are two ways they could be forced out: first, by
cutting off the flow of bail-out funds, which would mean that the Greek
government would have to meet its deficits by issuing IOUs that would
start to circulate as a
de facto parallel
currency, trading at a discount to euros; second, by cutting Greek banks
off from refinancing from the ECB and its payments system. The first
approach might take some time but would create such monetary chaos that a
clean break would eventually seem preferable. The second would force
the issue since the banks would collapse without access to ECB
liquidity.
XIII.What would happen then? Even if Greece did slide towards the
exit rather than jumping, at some stage the government would have to
complete the process by introducing the new drachma one weekend when the
markets were closed. All assets, debts and contracts written under
domestic law, including bank deposits and loans, would be redenominated
one-for-one from euros to drachmas. Crucially, the moment the markets
reopened, the drachma would depreciate, probably by more than 50%.
XIV. That devaluation, if not squandered in a lurch towards
hyperinflation, could deliver Greece from its current misery of
perpetual recession by letting it regain lost competitiveness at a
stroke, rather than by grinding down domestic costs over several years.
That should swiftly deliver a hefty boost to the sagging economy from
net trade. But what would it mean for Germany?
XV. First, you can count on the move being popular—and not just in
Germany—making it feasible to win support from other European leaders
whose electorates are just as fed up with the feckless Greeks. Second
and vitally, expelling Greece would draw a line under the costs of
bailing it out and prevent it from becoming a permanent drain on German
taxpayers. Third and scarcely less important, the decision would give
bite to conditionality, sending a stern lesson to the rest of Europe
that bail-out terms cannot be flouted with impunity.
XVI. Set against these benefits there will be costs. From a strategic
perspective, there is the danger of Greek politics souring still
further and the country becoming a permanent trouble-spot in the eastern
Mediterranean, even if it is out of the euro. To fend off that
possibility it will be essential to show goodwill by keeping Greece in
the EU. So it will in fact need a third bail-out (only we will call it
an aid package) to pay for things like essential drugs for patients. We
think this could be capped at, say, €50 billion ($60 billion) of which
Germany would chip in a third, or around €17 billion.
XVII.That will be just the beginning. Drawing a line also means
ending the fiction that our loans to Greece will be repaid in full.
Germany, along with other European creditor nations, will face hefty
losses (see chart 1) arising from our exposure to Greece. First, there
is the money already disbursed: almost €130 billion. Second, the ECB
still owns Greek government bonds worth some €40 billion. Third, the
Bank of Greece owes the ECB about €100 billion in so-called Target2
debts, which have arisen through the Target2 payments system as local
banks made up for the drain of deposits out of Greece by borrowing from
the central bank. That adds up to an exposure of over €270 billion, or
3% of euro-wide GDP. (We don’t include the indirect exposure we all have
through our stakes in the IMF, which has lent Greece about €20 billion,
since the IMF usually gets its money back).
XVIII. Some of that €270 billion might be recovered, but it would be
irresponsible to bank on any of it. The devaluation would increase—in
drachma terms—Greece’s euro indebtedness. That will force the Greek
government wherever possible to redenominate its liabilities into
drachma, inflicting heavy losses on creditors; and it may follow that up
with a further write-down. Prudence suggests that we should assume no
recovery and that Germany will be on the hook for a third of European
losses—more than its formal share of just over a quarter, on the
assumption that the other bailed-out states won’t be able to pay
anything at all. That would cost Germany €90 billion, raising the bill
(including the aid package) to almost €110 billion. On top of this
taxpayers might have to stump up €10 billion to support German banks as
they wrote off their claims on Greece. Assuming that the state picked up
half the resulting losses, this would take the total German bill to
nearly €120 billion, or 4.5% of GDP.
GOING FOR BROKE
XIX. If that was that, it would be a bargain compared with the likely
present value of transfers from Germany to Greece over the next few
years and maybe decades. But there is a sizeable risk that a Grexit
could turn into a calamity, as markets reacted badly to the admission
that euro membership was no longer irreversible. At worst there could be
a market collapse to rival the one that took place after the Lehman
bankruptcy in late 2008, which could in turn trigger a recession on the
scale of the desperate downturn of 2008-09. In the panic, you would come
under intense pressure (Barack Obama would be on the line immediately)
to concede debt mutualisation without getting the
quid pro quo
of fiscal control at a European level that you have been demanding.
After holding out for so long against demands that you write a blank
cheque, that is what you might well end up having to do.
XX. Given the risk that Germany might have to pay such a heavy price
for a Greek exit, does that mean Plan B is a non-starter? Not
necessarily. Another conclusion might be that the seemingly safer
scenario of an exit by Greece alone is in fact the riskier option. If
Germany is going to have to make big concessions to deal with the exit
of one state, it might make more sense to make such concessions in
conjunction with more radical surgery that really gets to grip with the
euro crisis. Altogether, five out of the 17 member states have been
rescued or asked for a bail-out—testimony to the fact that they have not
been able to cope with the rigours of the single currency. The other
four—first Ireland, then Portugal, and now Spain and Cyprus—are also
teetering in the relegation zone. Expelling them too might be better for
them, for the euro and for Germany, because it would make the remaining
euro area more viable.
XXI. The plight of the other four economies reflects private debt
(especially in Cyprus, Ireland and Spain) as much as public debt (which
was clearly at fault in Greece and to a lesser extent in Portugal). But
the fundamental weakness that they all now share with Greece is that
they owe foreigners far more than they own abroad. In each of the five
countries, external liabilities exceeded domestically owned foreign
assets by between 80% and 100% of GDP in 2011, putting them in a league
of their own within the euro area (see chart 2). Italy, by contrast, has
low net external liabilities worth only 21% of GDP (lower than
America’s 27%).
XXII. External-debt levels are far higher in the five countries than
in emerging economies that have fallen victim to “sudden stops”, in
which foreign investors and banks stop lending and try to pull out their
money. Small wonder that the markets have lost confidence in them. But
even though bail-out loans can shield governments, that loss of
confidence continues to undermine the peripheral economies, as foreign
deposits are withdrawn and foreign investors refuse to buy their debt.
Central-bank funding is plugging the gap, but that makes banks
worryingly beholden to the ECB, causing them to clamp down on their
lending to firms and households. This squeezes the economy even more
tightly and makes it harder to get the public finances in order.
XXIII. As well as being burdened by unsustainable levels of external
debt, all five economies share the misery of trying to regain lost
competitive ground through internal devaluation, in which domestic costs
are ground down year after year. With the exception of Ireland, which
has achieved a worthwhile reduction in its unit labour costs (though
after the biggest rise of all), you could hardly select a group of
countries less able to make a success of internal devaluation. Labour
markets in southern Europe are notorious for protecting insiders
(permanent workers) at the expense of outsiders (employees on temporary
contracts or the unemployed). This rigidity means that firms cut their
labour costs through hiring freezes and by sacking temporary employees,
rather than by reducing pay rates.
XXIV. Some progress is being made, but as in a marathon, it is the
second half of the race that is the most agonising. Unemployment has
already risen to perilously high levels: around 15% of the workforce in
Ireland and Portugal and 25% of the workforce in Spain. Ireland has been
running a small current-account surplus and deficits have generally
fallen (though they remain very high in Cyprus and Greece) but they
would be far worse if the peripheral economies were not so depressed,
which has slashed demand for imports.
XXV. What this suggests is that if Greece has to depart, it should
not go alone. Like Greece, the other four bail-out countries would gain
from the swift improvement in competitiveness that currency devaluations
would achieve, provided credible policies were pursued to ensure it was
not frittered away in runaway inflation. And if politics can trump the
law for Greece, then the same should be true for all five countries,
allowing them to stay in the EU and retain access to the single market.
XXVI. Such a move would of course come as a tremendous shock, and it
would be essential to protect Italy and France at once by making
far-reaching concessions that shift the remaining euro area towards
mutualisation of debt and the creation of a banking union. But that
would be less of a setback for Germany than before, because in principle
there should be less need for burden-sharing in a more viable monetary
union. Indeed, the most important potential benefit of this bigger
break-up is that it could bring the euro crisis to a decisive end by
restoring confidence in a smaller but sturdier single-currency area.
XXVII. In addition, a line would have been drawn under potentially
much higher costs by preventing the bail-outs from becoming a permanent
flow of transfers. This is what happened in Germany after reunification
and is still happening. Recent research by the IMF shows that the flow
of money to the poorer German states has created a form of benefit
dependency. The German public’s big fear is the same outcome, writ
large, across the euro area. For example, a transfer union across the
existing single-currency zone based on the Canadian model would seek to
make governments’ revenues more equal. Transferring cash so that the
poorest governments (including Greece and Spain) had a level of revenue
close to that of a mid-tier but still below-average country like Ireland
could involve annual transfers of €250 billion—of which €80 billion
would need to come from Germany, around 3% of its GDP.
XXVIII. In the short term, however, the cost of a five-country exit
would clearly be much heavier than that of a Grexit. Although the other
four departing states would be in a less desperate condition than
Greece, they might also need some aid to smooth the way—a further €100
billion, say, of which Germany’s share would be €33 billion. The
additional exposure through official loans would be bearable because the
other four bail-outs were individually much smaller than Greece’s.
Altogether euro-area governments have made commitments approaching €200
billion—the same as to Greece—but actual disbursements have been less
than half that. The big exposure lies in the euro system. The ECB is
estimated to hold an additional €80 billion of Irish, Portuguese and
Spanish bonds bought over the past two years to calm markets. In
addition, it has claims on the other four countries through the Target2
system of around €600 billion.
XXIX. That would bring the cost arising from an exit of all five
countries to €1.15 trillion, of which Germany’s share would be €385
billion, or 15% of its GDP. The additional expense of bank bail-outs
would increase this to €496 billion, or 19% of GDP, lifting German
government debt from 81% of GDP in 2011 to 100% and imperilling
Germany’s triple-A credit rating. German non-financial firms and
individuals would also take a big hit on their claims of over €200
billion in the five economies.
XXX. The biggest risk associated with this scenario is that the moves
towards debt mutualisation and a banking union might not, after all, be
enough to stabilise the remaining euro area, resulting in a total
break-up of the euro zone and triggering a savage recession with hugely
damaging economic consequences. Markets invariably ask “who’s next?” and
there is an obvious answer. Italy might not need to leave the euro on
grounds of its net external liabilities, and its primary budget (ie,
before interest payments) is under control. But its public-debt burden
of 120% of GDP is the second-highest (after Greece’s) in the euro area.
And it is mired in recession again. Like Greece, Italy has found it hard
to live with the single currency. Growth has been dismal over the past
decade (Mr Berlusconi was an economic calamity) and unit labour costs
have risen sharply. The task of restoring Italian competitiveness would
be far harder once the five departing economies had adopted new, much
cheaper currencies.
XXXI. The more that markets fretted about Italy, the more they would
also fret about France, given its strong trading and financial links
with Italy. Given all this, it would be very difficult for Germany to
get support in the European Council for this more drastic plan. The
political obstacles to co-ordinating a solution that keeps the euro area
intact may seem insuperable, but getting agreement for a planned
ejection of five countries would be even more daunting.
CONCLUSION
XXXII. Of the two options, our judgment is that the larger break-up
makes more overall economic sense than an exit of Greece alone. But we
must emphasise that the economic and financial risks of it going wrong
are much greater, and pushing it through would be an order of magnitude
more difficult than co-ordinating an exit by Greece alone. Finally, a
drawback associated with both options, even if they were to work, is
that many of the benefits would lie in the future (by not having to make
transfers to peripheral Europe) whereas the costs would be felt here
and now—and blamed on you and your government.
A note attached to this memorandum by a member of
her staff indicates that after reading it, Mrs Merkel thought long and
hard about how to respond. She is a scientist by training, a politician
by vocation and, most important of all, a cautious person by
temperament. After much deliberation she concluded that despite the
advantages of Plan B compared with her current strategy, she was
unwilling to countenance the associated risks—at least for the moment.
She ordered the memo to be shredded, resolving that if the euro area is
to fragment, it will not be at her behest. But the staff member who was
told to destroy the memo thought it might be useful to keep Plan B in
reserve just in case. Plucking it from the shredder, he filed it away
instead. No one need ever know that the German government had been
willing to think the unthinkable. Unless, of course, the memo leaked…
http://www.economist.com/node/21560252
