25/9/2012
Don't believe the politicians. The common currency can't survive as is. Here's the right way to handle a split.
FORTUNE – Roger Bootle prides himself on being something of a modern-day Nostradamus -- with good reason. In 1999 the British economist predicted a bursting of the dotcom bubble, and in his 2003 book, Money for Nothing, he forecast a worldwide crash in housing that would prove dire for the financial system. A rigorous student of markets, Bootle, 60, is a onetime Oxford don and chief economist for HSBC (HBC) who now runs Capital Economics, a London consulting firm. Operating out of a 19th-century Victorian townhouse near Buckingham Palace, the bald, bespectacled son of a civil servant confidently advises major banks and hedge funds from New York to Beijing. But away from the office he isn't much of a risk-taker. Bootle likes to unwind at England's famous Ascot Racecourse, where he wagers no more than "five or 10 quid just so I have a horse to cheer home."
Today Bootle is betting his professional reputation on another bold contrarian call, one with long-term ramifications for the world economy and global stock markets: He strongly believes that at least a partial breakup of the eurozone is inevitable and that massive changes are coming for the euro, the currency now shared by 17 nations accounting for one-eighth of world GDP.
In July, Bootle and his team won the prestigious Wolfson Economics Prize for providing the best answer to the following question: "If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed?" In a 114-page report, "Leaving the Euro: A Practical Guide", Bootle delivered a blueprint for the steps a nation should take in exiting the common currency. He also went further, summoning a powerful argument for why an exodus of weak countries is the only solution for Europe's deep malaise.
Bootle is not shy about championing his highly unpopular view. "The euro is a depression-making machine," he tells Fortune. "The politicians keep throwing money to support the weaker nations' debt problem. They never talk about restoring growth. Far from a disaster, a breakup of the euro is the only way to bring back growth and get Europe out of this mess. It can't happen soon enough."
Policymakers continue to take a diametrically opposite approach. Almost without exception, Europe's political leaders and regulators strongly back the euro's survival and generally claim that a breakup would bring economic Armageddon. Optimism that the eurozone will hold rose on Sept. 6, when Mario Draghi, chief of the European Central Bank, announced a giant program for purchasing the sovereign debt of weak eurozone nations. Draghi further stated that "the euro is irreversible." Then, on Sept. 12, a German court approved the country's participation in the European Stability Mechanism, a rescue fund with a lending capacity of $645 billion. Over five trading sessions, the S&P 500 jumped 2.4% in a potent relief rally.
But the continued bailouts are just buying time. Even economists who dread a euro breakup admit that it will probably happen eventually unless Germany and other healthy nations provide far greater support to their weak neighbors. "Europe needs to create federal-style debt shared by all the eurozone members," says Greek economist Yanis Varoufakis. "If that doesn't happen, the eurozone will probably dissolve."
The bet here is that Bootle is right and that the euro will fracture in the next few years. The result will be extremely messy in the immediate aftermath, bringing severe hardship to the exiting countries -- a rash of bankruptcies, giant defaults on sovereign debt, and temporary panic in world stock markets. But the pain that a breakup compresses into a one-time shock will happen anyway if weak nations remain in the euro. It will simply stretch over a number of years and turn out far worse. As Bootle argues, Europe must choose growth, and a split in the euro will bring it back with surprising speed. Let's use his report as a guide for how a successful breakup could play out.
The continent's weaker nations can't possibly solve their two big problems if they remain in the common currency. The first problem is the one the politicians and regulators talk about most: the huge overhang of sovereign debt, exceeding 100% of GDP in nations such as Greece and Italy. But the second is even more important. Europe's PIIGS -- Portugal, Ireland, Italy, Greece, and Spain -- all suffer from a drastic loss of competitiveness because they face an excessive cost of production, especially compared with Germany. That disparity has decimated manufacturers in Spain and Italy struggling to compete with imports.
The competitiveness gap was a decade in the making. Its main source is the shocking divergence in labor costs between Europe's two tiers, which we'll call the "core" and "peripheral" nations. From 1999 to 2011, unit labor costs -- the wages and benefits required to produce a car or computer -- rose 4.3% a year in Spain, 3.4% in Italy, and 4.1% in Ireland, compared with a 0.9% annual increase in Germany. That leaves the peripheral countries with a competitiveness gap of 30% to 40% vs. the core nations, by Bootle's estimate. As a result, Italy's exports as a share of the world total dropped from 5% in the late 1990s to about 2% last year.
If they remain in the euro, peripheral countries must solve their competitiveness problem through austerity -- by letting high unemployment grind down wages, by raising taxes, and by slashing government spending. "That process could take 10 years," says Bootle. Worse, their debt and interest payments would remain in euros and keep rising, while tax receipts fall. It would be nearly impossible for those nations to default on their debt and stay in the eurozone. "The ECB has been supporting the banks in weak countries," says Charles Goodhart of the London School of Economics. "The collateral is largely their sovereign bonds. If they default, all aid to the banks would cease, causing their collapse."
An immediate exit could solve both the debt and the competitiveness problems in a single stroke. Bootle believes it's likely that peripheral countries will begin to split off one by one. In his study, he concludes that although the legality of an exit is fuzzy, it can be justified under international law as essential to a country's economic survival. Nor would it require approval of Parliament prior to departure. That's important, given the need for secrecy.
Here's how the mechanics might work if, say, Spain decided to withdraw. The government would announce the decision on a Friday, shortly after the Prime Minister and cabinet reached the decision. It would state that by 12:01 a.m. Monday all wages, bank deposits, pensions, and prices would be reset in pesetas at a 1-to-1 ratio with the euro. Over the weekend, all ATMs and bank branches would be closed and no electronic transfers allowed, to prevent citizens from moving money to, say, Switzerland before the conversion. Bootle recommends that departing nations start printing notes and coins only after the announcement. In the interim all transactions would be via credit or prepaid cash cards. Euros would also be accepted for cash purposes for a fixed period. Starting on Monday morning, the euro would make its debut as a foreign currency. Its value would rise sharply against the new peseta. So a taxi fare priced at two pesetas might go for just one euro within days.
How about the debt issue? Bootle advises nations to re-denominate all sovereign bonds in local currency. The re-denomination really amounts to a default, since the foreign creditors would take big losses. Bootle advocates going further. He wants exiting nations to immediately cease all interest payments and demand a write-down bringing debt to a manageable 60% of GDP. Between the devaluation and the write-down, most creditors would lose 70% of the face value of the bonds. Bootle's argument is that their original value is a pure fiction anyway and a default of that magnitude is inevitable.
As for the private sector, Bootle recommends re-denominating loans to the stricken banks in the local currency. Otherwise, their capital, and all domestic lending, would evaporate. For corporations, loans would remain in euros. Naturally, a multitude of companies would be unable to service their debt with revenues in local currencies now worth far less in euros. This is perhaps the most difficult part of a euro exit. Bankruptcies would proliferate, and lenders would engage in negotiations for restructuring debt.
Bootle doesn't foresee the core countries abandoning the euro. In fact, he predicts that Germany, the Netherlands, Austria, and other Northern European nations will maintain the euro in their own single-currency zone -- an outcome that would be likely to cause the euro to strengthen over time against the dollar and the pound sterling.
An exit would bring a surge in inflation in newly departed countries as the cost of imports rose. Hence, wages would also rise, though less than prices because of the big pool of unemployed workers. As a result, Bootle calculates, a large drop in the value of the new currencies against the euro would be necessary: The Greek currency would need to fall 55%, those of Spain and Italy 40%, and the new Irish pound by 25%.
The departing nations would suffer several months of declining growth and rising unemployment. World stock markets would swoon. But just as occurred in Argentina after its currency was devalued a decade ago, the economies would start growing again within a year, driven by strength in exports. Germany would suffer from a far higher, properly valued currency that would hurt its exports. But it would also benefit from lower import prices and growing, rather than failing, neighbors to the south.
For Bootle, it's fundamental economics that will ultimately dictate the outcome. "I'm regarded as a pain in the neck and a party pooper," says Bootle. "But the truth is that the politicians have it totally wrong. They waffle and get lots of money from the public sector to buy time, but the markets win in the end." For Europe, abandoning the single currency is no longer an unthinkable choice, but the right choice.
This story is from the October 8, 2012 issue of Fortune.
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