It pays for Berlin to quit the eurozone

4/11/2014

By Edward Chancellor

Wolfgang Schäuble, the German finance minister, has recently been pushing for fiscal union across Europe. Greater fiscal integration is necessary if the European Monetary Union is to survive. But such a move would likely prove expensive to Germany in the long run. Nor would it provide a panacea for the periphery’s ills. Instead, it’s time for Berlin to consider the opposite course. A German exit from the eurozone might be less painful than is commonly believed.

It’s clear that the eurozone doesn’t meet the standard economic criteria for an optimal currency area. Wages are not flexible and there’s little labour mobility between member countries. Still, even if the economic fit isn’t perfect, currency unions can be held together by fiscal transfers from the richer to the poorer regions. This is what happens in the United Kingdom, where Wales and Scotland are the recipients of English largesse.

Germany has had its own recent experience with a transfer union. Since the country’s reunification in 1990 large sums have flowed from the other Bundeslander towards east Germany. To date, west Germans have paid upwards of €1tn ($1.29tn) to support their brethren in the former German Democratic Republic. A eurozone fiscal union could prove even more expensive. The annual cost to Germany can be approximated by totalling the current account deficits of the eurozone periphery, which last year totalled €93bn, equivalent to 3.6 per cent of German gross domestic product.

Fiscal transfers are not merely expensive, they don’t resolve any competitiveness issues within currency unions. On the contrary, transfers tend to support a permanent state of disequilibrium. The Germans should know this well enough. Since reunification, east German output per capita has remained stubbornly below the level of the rest of the country. The same effect can be seen in Wales, where labour productivity is some 30 per cent lower than the UK average, according to Andrew Hunt Economics.

If Germany stood to profit much from continued EMU membership, it might make sense to act generously towards the weaker eurozone members. There is little evidence, however, that Germany has gained from jettisoning the deutschmark in favour of the euro. “It’s difficult to identify the hard and lasting benefits of EMU beyond the moderate gains from savings on transactions costs in intra-EMU trade,” writes former Deutsche Bank chief economist Thomas Mayer in his new book, Europe’s Unfinished Currency.

Since 2000, German exports to the rest of the world have grown faster than its trade within the eurozone. In fact, on just about every important economic measure – productivity gains, consumption growth, average inflation, average unemployment, job creation, fiscal deficits and current account balance – Switzerland has performed better outside of the eurozone than Germany has within. As Charles Dumas of Lombard Street Research suggests in a recent report, “Germany should not, maybe cannot, afford the euro”.

The euro has resulted in vast amounts of German savings going up in smoke. Since 2000, much of Germany’s fabled trade surplus has been recycled into investments in the eurozone periphery. The capital was not well invested. Mr Dumas points out that the value of Germany’s foreign assets would now be nearly €300bn larger if the money had simply been placed on deposit at the European Central Bank. The periphery is staggering under debts which, relative to GDP, are around €2.5tn larger than a decade ago. As a leading creditor, Germany is most exposed to future defaults.

German savers are also threatened with the rising risk of eurozone inflation. The hard-money types at the Bundesbank have been heavily outgunned at the ECB, which has found clever legal grounds to evade rules forbidding the monetisation of government debt. Over the past couple of years, Germany has also received huge capital inflows from across the eurozone. These inflows are sitting unused in the German banking system. They provide the potential tinder for a future inflation. Negative real interest rates also enhance the chances of a future inflation shock in Germany.

It’s widely held that the costs to Germany of quitting the euro are too high to contemplate. Yet economist Dirk Meyer of Helmut Schmidt University reckons there would be a one-off charge of €390bn against a running cost to Germany of €150bn a year for staying in the eurozone. The exit charge stems largely from currency losses on euro-denominated foreign investments. Yet properly viewed, these aren’t new costs but a belated recognition that loans to the periphery can’t be repaid at face value.

Edward Chancellor is a member of the asset allocation team at investment manager GMO

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