There's no escape from the euro club

ECONOMICS:Exiting the euro would be a disaster for a country – and may not even be feasible

RECENT EVENTS in Greece and Iceland have rekindled the debate about debt and default, and even prompted some to muse about leaving the euro.

The background is that the true state of the Greek budget deficit appears to have been concealed from its EU partners until late last year.

Initially, the Greeks were reluctant to contemplate the necessary fiscal correction but they may be forced to relent in the face of a stick and carrot approach by Brussels.

This is reminiscent of the situation here early last year when we were in the firing line. Unlike Greece, there was no public sign that the Government contemplated not playing ball. Instead, there was silence for a few months, followed by an announcement that we would control the public finances. Hard on the heels of this came statements by senior German politicians and the president of the ECB that there were no weak links in the euro – code that they would stand behind us provided we took the medicine.

The question of what would happen if Greece, a euro member, refuses to comply is an open one.

Before Christmas, the ECB produced a timely legal paper on withdrawal from the euro zone. It concluded that, while withdrawal from EMU may be possible, it would be legally problematic and inconceivable without also exiting the EU, to say nothing about the political and practical consequences. However, by much the same token, expulsion from either would be next to impossible.

With few exceptions, the general view of economists and policymakers is that exiting the euro would be a disaster, even if it were feasible. Presumably, it would only be contemplated in dire circumstances or to steal a competitive advantage on erstwhile partners via currency depreciation. An exiting member would thus face either a voluntary or a forced depreciation as it attempted to introduce a new currency or revert to its old one.

Iceland is a useful parallel. Since the banking crisis unfolded there, the krona has fallen by about 50 per cent, official interest rates hit 18 per cent at the peak and are still in double digits. The consequences for its highly indebted population are severe.

Were Ireland or Greece to exit EMU the currency and interest-rate experience could be similar, albeit with an additional catch.

When the euro was introduced a decade ago the general view was that liabilities assumed in euro remained denominated in euro come what may. While a law could be passed redenominating domestic euro liabilities into, say An Punt nua, this would be open to challenge and it is probable that foreign investors would force repayment in euro anyway. Therefore, part, if not all, of existing debts, public and private, would mushroom as they remained denominated in the (stronger) euro.

The uncertainty would, in any event, prompt a run on the banks as economic agents attempted to shift deposits abroad and/or sell investments. This has led economists like the US’s Barry Eichengreen, no lover of the euro, to conclude that adopting the euro is effectively irreversible.

The corollary is that the rules of the club must be obeyed or at least not flouted openly. This, in turn, means fiscal correction for countries like Greece and Ireland.

It also implies that debts cannot be reneged upon.

Here, the recent decision by the president of Iceland to refuse to sign a controversial bill on reparations of almost €4 billion (50 per cent of GDP) to Britain and the Netherlands is topical. The money was to pay for refunds to British and Dutch depositors who were bailed out by their own governments when the Icelandic banks collapsed.

It prompted some to renew suggestions that Irish banks should default on their obligations in lieu of the State guaranteeing and, in many cases, financing their repayments. This would involve reneging on the guarantee given in September 2008, something no government would do lightly.

It also misrepresents the true Icelandic situation. Iceland has not repudiated its debts; in fact it committed to pay them in an act passed and signed last year, albeit on terms less demanding than those in the more recent bill forced on the Icelanders.

Nonetheless, the penalty has been severe, with Fitch downgrading their debt to junk status, bond yields (cost of borrowing) about five percentage points above Germany compared to 1.5 per cent here, and threats of political isolation and vetoing of their application for EU membership. It is hard to imagine any EMU country risking similar consequences.

In addition, there are the usual legal issues. Whatever about subordinate debt, and even here the position is not clear, senior debt issued by banks is not risk capital to be repudiated at will. Rather, it is part of normal funding and ranks pari passu with deposits in a wind-up situation.

A default on such debt would likely prompt a response even more dramatic than that which Iceland got.

EMU is like the roach motel; you can check in but you can’t check out. Moreover, any bills incurred while in residence must be settled promptly.