Lord Wolfson: Why an easy exit from the euro is impossible

ΠΗΓΗ: Telegraph

By Lord Wolfson 31 Mar 2012

Last September, as Europe grappled with the sovereign debt crisis in Greece, I launched a £250,000 economics prize.

Contributors were challenged to chart the course Europe should take in the event the euro fell apart. In the eye of that economic storm some asked, was I too late? Surely it would all be over before the entrants’ ink had time to dry?

Now financial waters are calmer, people wonder whether it all wasn’t just a bad dream. Perhaps things will quietly sort themselves out? Perhaps the prize was a waste of money? I sincerely hope it was. No one wants the chaos and hardship that would follow in the wake of the euro’s demise.

But financial crises are like tsunami – deceptively quiet one moment, devastating the next. Sadly, it is likely we will see more turmoil in the eurozone. The underlying problems of high unemployment and low growth are still as bad today in Greece, Portugal, Spain and Italy as they were four months ago. And therein lies the problem.

Spain is weighed down with staggering 21pc unemployment. You would expect, with joblessness so high, that the international price of Spanish labour would be low. Yet quite the reverse is true. In the years before the credit crunch when the euro kept Spanish interest rates artificially low, chronic inflation set in. Over 10 years, Spanish wages rose 20pc faster than those in Germany. Greece was even worse at 30pc.

In pre-euro days, national currencies would have devalued to offset the effects of wage inflation. This is not possible today. With inflexible exchange rates, these countries are locked into being structurally uncompetitive. This wouldn’t be quite so bad if their governments were not mired in growing debt they cannot afford. Their economies are incarcerated in an international debtors’ prison.

There is a real risk that the fiscal disciplines, imposed by their northern European creditors, will only make matters worse. The combination of higher taxes and lower government spending could simply drag countries further into decline unless they can be mitigated by competitive devaluation and low real interest rates. But that can only happen if they have their own currency. What seems likely to happen is that, as their public finances deteriorate, one of these countries will again be unable to refinance its debts.

At this point the tsunami hits and the danger of financial contagion may dictate an urgent re-think of the euro.

If that moment comes, the world must be prepared – with an understanding of the challenges and a plan. We will need an economic fire drill that minimises the damage caused by the euro’s disintegration and gives Europe the best chance to return to prosperity.

On first inspection the problem appears deceptively simple. If Spain, for example, came out of the euro, a Spanish worker who was paid €30,000 (£25,000) a year would simply be paid 30,000 New Pesos, the shops would convert their prices to New Pesos, the currency would devalue by 20pc, Spain would be competitive, tourists would flock to holiday in Spain and so would start the slow road to recovery.

Or so you might think. But where does that leave the Spanish worker’s mortgage? That was in euros and if it stays in euros then how can he repay his debts? His mortgage will have gone up 20pc relative to his wages.

Simple you say. His mortgage should be converted into New Pesos too, problem solved.

Yes, but, that poses a different problem. If his bank is being paid back in Pesos what can it pay to its depositors who put their savings into the bank? Simple, convert their savings into Pesos.

But here we hit a wall. What if the depositors suspect the banks might do this? They might sensibly decide to withdraw their euros and deposit them in a German bank. If they all rush to do so at the same time you end up with Northern Rock on a grand scale, with banking collapse and riots on the streets.

Welcome to the problem of capital flight, an important issue all prize participants needed to address. Underestimate this problem at your peril. At least €350bn has already fled from southern Europe to banks in Germany and the Netherlands.

The problem actually gets worse. What if the bank lending the Spanish mortgage is in fact Dutch or British? The dangerous asymmetry is apparent. On the one hand its Spanish mortgages have been devalued into Pesos. On the other hand its British or Dutch depositors are entitled to get their savings back in relatively expensive pounds or euros. If these imbalances are too large some banks may end up owing more than they are owed – that’s bankruptcy.

Then there is the issue of business contracts. What if a German company has agreed to lease trucks to a Spanish haulier for 10 years? The contract would have been denominated in euros, but if it stays in euros how can the Spanish haulage company afford to pay? All its local customers are now paying in devalued New Pesos. If alternatively the contract is converted to Pesos, the haulier is fine, but how can the German company repay the bank that financed the manufacture of the vehicles? Most businesses would come to a compromise and share the pain, but what if they couldn’t agree, what should the law be?

All these problems may sound intractable, and indeed there is no painless way of dealing with all of them. But I am pleased to report that this competition has produced a number of high quality papers that answer many of these questions. There have been entries from lawyers, economists, journalists, politicians and businessmen from around the world.

On Tuesday, the judges will announce and publish the work of five shortlisted entrants, all of whom will be given the chance to expand on their entries in response to questions posed by our panel.

By June we will have an outright winner.

We all have to hope that the euro will survive, but if it does not we may have reason to be very grateful to the eventual winner of this prize.

Lord Wolfson of Aspley Guise is the chief executive of Next