The European Union (EU) may be better off introducing flexibility into the euro instead of a 'hard euro' position to do whatever it takes to conserve the common currency.

That is the theory by Michael Pettis, Senior Associate at the Carnegie Endowment for International Peace, who goes as far as picturing a scenario in which Spain is forced to leave the euro.

Pettis bases the theory on the premise that highly indebted countries could reach a point in which they are unable to service their debt. Spain is the example offered by Pettis, as he believes the country could limit economic damage by leaving the euro or at least forcing the European Union to consider a more flexible approach to the euro.

Three problems: a liquidity crisis, a solvency crisis, and a demand imbalance

Pettis, who is also a finance professor, says that Europe considers the battle of the euro to have been won, but there is more than one "battle" around the euro. Particularly, he sees three separate problems that erupted in the 2008-09 euro crisis: a liquidity crisis, a solvency crisis, and a demand imbalance.

The liquidity battle indeed appears to have been won thanks to the European Central Bank (ECB's) resolve to do whatever it takes and promising unlimited liquidity to roll over European sovereign debts. However, Pettis believes that the other two problems have not been resolved.

The solvency crisis, for one, is still a problem because the concern over the sustainability of peripheral European debt was not irrational. In other words, debt has grown much faster than GDP in all of the heavily indebted countries and will continue to do so for many years even if optimistic growth targets are reached. Low interest rates make the debt burden seem manageable but "at some point debt levels will seem so high that further unlimited promises by the ECB will simply not seem credible," says Pettis. "At that point, investors will flee the government bonds issued by peripheral European governments."

The dilemma, according to Pettis, is that interest rates are low mainly because growth is non-existent. Should Europe start to grow, interest rates would be forced up and prevent highly indebted countries to grow their way out of debt.

The third problem, the demand imbalance, has to do with unemployment and this is where Germany is mainly responsible. Around the year 2000, Germany improved its international competitiveness by forcing down wage growth and consequently consumption. As a result, domestic demand fell, but this was offset by a rising trade surplus that prevented unemployment from rising. Then, excess German savings fed rising demand from the periphery on the back of rising debt. This imbalance would be addressed by raising wages and government spending in Germany but the country does not want to risk losing credibility when forcing the periphery to tackle debt burdens.

"German businesses must continue to rely indirectly on demand from the rest of Europe, which must consequently continue to absorb weak German demand in the form of higher domestic unemployment," says Pettis.

Pettis explains that German demand deficiency is being resolved by the rest of Europe because of a common currency. Without a common currency, Germany's currency should have risen and the currencies of other European countries should have dropped given their respective trade account balances. However, Germany benefited from a weak euro while other European countries suffered from a strong euro.

How tolerant is the periphery of high unemployment?

The question becomes - how much longer is the rest of Europe willing to maintain high unemployment in order to support the German economy? In the context of the latest European elections, Pettis says that the policy-making 'elite' may eventually be forced into retreat by an angry electorate for insisting there is no flexibility on the euro and its priority for protecting bankers at the expense of the working and middle classes.

"The longer unemployment and hopelessness drag on, the greater the erosion of support for the establishment and the stronger the support for the radicals who want to abandon the euro," says Pettis. So far, peripheral Europe has been remarkably tolerant of high unemployment but this may have its limits and force the euro debate to move from the 'radical' part of the political spectrum towards the centre.

According to Pettis, refusing flexibility into the euro can be more dangerous for the euro because if a country were to voluntarily leave, the euro would strengthen and be concentrated among a smaller group of countries, forcing additional imbalance pressures on its weakest link. By not being flexible, the euro could fall apart very quickly, he argued.

Flexibility into the current system would include the possibility of a temporary euro withdrawal, otherwise any break will be permanent, says Pettis, who imagines what would happen if Spain were to leave the euro and return to the peseta.

If Spain leaves the euro...

First, Spain's debt burden will soar because Spain's peseta would immediately fall. If this happens when Spanish external debt is 110% of GDP, a 20% peseta devaluation will raise the debt to 137.5% of GDP. Nonetheless, the size of the devaluation would depend on its political structure. The longer it takes for Spain to arrive at a decision to abandon the euro, the greater the likelihood of a radical right or left party taking power, in which case the euro would likely not stabilise at a 30-40% discount.

Regardless of the size of the devaluation, debt would surge and interest rates would rise, which means Spain would have to restructure its debt burden.

"It is in everyone's interest that Spain immediately receive a significant debt haircut or else it will not return to growth and the devaluation will have been wasted. I would argue that Spanish external debt should be reduced to 60% of GDP and payments stretched out between 10-30 years," says Pettis.

The argument is that a currency devaluation would help Spain's economy soar with growth rates of at least 5% for several years, partly thanks to a poor legal structure reformed under Rajoy. "Spain has not completely wasted the crisis. It has implemented very serious reforms, especially labor reforms, but these reforms were aimed at old distortions in the Spanish economy and had nothing to do with the current crisis, which is caused by excess debt and an uncompetitive exchange rate."

In other words, Pettis concluded that Spain cannot resolve its crisis on its own. It needs concerted action by Europe, and especially by Germany, in order to bring down unemployment. The dilemma is that Germany cannot play its role because this must involve debt forgiveness, and "Germany will not be prepared to acknowledge the need for debt forgiveness until German banks are sufficiently capitalised to recognize the obvious."

"There are no winners here, Europe's demand deficiency means that there will be high unemployment somewhere, but Spain can decide how to distribute the cost of adjustment by deciding whether or not to remain inflexibly within the euro."

JP

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