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Monday, September 25, 2006

Woffgang Munchau

"In an environment of rising global inflation I would expect the euro to become increasingly important as a global reserve currency.....

Thus writes Wolfgang Munchau in today's FT. Well, well, not a man to mince his words:

Rest assured, the eurozone will prove its durability

The long-term viability of the eurozone has become a hotly debated topic. The blogs are full of it. The latest contribution comes from the London-based Centre for European Reform in the form of a pamphlet entitled: Will the Eurozone Crack?

My own prediction: it is the critics who will crack first.

What follows is now updated based on the full version of Wolfgang's piece which is avaialable here.

The debate on the blogs which he mentions was adequately covered by Sebastien Dullien here (and here and by me here).

Essentially Wolfgang makes 2 points:

1) That the Zone itself will not disintegrate:

What are the circumstances under which the eurozone could disintegrate? In practice, that would happen only if either Germany or France decided to quit. A departure by Italy or Spain, or both, would not suffice. However, it is extremely difficult to construct even a purely theoretical scenario under which it would make sense for France or Germany to reintroduce national currencies. A decision to quit would never pay off for the quitter in the short run. The administrative costs would be crippling, financial markets would be in turmoil and the quitter would almost certainly have to pay higher risk premiums on its bonds.

Now at this point it is worth bearing in mind that the target in his article is the the London-based Centre for European Reform who published a pamphlet entitled: Will the Eurozone Crack? The centre is strongly 'eurosceptic' and is grinding axes, so in this sense it is a long way from the actual debate which took place on the blogs, which was much more focused on the specific situation in which Italy finds itself.

Basically I completely agree with Wolfgang on the big picture story. It is extraordinarily unlikely that the Zone itself will disappear. There is however a secondary problem which Wolfgang doesn't consider which is what would happen if Germany hits ongoing deflation (a la Japan). This is not an entirely unconceivable outcome since it was clearly the German economy which was most at risk last time we were on deflation alert. Now in this case the ECB ought to follow a Japan-style zero interest rate policy, but this does leave us with the issue of how this would affect France, Spain, Ireland etc. No easy answer here.

2) The possibility that Italy might leave. Wolfgang is certainly much more guarded here, and in fact he doesn't exclude this possibility:

whether it is conceivable that one or more member countries could leave the eurozone without destroying the monetary union. The answer is yes, it is conceivable, but I would not bet my life savings on it. The second question is whether monetary union itself could collapse and member states revert to national currencies. My answer to that question is unequivocal: no, forget it.

Most hypothetical exit scenarios involve Italy, which has suffered from a large and persistent loss of competitiveness, as measured by the real exchange rate. So what would happen if Italy left or was forced out? Do not believe anyone who claims to know the answer. There is no script for such an event. In particular, it is not clear whether a country that left the eurozone would also have to leave the European Union.

Again I agree with him. No-one knows where this would lead us, although we can make some intelligent guesses. Even though it is not clear, I doubt in the extreme that Italy would leave the EU. That I really do find inconceivable, and there would be no evident necessity since, remember, 13 of the current members of the EU are already outside the zone.

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