Germany Should Leave the Euro but Probably Can't

HBR.org 2012-06-11

With Greece seemingly on the way out and Spain now on the bailout list, it's definitely fair to ask whether the euro can survive. And if you conclude it won't, perhaps can't survive, then the question becomes: how will it break up?

If that's the question, then here's an interesting thought: Why don't Germany and its fellow creditor nations pull out of the euro instead of kicking out Greece, Spain, Italy and the rest? It's not a new proposition, of course, and I asked the question myself about nine months ago but I think it's worth revisiting.

There are some reasonable arguments for it. According to some, an underlying problem in the euro zone is the productivity gap between the creditor nations and the "Club Med" countries, 20 or 30 percent by some counts.

Inside a currency zone like the euro, the way to reduce that imbalance is for the less productive countries to slash wages and payroll. You'd hope that excess workers could move to the more productive countries to get jobs and that the social costs could be softened by some transfer of funds from the richer counties to the poorer ones. But whatever mitigation you could provide would do little to change the awful social reality of that adjustment.

The alternative, of course, is to restore the currency markets. A 20-to-30 percent fall in the value of a new peseta or drachma would do a lot to make the southern countries more competitive. People could keep working, and the private sector could take the lead in any recovery. Southern companies and the governments would have to pay more to borrow internationally, to be sure, but at this point, a great deal of that premium may already be priced into their bond prices in the euro. It won't be easy, of course, but it might be better to go through the short, sharp shock of devaluation than to die a slow death inside the zone.

Still, a forced exit from the euro would be seen as humiliating. And it would foster precisely the sort of resentment that European politicians have spent the last 60 years trying to avoid. The whole European project is about bringing countries together rather than driving them apart. Although it may make sense economically for Greece, Spain, and the rest to revert to their national currencies, it could be politically and socially extremely difficult.

So why not have Germany walk out instead? The economic effects might be much the same as forcing Greece, Spain, or Italy to exit. The move could be spun externally as a self-sacrificial move by a noble Germany to correct the productivity imbalance in the EU. Internally you could sell it on the basis that German taxpayers would no longer be on the hook for all the presumed spending excesses of the South. In other words, a German exit might be a way to throw out the bathwater without losing the baby.

One problem with this strategy, if it can be called that, is simply that a break-up of the euro may not in Germany's short-term interests.

Being in the euro helped Germany become more productive relative to its southern neighbors. If Germany still had a deutschmark, the discipline of its businesses would have been rewarded by a relative increase in its value, thereby limiting the disparity between Germany and other countries. Germany would not, therefore, have experienced to such a degree the low unemployment and growth that its voters have gotten used to. In turn, this would have tempered the flow of German funds recycled southwards as investments in Greek, Spanish, and other assets, reducing the bubble pressure on Club Med asset prices.

Breaking up the euro, whether by Greece and Spain or by Germany, could at a stroke eliminate those productivity advantages and possibly stall the German economy. It could also instantly crystallize losses on assets held by German savers in Club Med bonds and loans, probably necessitating an immediate capitalization of the German banking system. In other words, the problems currently being experienced in the South would get transferred to the North.

Now whether or not you think that this is fair or whether or not you believe that maybe Germany is better able to bear such a crisis or not than the South, it's easy to see why German politicians might be hesitant to actually take the initiative on breaking up the euro. Reviving the deutschmark will involve certain and immediate pain for German voters. Muddling through might cushion that pain by leaving more of it with other electorates and enable German voters to blame the policies and work-cultures of Southern Europe.

But that's hardly a recipe for peace.