Last week, Paul Krugman argued here that Cyprus must leave the euro. “The convenience and efficiency of a single currency is gone; meanwhile, the future for Cyprus on the euro is one of years of grinding deflation and catastrophic austerity. Is the hope of someday, somehow restoring the status quo ante enough to justify all of this?,” he wrote.
Krugman is right. A Cyprus downturn adjustment would be less painful outside the euro. The reason for this is very simple: There is no such thing as a monetary union currently in Europe. Cyprus, Greece and the rest of the periphery are in a gold-standard type of mechanism: adjustment to bad times is done via a deep recession.
This unfortunate fact was not realized when we were in good times. During the first years of the single currency, markets thought that the eurozone was an economic and political union with perfect factor mobility. Therefore sovereign risk disappeared and “too much” credit flew from the center to the periphery. It fueled excessive optimism which — combined with a lot of local financial inefficiencies, to put it mildly– inflated the economies. A big party that lasted until 2008.
Now that things are going badly, we need a flexible price mechanism that will allow a depreciation of the real exchange rate so that countries can regain their competitiveness. But a unified currency with inflexible labor markets cannot achieve this. Result: high unemployment.
In the absence of labor flexibility, we need labor mobility. Unfortunately, we do not have that either. Just check the unemployment rates disparity among Spanish regions.
Also, there is no supranational national fiscal institution (a federal government) that can transfer money to the regions/countries in trouble. Nor do we have euro bonds that could lower the cost of borrowing. Lastly, the eurozone also lacks a banking union that would contain the buildup of risks, deal with failing banks and sustain depositor confidence. Just remember what happened in Cyprus, where deposits were confiscated (a “bail-in”) and a corralito — à la Argentina 2001– was imposed.
Why is a corralito needed? Because we do not have a monetary union, therefore the ECB is not a lender of last resort. The euro is a “foreign” currency for the countries on the periphery. Furthermore, euros inside Cypriots banks are not the same as euros inside German banks.
In sum, the eurozone is working like a hard-peg exchange rate system. It is like the currency board that Argentina had, whereby the Argentinean peso was pegged against the U.S. dollar. And as a result, the corralito.
Cyprus’ future inside the euro will be very similar to what happened in Argentina and other developing countries when they faced a balance of payments crisis. The Cypriot economy is all but certain to enter a depression as private and public sectors cut spending and foreign investment dries up. Inside the euro, Cyprus will not have one of the pathways to recovery that Argentina had at its disposal: a currency devaluation.
A devaluation is no magic potion. It means the country’s savers are wiped out and that Cyprus would not be able to pay its debt, which would be denominated in an expensive foreign currency. But it would also sow the seeds of a recovery. If the currency depreciates, that country’s exports become more competitive, at least in the short run.
The rest of Europe has plenty to lose if Cyprus exits the euro. The exit could translate into a euro-systemic risk, in which case the Cypriot exit would be child’s play. The worst-case scenario is one in which a Cypriot exit unleashes bank deposit withdrawals on the periphery. In this case, more Cyprus-style programs, which will tax whatever is left in deposits, would be required. This, in turn, would justify bank deposit withdrawals elsewhere. This euro-systemic risk would probably be the end of the euro.
A much cheaper solution to this dreadful picture would be a simple bail-out. Total Cypriot bank assets represent less than 0.2 percent of eurozone GDP or 0.5 percent of the European Central Bank’s own balance sheet. Cyprus, and the rest of the countries in trouble, need some external aid to mitigate the cycle. But both moral hazard and political motives make this a solution difficult to swallow for the core countries.
So we can only hope that the euro authorities realize the risk that we are facing and that the disequilibrium created by the Cypriot bail-in will not be accepted by distressed citizens elsewhere.