THE simple fact is that Eurozone policymakers are still not doing enough to deal with the root causes of the crisis. Peripheral economies are fundamentally uncompetitive inside the currency union and will be unable to return to solid economic growth and fiscal health without exiting. Some form of Eurozone break-up remains likely.
As we, at Capital Economics, argue in our winning essay for the Wolfson Prize, the most realistic scenario is still that one or more of the weaker countries, probably led by Greece, leave the Eurozone, introduce a new currency which then falls sharply, and defaults on a large part of their government debt.
Preparations for exit would need to take place in secret to prevent a banking collapse, and new notes and coins would therefore not be available straight away. Initially, then, small transactions could continue to be paid for with euro notes and coins. To make life easier, the new currency should be introduced at parity with the euro.
The government should redenominate its debt in the new currency and negotiate a reduction in the level of its debt to a sustainable level, perhaps 60 per cent of GDP. Once the new currency is introduced, it would fall perhaps by as much as 50 per cent, which should provide exporters with a boost and kick-start economic growth. In the short term, though, the depreciation would also lead to a jump in consumer prices, piling further pressure on struggling households. Nonetheless, international experience suggests that fears of an exit prompting a long period of high, or even hyper inflation, with catastrophic consequences are exaggerated. Policymakers could further reduce the risk of this and improve medium-term growth prospects by introducing an inflation targeting regime, tough fiscal rules and continuing to implement much-needed structural reforms.
Needless to say, the uncertainty created by a break-up would initially damage business and consumer confidence in the rest of the Eurozone. And to minimise the risk of contagion, the northern core may need to accept faster progress towards full fiscal and political union. Once the dust settled, the euro would probably appreciate, with damaging consequences for exporters. These factors could result in the remaining Eurozone economies falling deeper into recession. But this would give these economies the incentive to loosen monetary policy and implement structural reforms to boost domestic demand. A rebalancing of the economy away from a reliance on net exports would be in the interests of the whole of the current membership of the Eurozone, as well as countries outside it.
A Eurozone exit would present enormous challenges for the economies that exited and the rest of Europe. But all of these difficulties could be overcome.
Roger Bootle is managing director of Capital Economics, which won the Wolfson Economics Prize yesterday.