Too European to Let Fail

Rather than a withdrawal, an EMU bailout is far more likely

Opinion | Sebastian Dullien, Daniela Schwarzer | June 2009

Among investment bankers, there is renewed speculation about the possibility of a country leaving European Monetary Union – or being pushed out. Rating agencies have downgraded Portugal, Greece, and Spain, owing to their poor prospects for economic growth and weak public finances. Ireland has been assigned a negative outlook and could soon suffer a downgrade as well.

With fears mounting that one or another euro-zone country may default, yield spreads on government bonds between EMU countries have reached record highs. For some time now, Greek ten-year government-bond yields have been about 300 basis points above German yields. This is a sign that investors now see a significant risk of a Greek default or of Greece exiting from EMU and redenominating its government bonds.

But the panic that EMU may disintegrate is overdone. Rather than a default and subsequent exit from the euro zone, the member states are more likely to overrule a fundamental principle of EMU and bail out a fellow member state.

Leaving EMU would be a costly option for weak-performing countries. Of course, regaining the exchange rate as an instrument for competitive devaluation could help overcome competitiveness losses due to soaring unit-labor costs. As Argentina showed after its default and devaluation in the winter of 2001/2002, such a move can reignite exports and economic growth.

But Greece, Portugal, Italy, and Ireland are not Argentina. The European Union treaty does not provide for an exit from EMU. As a default would demand a change in the currency involved in private contracts, business partners from other EU countries would surely sue, legal uncertainties would drag on and on, and an exiting country’s trade with its main trading partners would be impaired for years to come. So none of the countries at risk would seriously consider reintroducing a national currency.

It is possible that an EMU government will come close to insolvency or illiquidity. Indeed, even something like a self-fulfilling debt crisis is thinkable: if market participants believe that a default or an exit from EMU is imminent, this would drive up government bond yields for the country in question. At some point, yields might become so high that the government concerned could not refinance its maturing debt or finance its current expenses. In this situation, a country would be faced with the sole option of default.

But even if this scenario is possible in theory, it is unlikely to occur in practice. Letting one member fail would create speculative pressure on other EMU governments with weak fiscal positions or shallow domestic bond markets.

A widespread default of several countries in EMU would lead to serious disruptions of trade within the EU and to new problems in the banking system, which would have to write down their holdings of government bonds. The large EU governments are well aware of this problem and would act accordingly.

With its loans to Hungary and Latvia, the European Commission has already revived a credit facility which was dormant since the European Monetary System crisis in 1992 – and for countries outside EMU. The support is huge. Together with the International Monetary Fund’s contribution, the EU loan to Latvia amounts to more than 33% of Latvian GDP.

By supporting to such a degree two new EU members that are not part of EMU, the EU countries have demonstrated a much greater commitment to mutual aid than was thinkable only a few years ago. And more is expected to come: in November 2008, the Ecofin Council increased the ceiling for possible balance-of-payment loans to non-EMU countries to €25 billion.

Against this background, it seems inconceivable that the EU should refuse to support an EMU member in a situation similar to that of Hungary and Latvia, especially as all the countries that are currently on market watch lists are long-time EU members. In case of real distress, the rest of the EU will offer a bailout package.

Indeed, the no-bailout clause in Article 103 of the EU Treaty – according to which neither the European Central Bank, the EU, nor national governments "shall […]  be liable for or assume the commitments" for other national governments – has lost its credibility. The political and economic costs of letting a fellow member government fail are simply too high in the closely interconnected EMU.

Because there is no current blueprint for this move, one can only speculate about what it would look like. One option is for large EU countries to construct a bailout package.

Alternatively, the EU could create a special facility through which it borrows money in the bond market to help the member in trouble – an arrangement similar to the bonds that the European Commission has already issued for the emergency facility from which Hungary and Latvia have been borrowing.

The EU is good at circumventing treaty obligations in times of real crisis. There is no reason to expect this skillfulness to desert it this time around.


Sebastian Dullien is Professor of international economics at the Fachhochschule für Technik und Wirtschaft (University of Applied Sciences) Berlin; Daniela Schwarzer is Head of the EU integration division at the German Institute for International and Security Affairs (SWP).

Copyright: Project Syndicate, 2009.

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