Willem Buiter Argues Against Eurozone Breakup Worries

Predicting the demise, or at least the marginalization of the euro is a popular pastime for some writers (Ambrose Evans-Pritchard of the Telegraph, one of our favorite deflationistas, engages in occasional euro-bashing). Similarly, quite a few investors I know think the euro has no hope of serving as a reserve currency. particularly because some eurozone members could defect as the crisis progresses, calling the future of the entire enterprise in question.

Willem Buiter examines that idea and finds it sorely wanting. Buiter is not obviously disposed to take that point of view, either. While Buiter takes pride in his multiple passports and citoyen du monde pedigree, he has an English sensibility (he adores the Church of England and the Economist, and writes in a decidedly OxBridge style). And most of the noisy Euroskeptics are British (thus more properly Eurosceptics).

But Buiter was also brought in at the 11th hour to advise Iceland as it was going into meltdown mode, so he has a keen appreciation of what can happen to little countries with little currencies that get themselves in a heap of financial trouble. As he sets forth, he thinks it is far wiser to remain in the euro fold than exit it.

From Buiter:

A recent (January 13, 2009) column in the Financial Times by John Authers provides a good example of a logical slip on the banana peel of an alleged link between the external value of the euro, the likelihood of the eurozone breaking up and sovereign default by a eurozone national government….

The relevant passages from Authers’ The Short View follow in full:

Greece has always been treated as a peripheral eurozone member, not only in geography. Even before last year’s civil unrest, its bonds traded at a significantly higher yield than those of Germany – showing a higher perceived default risk.

The market is nervous about other nations on the eurozone’s periphery, notably Ireland and Spain, which grew overextended during the credit bubble.

A eurozone country defaulting and leaving the euro is close to an unthinkable event. But Friday’s news from Standard & Poor’s that Greece and Ireland were on review for a possible downgrade, followed yesterday by Spain, left many thinking the unthinkable.

The spread of Greek bonds over German bunds is 2.32 percentage points, almost 10 times its level of two years ago. Spanish spreads yesterday rose above 90 for the first time. An Intrade prediction market future puts the odds on a current eurozone member leaving the euro by the end of next year at about 30 per cent.

The euro dropped more than 1 per cent against the dollar within minutes of the Spanish news, and is down 9.8 per cent in the last few weeks.

Three issues are being linked in this passage. The emergence of high levels of sovereign default risk premium differentials between different eurozone member states, the external value of the euro and the likelihood of the eurozone breaking up. There is no self-evident link between these three issues. The first is neither necessary nor sufficient for the second or the third. More than that, the threat or reality of sovereign default by a eurozone member state is much more likely to reduce that country’s incentive to leave the eurozone than to increase it….

Would a eurozone national government faced either with the looming threat of default or with the reality of a default be incentivised to leave the eurozone? Consider the example of a hypothetical country called Hellas. It could not redenominate its existing stock of euro-denominated obligations in its new currency, let’s call it the New Drachma. That itself would constitute a further act of default. If the New Drachma depreciated sharply against the euro, in both nominal and real terms, following the exit of Hellas from the eurozone, the real value of the government debt-to-GDP ratio would rise. In addition, any new funding through the issuance of New Drachma-denominated sovereign bonds would be subject to an exchange rate risk premium, and these bonds would have to be sold in markets that are less deep and liquid that the market for euro-denominated Hellas debt used to be. So the sovereign eurozone quitter and all who sail in her would be clobbered as regards borrowing costs both on the outstanding stock and on the new flows.

A sharp depreciation of the nominal exchange rate of the New Drachma vis-a-vis the euro would for a short period improve the competitive position of the nation because, with domestic costs and prices sticky in nominal New Drachma terms, a nominal depreciation is also a real depreciation. Nominal rigidities are, however, less important for eurozone economies than for the UK, and much less important than in the US. Real rigidities are what characterises mythical Hellas, as it does real-world Greece, Italy, Spain, Portugal and Ireland. The real benefits from a nominal exchange rate depreciation would be eroded after a year – within two years at most – before you could say cyclical recovery. The New Drachma would be a little currency in a big global financial market system – not an instrument to be used to gain competitive advantage or to respond efficiently to asymmetric shocks, but a source of extraneous noise, excess volatility and persistent misalignments, rather like sterling.
A eurozone member state faced with the prospect of sovereign default, or just having suffered the indignity of sovereign default, would be immensely relieved to be a member of the eurozone. The last thing it would want to do is give up the financial shelter provided by membership in the eurozone to try and emulate Iceland, New Zealand or the UK.

Was the depreciation of the euro that more or less coincided with the sovereign credit warnings and the Greek downgrade (although it started earlier) due to increased concern about the fiscal sustainability of some eurozone member states? Who knows? And what is more: who cares? The eurozone member states no doubt welcome the weakening of the euro, which had become the world’s second most overvalued currency, just as UK Ltd welcomed the decline in sterling, which reached more than 25 percent from its previous peak until the recent weakening of the euro. Depending on the fiscal measures taken by the sovereigns of the fiscally challenged nations, and depending on the response, if any, of the ECB to the threat or reality of sovereign default, any response of the euro can be rationalised.

I view the widening of the sovereign risk spreads inside the eurozone as a welcome development. With the revised Stability and Growth Pact effectively emasculated as a fiscal discipline device, it is essential for national fiscal discipline in the euro area, that the market believes (1) that national sovereign debt is indeed just national, not joint and several among all eurozone member states, and (2) that the ECB will not bail out ex-ante or ex-post a eurozone member state that gets itself into fiscal problems. The very low sovereign risk premium differentials in the early years of the eurozone were worrying to me, because it seemed to indicate that the markets believed that a fiscally incontinent government would be bailed out by the other eurozone national governments or by the ECB. The new larger and healthier sovereign risk premium differentials indicate that the markets may be able to provide more fiscal discipline than suggested by the early years of the common currency. That is good news indeed.

So we may well see sovereign defaults by EU national governments, both inside and outside the eurozone. But it is more likely in my view that Scotland will leave the sterling monetary union (and the United Kingdom) and adopt the euro as its currency than that an existing eurozone member will leave the eurozone. We shall see.

Note the post is a good bit longer, and for those with an interest in this topic, the omitted sections are also instructive.

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  1. Anonymous

    Buiter is one of those folks who (somehow) doesn’t believe that devaluation improves competitiveness… At least not in any sustained or significant way.

    The problem is… He is wrong. Argentina (2002), Korea (late 1990s), and Sweden (early 1990s) provide easily verified cases of marked improvements via devaluation.

    Of course, the U.S. after the Plaza and Louve accords is important case in point as well.

    See “Does mercantilism work in a Keynesian world?” (http://rodrik.typepad.com/dani_rodriks_weblog/2008/12/does-mercantilism-work-in-a-keynesian-world.html) for a post about devaluation helped countries minimze the impact of the Great Depression.

  2. Anonymous

    One more note. Before the current crisis, the ISK (Iceland Kronor) was trading at around 90 per Euro. The current account deficit was 15+% of GDP.

    The Kronor now longer trades (exchange controls have been imposed) but appears to be around 290 per Euro. That’s quite a fall.

    However, if Iceland was already using the Euro, no fall in the exchange rate would be possible. Clearly that would make eliminating the CA deficit much harder, if not impossible.

    The current crisis in Iceland is certainly grim. However, it would be worse without currency flexibility. The same statement applies to the UK as well.

  3. bb

    another untouched question: does a structurally weak country leaving the eurozone make the euro stronger or weaker?
    getting rid of the deadweight certainly improves the perception of the euro rather than weakens it.
    ambrose seems to be drawing exactly the opposite conclusions by assuming the quantity of states rather than the quality of their finances determines the strength of the euro. a pitiful and hateful englishman.

  4. Daniel from Eurozone

    Hi Yves,

    A great post as always.

    Currencies are certain a matter of debate and ideology.

    This dispassionate, equal, equitable, even-handed, moderate, nonpartisan view on the Euro is great.

    I do appreciate that your certainly WASP background does not obfuscate your judment on the Euro:)

    This currency was certainly not set up as a threat to the British Pound (sorry Ambrose, we just love Britain and British culture but could care less about the Sterling).

  5. vlade

    Buiter seems to assume that a country leaving EURzone would not default on its EUR debt. If a country would decide to take the drastic step of leaving EURozone, it would be precisely so that it could default on its EUR debt (as well as replace EUR with a devalued currency). In for a penny, in for a pound.

  6. Anonymous

    Italy staggered from devaluation to devaluation for decades after WW2. Argentina devalued by 2/3 in 2002 and is now covering up 20% plus inflation while pretending it is 7%. I see devaluations as a quick fix resorted to by gutless governments. The underlying malaise has to be dealt with, the Germans understand this very well. Perhaps the developed world has to go through a period of hyperinflation in order to educate their electorates to the dangers of easy fixes.

  7. wintermute

    The mention of New Zealand in the context of currency risk reminds me that this country deserves watching by NC followers.

    Reason. It has just elected a conservative government which includes a parliamentary balance-of-power alliance with the ACT party. This party is a strong believer in Austrian economics – and wants to implement as much of Von Mises teachings as practicable. When Roger Douglas was finance minister in the mid-1980’s his 3 years of Austrian economics policy set New Zealand on a sound basis for a decade. (Until later socialist “big government” Clarke policies stifled Douglas’s reforms).
    I bet that New Zealand will benefit again from the return to sound macro-economic principles.

  8. jwdeming

    Wintermute, I lived in NZ for 10 years. I do lots of business down there now. The new “conservative” gov’t of PM John Key’s National Party is far more wet than you imply. ACT is squishy libertarian but to say that ACT “is a strong believer in Austrian economics” is an exaggeration. And ACT got only c. 2-3% of the vote in the last election, which is typical of the last 3-4 elections.

    E.g. the dampness of the National Party: They’re “cutting taxes.” The cuts amount to an extra NZ$18/week (US$10/wk) for the avg worker. Nothing at top end but a small change in the amount of income at which the top income tax rate of 39.5% kicks in which at around NZ65K (US$40K) is truly pathetic.

    It is true that Roger Douglas is more or less a committed Austrian who did wonders for NZ while Finance Minister in the mid-80’s. But he is also about the most detested man in NZ these days. La plus ca change…

    Bottom line: I would not expect much from NZ’s new gov’t. It’s better than the nanny state Labour govt of the past 8 years. It’s possible that the economic crisis could cause John Key, who’s a smart cookie, to make radical changes in the direction of free markets and lower taxes. I hope he does but hope is cheap. The NZ electorate is a fairly socialist-greenie lot.

    Good thing about NZ is that being a small island country (Pop: c.4M) far away from centers of commerce it is utterly dependent on foreign trade. So there is a fairly large consensus for free trade. And socialist policies bite quickly so tend to be discarded more quickly than in the US or Europe.

  9. Richard Kline

    I strongly agree with most of Buiter’s contentions. And nonetheless contra that, if any EU member did exit the union, as wintermute says it would be exactly and only to default on their existing debt. . . . How in this here world would that _possibly_ improve their position in present systemic conditions?? That’s like slashing ones limbs with a small chainsaw and then jumping in to a shark tank. Iceland is functioning in a vegatative state only because the IMF has hooked up tubes.

    And Buiter’s comments on the status of sterling are both a total hoot, and dead on the bullseye; a source of noise . . . . And I agree that Scotland is far more likely to exit the UK and the pound than any country of any kind is likely to exit the euro or the EU. The first proposition is better than even, while the second, to me, is under 1 in 100.

  10. Anonymous

    UK November trade figures which came out this week were pretty grim reading with export trade value down 6 percent while import trade value was down 2 percent. Obviously manufacturing is not picking up the slack than financial services are withdrawing from the export equation. Devaluation of Sterling has done little at this point except increase import prices which can be seen in the price of coffee. This is not something other Europeans are likely to envy much.

    We should also note that that 6 percent reduction in exports was mainly to the US and it’s a bit different if you look at retail as a decline of some 1 or 2 percent leading up to Christmas compares favourably with the tanking retail sales in the US. All this points to a dislocation in trade flows in and out of the US, well unless you believe demand has tanked in the US like nowhere else in the world. This suggests to me that the US is suffering from having a strong currency and there is a possibility that trade flows in and out of the US have been so damaged that they could bring the US economy down.

    Other evidence that strong currencies may not be that advantageous comes from Ireland who are complaining about the UK devaluing as all their shoppers travel across the border into Northern Ireland to get their cheap goods. In real terms Ireland may have faced the same fate as Iceland without the Euro, but that does not stop the correction biting particularly deep as a result with an Irish university professor suggesting yesterday Irish house prices will fall by 80 percent.

    The UK faces a very real threat of a currency crises as its trade balance worsens and it becomes obvious that the UK can not keep up its loose fiscal policy. Not that the UK government seems to have a consistent policy with pulling billions of finance from local council budgets causing job loses while spending more at a central government level.

    There is no secret that Germany are making all the right noises about introducing laws to limit future fiscal spending with the objective of sustaining investor confidence. The real risk of the Euro breaking up could come once it is widely known that Germany the power houses behind the Euro is doing a lot worse than other European countries. Countries will exit the Euro rather than being dragged down by a tanking euro and German economy. Maybe it will take Greece, Italy and Spain to rescue Germany and the Euro before we are finished.

  11. Anonymous

    ¿the shelter of the euro?

    Take Spain: Unemploymnent is up by 1 million in a year, industrial production fell in November 15% y/y, taxes collected are falling at a 20% annual pace, the services PMI is at record lows.

    Of course, add the implosion of the housing bubble and the euro “shelter” looks more lika a Gulag.

  12. bill

    My sense is that someone leaving the Euro in 2009 would be pretty similar to someone leaving the Gold Standard in the 1930’s. Sounds bad on paper, but it seems to have helped.

  13. Skeptical Economist


    Would a country leaving the Euro convert its debt into “New Drachmas”? Yes, of course it would would. Buiter is simply in denial on this point.

    The comment from anonymous shows why these debates are so hard. Each side talks past the other. Yes it is (roughly) true that “Argentina devalued by 2/3 in 2002 and is now covering up 20% plus inflation while pretending it is 7%”.

    However, that nicely leaves out that before devaluation Argentina was in a depression as severe as the U.S. in 1933. After devaluation, Argentina enjoyed 5-6 years of near 10% real economic growth.

    The first two comments for this post were also from me (did not mean to be anonymous).

  14. Waldo

    Strength is the point of hardwork! Why work if not to gain.

    We can add volumes of financial and economic factors to one currency having an advantage being devalued and such but in a “caveman” point of view more food stored (stronger currency) in the cave the stronger the chances of survival.

    Winning a race is the first object of the competition. All the other factors (more press coverage, ugly commentaries, etc) come with being a champion.

    The Euro is stronger than the dollar! Less not forget the idea of the Euro is the dollar’s example (dollar’s leadership).

    When the Euro would transcend the dollar (in real terms, not today’s immoral reality here in America) it would be very subtle and would take considerable time (match infrastructure, single monetary governing body, etc). There was a considerable abrupt “jump” above the dollar.

    The Euro is essentially “storing” value from America (heavy lifting) until such a time as American money managers think all is safe again. Gold is doing the same heavy lifting.

    The English are subtly pushing the City (London) to get past NYC as the premier financial district in the world. This has never been more possible. But if the English gentleman thinks he can do it on the back of the Sterling he is sadly mistaken. It is like wanting to be the strongest sea captain by sailing a dingy. The world is changing. Unified currencies are a real tool in the formation of free market power. The UK is hindering this from occurring. Not smart at all.


    The British must find the humility.
    It’s continued reliance on the pound,
    Will risk Europe’s future; no tranquility;
    Completed unification; civil liberty to sound.

    The British must let go of their past,
    It’s identity being created by a queen.
    Find the courage so real freedom to cast,
    If not, will rot it’s free character; today unseen.

    Let go of the pound.
    Let go of the queen.
    Completed unification; freedom found.
    Uniting financial power to lead, to glean.

    They will always be unique, the United Kingdom.
    We will always be kindred spirits; America’s soul.
    Let them now stand for an individual’s freedom,
    Let them take their natural European role.

  15. Peripheral Visionary

    If a country was under the Euro but facing severe economic hardship, what is to prevent it from simply printing Euros? The benefits would be immediate and localized, the cost–inflation or hyperinflation–would take time to build and would be spread across the European nations. I see printing of Euros as far more likely than reverting to a localized currency.

  16. Tom

    "Friday’s news from Standard & Poor’s that Greece and Ireland were on review for a possible downgrade, followed yesterday by Spain, left many thinking the unthinkable".

    Why is the S&P opining about these 2 countries? It sounds to me that by doing this they are deflecting attention from our own eventual collapse. Its like a very insecure person talking bad everyone they work with to hide there own failings in life. I just got back from Italy (been going there for 13 years). I havent seen so many apartments being built and so many people with pockets full of cash. As we flew into Rome you can see the active mining going on for raw materials to build with. Stores being renovated, brand new BMW's, Audi's and Porsche's. Where is the financial crisis in Italy that we keep reading about? I remember when they didn't have a pot to piss in.

  17. Anonymous

    @anon. 2.07: if devaluation is good for competitiveness, all countries would be in a race to the bottom. Alternatively, Germany, one of the leading exporters, always believed in a strong currency, had one for decades (mark), and has proven a strong currency and competitivness can go together.

    @pv: only the ECB can print euros, not the countries

  18. FairEconomist

    A good currency is extremely valuable, and never more important than in financial crisis. If you want to see what the currency crisis did to Argentina, watch this. Iceland is having trouble importing food and oil. Plus in the case of most Eurozone countries, a separate currency is effectively slapping a 5% tariff on exports due to currency risk for trader and an enormous bill on its financial sector to rework for a multicurrency system. Yeah, you can leave the Euro, if you don’t care about social stability, eating, heating, and mass bankruptcies in your financial sector.

    The East Europeans get it. They are fighting like demons and willing to make large sacrifices to get under the Euro. The weaker a country’s own finances and situation are, the more it needs somebody else to run its currency. The only reason a country would want out of the Euro is if the Euro became toxic, probably from deflation in the current scenario.

    Devaluation is a temporary help with large long-term harm. Even on a short-term the benefits would probably be outweighed by the mess resulting from leaving the Eurozone and effectively having to renegotiate every contract written by anyone in the country.

  19. Tortoise

    The idea that the “spread of Greek bonds over German bunds is 2.32 percentage points, almost 10 times its level of two years ago” signifies the end of the line for Greece is ludicrous. To begin with, it is better than what Greece used to pay on its bonds before Greece joined the monetary union. By what rationale should one expect that Hellas should pay the same interest rates as the Bundesrepublik?

    Greece has tons of problems in an absolute sense but is curiously doing better than many other countries. Germany has already entered a recession period but Greece has not yet done so. Here are statistics regarding the third quarter 2008:


    Greece will be affected by the crisis but let us not jump the gun.

  20. Anonymous

    Perhaps Germany will leave the Euro so as not to be stuck propping up all the weak hands. Certainly the PIGS will fight true reform for as long as possible so as to force Germany’s hand. The new DM would instantly appreciate and generate a massive global wealth transfer to Germany.

  21. Martin


    Germany is very dependent on its investment good and long term stuff (like cars) industries. That means a very strong response to the global cycle. But I doubt that in the medium term the market for such stuff is already saturated in Eastern Europe and Asia. So there should be a significant recovery as well, once the global economy gets footage again.

    But in general less developed nations grow more than more developed ones, because we measure growth in relative terms but in reality the economy doesn’t grow exponential.

  22. Anonymous

    Bb’s makes an excellent point. The Eurozone and the EU in general will strengthen by shedding the weak and backward members. Nations like Greece, Spain, Portugal, and even Italy have no business being part of this troubled union. Anybody who has traveled through Europe lately can’t help but be shocked by Northern Europe’s decaying infrastructure, unmarked freeways, and dirty cities, all the while formerly third world Spain, Portugal, and Greece are enjoying fat pensions and modern highways. And, Spain, Greece, and Portugal continue to sport the same dismal work ethic and mentality of corruption they always displayed. As far as Greece is concerned, I would not even consider that to be a European nation. The modern Greeks are basically a Turkish people (what would one expect after 800 years of Ottoman occupation), and the nation belongs in the Middle East. Now, bringing the near-failed-states of Eastern Europe into discussion further strengthens my points. I have recently lived in Bulgaria, Romania, and Hungary, and have been utterly shocked by the backwardness, rampant corruption, medieval work ethic, and an utter absence of even a semi-modern infrastructure. After Romania joined the EU (2007) things actually became more corrupt than before, and the physical condition of the country’s infrastructure has further deteriorated (it takes a 4×4 to drive on Romania’s best roads, along with quick reflexes to avoid all the stray dogs, drunken pedestrians, gypsy caravans, and unmarked bicycles). The EU simply needs to go give up on its stupid European Dream, and go back to the original member nations (Northern Europe).

    BTW, there is a reason why the nations mentioned above have a tradition with dictatorships – that’s the only form of government that works there. I say let’s export Bush to them, and establish an Empire of Texas in Southern and Eastern Europe.

    As far as some of the other points made above, I beg to differ that prices in the UK have risen since the pound shed 25%. I currently reside in the UK, but travel frequently to Germany and France (btw, France is another near-backward nation that has become an EU liability), and can assure you a cup of coffee costs nearly twice as much in Germany as it does in the UK. Actually, at the moment I find the UK more affordable than the US, where I lived until a few months ago.

    Vinny Goldgerg — a proud American on business exile in Europe, but looking forward to returning to the Land of the Free asap, to spend his fiat currency Dollars on quality American-made products (such as GM and Chrysler 8 cylinder SUVs).

  23. Anonymous

    Tom wrote: “I havent seen so many apartments being built and so many people with pockets full of cash. As we flew into Rome you can see the active mining going on for raw materials to build with. Stores being renovated, brand new BMW’s, Audi’s and Porsche’s. Where is the financial crisis in Italy that we keep reading about?”

    You must have witnessed the prosperity of Italy’s largest industry: the Mafia.

    Vinny Goldberg

  24. Anonymous

    Anon 5:00 PM wrote: “Perhaps Germany will leave the Euro so as not to be stuck propping up all the weak hands. Certainly the PIGS will fight true reform for as long as possible so as to force Germany’s hand. The new DM would instantly appreciate and generate a massive global wealth transfer to Germany.”

    Thank you! Finally, somebody spoke the Gospel truth about what the EU really is. One day soon, Germany will wake up, shake the parasites off its back, and start rebuilding its own decaying infrastructure, improving its failing education system, and satisfying its hard-working but exasperated citizenry.

    A few months later famine sets into Eastern and Southern Europe. But alas, Mother Russia offers the PIGS free grains and cheap gas in exchange for membership in the New and Improved Soviet Union and the oil-backed RubleZone. And the PIGS make it through the winter!

    Vinny Goldberg out.

  25. Anonymous

    Anonymous 7:46,

    Spain has a tradition of dictatorship? What should we say then about Germany? It was German bombers and US money what brought us that tradition with Dictator Franco.

    On the contrary, Spain’s first universal suffrage took place in 1933, three decades before that happened in the US (1964).

    Much more important to economic growth than EU funds (which were under 1% GDP and just a payment for dismantling some key Spanish industries such as vessel construction and ironworks) are education (40% of the Madrid population hold a university degree, compared to 35% in New York, 28% in Paris or 24% in Sydney) and immigration (over 700,000 immigrants every year in the last decade, compared to none in France and Germany).

    By the way, education and immigration are also key factors behind US and UK economic growth; and, admittedly, education stats are much worse in Portugal and Greece.

    Best regards,


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