There's Safety in the Euro Zone

Thinking of leaving the single-currency area? Think again.

From today's Wall Street Journal Europe

According to a cruel joke making the rounds these days, the difference between Iceland and Ireland is one letter and six months. An even crueler epithet calls London "Reykjavik on the Thames." As European governments pile on mountains of debt to recapitalize their overleveraged banks and pump-prime their economies, the hitherto unthinkable is now a distinct possibility: national defaults.

On Monday, S&P downgraded Spain's credit rating to AA+ from triple A, following a similar cut for Greece last week. Ireland and Portugal were put on credit watch, and Italy may be next in line. The yield spreads between German bonds, the euro zone benchmark, and Greek, Belgian, Italian, Portuguese, Spanish and Irish bonds have widened to new heights -- an indication that the market considers the latter less safe.

All this has led to speculation that the euro zone's breakup is imminent. Jean-Claude Trichet, president of the European Central Bank, felt compelled yesterday to dismiss such talk as "unfounded."

The thinking of those who believe Greece or Italy may drop the euro goes something like this: Freed of the shackles of a one-size-fits-all monetary policy and back in charge of their own currencies, these countries could devalue themselves out of the crisis, giving their industry a competitive advantage.

But this makes little economic sense. Any benefit from a devalued currency would be short-lived; it would surely lead to wage inflation, thereby neutralizing the advantage for exporters. The pitfalls of leaving the euro, though, would be enormous.

The bond spreads mean that the markets consider the likelihood of a default of German debt to be much lower than for, say, Greek or Spanish debt. The idea that those concerns would disappear if only Athens and Madrid dropped the euro is absurd. If the Greek and Spanish governments have to pay a premium for issuing euro-denominated bonds, imagine what the surcharge would be if they tried to sell investors peseta or drachma bonds.

Even though the insurance against debt default has ballooned for these countries, they haven't yet had any problems raising money. Greece is attracting strong demand for a planned five-year bond. Whether investors, even for an additional risk premium, would flock so willingly to drachma-denominated bonds is questionable. A Greek currency bond market would be much less liquid and therefore less attractive.

The "tensions" in the euro zone, i.e. the bond yield spreads, actually underline that joining the euro was the right decision and leaving now would make things worse. Leave aside the huge costs of reintroducing national currencies and redenominating all debt. Even if this could be done at zero administrative and political cost, it would still be economic suicide.

Let's say Italy tried to go it alone. Since it would be clear that Rome was leaving the euro to devalue its resurrected national currency, investors would pull out their money faster than Italy could print 100,000 lira notes. A bank and lira run would follow; inflation and borrowing costs would skyrocket.

Consider the example from across the Channel. British euro skeptics always considered it a blessing that the U.K. never joined the single currency and they are particularly happy about their independence in the current crisis. It allows the country to do what euro zone countries can't do: watch their currencies decline. The pound has lost 20% in value versus the euro over the past year and even more against the dollar and the yen. How much this will help British manufacturers remains to be seen.

What is certain is that with the rapid fall of sterling, servicing British debt denominated in foreign currencies is becoming increasingly costly. In addition, the U.K. will have to pay a hefty exchange-rate risk premium for issuing new debt while investors are selling British assets. What some consider a necessary adjustment of an overvalued currency, others fear may actually be a run on their currency. A veritable sterling crisis would only aggravate the banking problems.

This is one headache euro zone members don't have to worry about. It's also one of the reasons why Fitch, unlike S&P, affirmed Madrid's triple-A rating on Monday. "Spain's membership of the euro area supports its rating, as it eliminates the risk of a currency crisis," its statement read.

There is safety in numbers. As a global reserve currency, the euro enjoys advantages the relatively small sterling zone lacks. In this global financial crisis, investors increasingly will seek relative security in the dollar and euro zones.

The euro has also brought other advantages. We never thought much of the arbitrary rule that budget deficits must not be higher than 3% of GDP, but the overriding idea of fiscal responsibility is sound. As a result, many euro zone countries are now in a better position to absorb their rising deficits.

Last but not least, having one single currency for 16 European countries has made international coordination during this global banking crisis much easier. Henry Kissinger's famous question -- "Whom do I call when I want to talk to Europe?" -- does not apply to monetary policy. The existence of the ECB facilitated coordinated interest-rate cuts with central banks around the world. Imagine the cacophony of policy responses if there were an additional 15 central banks in Europe.

The euro is an anchor of stability, particularly for small members that otherwise would be much more exposed. Denmark may hold a referendum on joining the euro next year and in Iceland, which hitherto has declined to join even the European Union, a clear majority now favors adopting the single currency.

Perhaps the euro skeptics in the other Reykjavik, the one on the Thames, may soon rethink their position as well.