The Secret of the Euro's Survival

It appears that the euro and the eurozone will survive without expulsions, secessions, or, critically, defaults. The Continent's fiscal-financial crisis will almost surely go on, indefinitely it seems. The debt burdens are high, many of the zone's members have broken political-economic models, and the ongoing recessions and near recessions in many member countries will compound the financial strains for some time to come. But set against these difficulties, unity in the zone enjoys three broad supports: 1) a tremendous political will to continue the eurozone experiment; 2) continued support by the European Central Bank (ECB); and 3) tremendous pressures on Germany, Europe's paymaster, to sustain the euro and the eurozone as it is presently constituted.

It may seem counterintuitive, but all the debate, compromise, even the tensions that have overtaken Europe since the crisis broke in 2010 speak to a tremendous will among its members to make the currency union work. Each nation has maneuvered for the best deal it can get. The French and others have argued for zone-wide bonds to cover budget shortfalls, while the Germans, who know they will have the ultimate responsibility to meet such obligations, have refused. While some, particularly the Spanish, have looked for zone-wide funding of bank capital needs, Berlin has demurred until there is also effective zone-wide bank supervision. But in all these and other disputes, never once has a nation threatened to break off negotiations, much less withdraw from the common currency or the institutions that support it.1

The commitment of the ECB in part reflects this impressive political will. It is, after all, an institution established by the same parties negotiating the ins and outs of the crisis. To be sure, the bank has at times talked out of both sides of its mouth. It has on occasion dragged its feet about providing liquidity to troubled financial markets, worrying over non-existent inflationary pressures instead of more immediate needs. The bank has, at various stages of this crisis, refused to help because of legal niceties that at other times it willingly ignored. But in the teeth of the worst trouble, it always moved to relieve the crisis. In the summer of 2011, for instance, when tensions came to a head over Spain's budget and banking shortfalls, the ECB set aside its past reluctance to buy the debt of these troubled countries, at once easing their and the market's acute liquidity shortages and concerns. It has followed that policy since—and it will likely continue to do so. ECB president Mario Draghi has said that the bank will do whatever it takes to secure the currency and its zone. He and everyone else at the ECB have a powerful personal motivation to do so, too, since without a euro, they know that there would be no need for a European Central Bank—or their jobs.2

Berlin, as leader of Europe's most significant and viable economy, seems entirely committed to protecting the euro and its zone from any dissolution or dismemberment. It is noteworthy in this regard that for all the strains and debate in Germany's September election, the voters overwhelmingly returned the pro-Europe Angela Merkel to the chancellor's office. Similarly, the voters refused to give significant votes to any party that advocated German withdrawal. But more than personal and party commitments, Germany has little option but to support the euro and work to preserve the eurozone as it is presently constituted. Economic and financial imperatives compel it. Even if the vote this past September had gone less well than it did, the country simply is too tied to the euro and the union to turn away. Berlin may negotiate its best deal, but it knows that if it were to let the common currency fail, even in the part, it would do itself great economic and financial harm.

The vulnerability of German banking alone is impressive. By their own accounting, German banks and other financial institutions hold some €400 billion in Spanish, Greek, Portuguese, and Irish obligations alone. This exposure amounts to about 270% of the German banking system's tier 1 capital and 17% of Germany's gross domestic product (GDP). No doubt, exposure to Italian debt only pushes this vulnerability to greater extremes. Dissolution of the eurozone, the expulsion of some current members, and the unavoidable defaults such events would produce would consequently threaten Germany with such severe credit constraints that the economy would surely tip into a deep recession. The only way Berlin could avoid such an outcome would be to support the banks directly. There are, then, only three options: recession, direct support for the banks, or support for the periphery. Politically and financially, it is easier to marshal Europe to do the last than to face the others.3

German industry has almost as much at stake in the euro and in the survival of the zone. To be sure, German business went into the currency union with great skepticism. But since, it has learned to love the euro. To see why, all one need do is consider what German industry would face in the absence of the common currency. Money now is pouring into Germany. It is, after all, the only viable large economy on the Continent. A separate deutschemark would by now have risen into the stratosphere. German business would have lost any pricing edge on global markets. Its exports would have suffered horribly. But because the euro encompasses weaker economies, it has not risen as high as an individual German deutschmark surely would have. The common currency has effectively saved German producers, and they know it. No doubt business leaders frequently brief Berlin on this economic fact of life.4

Berlin also knows that a dissolution of the euro would steal the special trade advantage Germany has within Europe. Because Germany joined the euro when the deutschmark was cheap relative to German economic fundamentals, the common currency has effectively enshrined a competitive pricing edge for German producers across the entire zone, especially compared to producers in Europe's periphery nations, which joined the euro when their respective currencies were dear. International Monetary Fund (IMF) data show that these currency differences initially gave German producers a 6% pricing advantage over their Greek, Spanish, and Irish competitors. But since subsequent developments have encouraged greater industry and investment in Germany while discouraging it in the disadvantaged periphery, that advantage has widened. Calculations using recent IMF data put Germany's pricing edge over these countries at double digits.5

Rather than risk suffering on all these fronts, Berlin knows that it would do well to support the weak periphery and keep the broad eurozone intact. Bailouts and rescue packages might look large in the headlines, but ultimately they impose far lighter burdens than the economic and financial costs implicit in any eurozone dissolution, complete or partial. With this clear pressure and the commitment it engenders added to the political will elsewhere in Europe and the cooperation of the ECB, there is every reason to expect that the euro and the eurozone will survive for the foreseeable future, even as Europe's ongoing crisis drags on and periodically creates false, if understandable, fears of dissolution and default.

1 See, "The SDP 'Has to Negotiate' with Merkel," Spiegel On Line, September 25, 2013, and Anton Troianovski, "Merkel's Next Challenge: Finding New Governing Partner," The Wall Street Journal, October 5, 2013.

2 Milton Ezrati, "Europe's Queasy Statue Quo," Economic Insights, August 12, 2013.

3 "On Being Propped Up," The Economist, May 25, 2013.

4 Ullrich Fichtner and Alexander Smoltczyk, "Schauble's Search for a Way Forward," Spiegel On Line, September 26, 2013.

5 International Monetary Fund.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

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