Controlled Dismantlement of the Eurozone

Controlled Dismantlement of the Eurozone: A Strategy to Save the European Union and the Single European Market

The first Polish version of the article has been available at and since 11 April 2012. The first English version entitled ‘Controlled Dismantlement of the Euro Area in Order to Preserve the European Union and Single European Market’ was published as a working paper in the series CASE Network Studies & Analyses (no. 441/2012) on the 22 June 2012. We would like to thank some people who contributed to this text. Krzysztof Błędowski, Marcin Gozdek, Kamil Kamiński and Agata Miśkowiec provided us with some data and analyses. All of them and also Mark Allen, Wojciech Arkuszewski, Sergiusz Kowalski, Adam Parfiniewicz, Jerzy Strzelecki and Cezary Wójcik, as well as Walter Krämer and two anonymous referees provided us with valuable comments and critical remarks, which in some cases were far off the views presented in the text. Teresa Siwicka supported us in the English editing. This article expresses the personal views of the authors. This version of article firstly was published on German Economic Review (


The problems with a single currency in Europe are neither temporary nor curable. Any persistent defence of the euro will result in a long-lasting recession and high unemployment in countries using fiscal austerity to pursue ‘internal devaluation’. It may lead to a revival of populist and nationalist movements, political collapse and disorderly eurozone break-up. This article argues for a controlled segmentation of the eurozone via the exit of the most competitive countries and an agreement on a new European currency coordination system.

1. Introduction and overview

Conflicts in Europe resulted in two disastrous World Wars in the first half of the twentieth century. But, in the second half of that century, the spirit of European integration resulted in the creation of the European Union and the Single European Market, both of which can be considered great political and economic successes. The introduction of a common European currency at the turn of the twenty-first century was a further step towards integration that generated exceptionally high hopes. However, after nearly a decade of success, the eurozone has come to a crossroads. The current crisis is occupying a considerable amount of the attention of politicians and the public, with calls for a decisive defence of the euro, because the single currency’s demise is believed to be the beginning of the end of the EU and Single European Market. We acknowledge that view and share some of its premises. However, we are afraid that preserving the euro may result in the disintegration, rather than the strengthening of the EU and the Single European Market. The fundamental problem with the common currency is the inability of individual countries to correct their external exchange rates, which is normally a rapid and efficient adjustment instrument, especially in times of crisis. Europe still consists of nation states that constitute the cornerstones of national identity and major sources of government legitimization. Staying within the eurozone may sentence some countries – which, for whatever reason, have lost or may lose competitiveness – to economic and social degradation and make it very hard to overcome this situation. This may disturb social cohesion, encourage populist tendencies and endanger democratic order in some member countries as well as the economic cooperation and peace in Europe.

The introduction of the euro proved to be a step that contradicted the prevailing philosophy of European integration based on respecting member’s needs and accepting only measures which do no harm to any country. To return to the origins of European integration and avoid a chaotic break-up of the eurozone, the euro area should be dismantled in a controlled manner. Eurozone segmentation conducted via the exit of less competitive countries could result in bank runs and the collapse of the banking sectors in these countries. Therefore, we opt for a different scenario, in which the eurozone is dismantled from the other end via the gradual exit of the most competitive countries. Along with the segmentation of the eurozone, a new mechanism for currency coordination should be established in Europe aimed at preventing currency wars as well as the excessive appreciation of the new German currency.

Controlled segmentation of the euro area would improve the competitiveness of endangered countries via currency depreciation. Some of them may still need to restructure and reduce their public debt. The necessary reduction of debt and the underlying costs borne by creditors would be smaller, although, than if these countries stayed in the current eurozone.

2. Loss of competitiveness as the major source of problems and two short-term remedies

In 2010, Greece, Portugal, Italy, Spain and Ireland faced serious problems in auctioning their bonds. Initially, the political and economic leaders of the EU claimed that there was only a temporary liquidity problem and afflicted countries would be able to payoff their debts after introducing proper reforms. By now, however, at least in the case of Greece, the official EU position is that there is a solvency problem and debt reduction is necessary. Solvency fears are also a common feature of the other member countries in crisis.

The key to the problems of the eurozone countries in crisis (except Ireland) is the loss of international competitiveness. This phenomenon occurs when wages become too high compared with productivity in the tradable goods sector. As a result, domestically produced goods start to be crowded out (within a country and abroad) by foreign goods. Subsequently, output and employment in the tradable goods sector fall. As long as this fall is offset by growth of employment and output in non-tradable goods sectors – in particular in construction and services – the erosion of competitiveness does not necessarily lead to a decrease in employment and output in the whole economy, but usually manifests itself in the worsening of trade and current account balances. Negative trade and current account balances can be sustainable, unless there are problems with foreign financing.

In 1999–2011, unit labour costs (the value of wages per unit of output) in Greece, Spain, Portugal and France increased relative to Germany by 19–26%, leading to worsening trade and current account balances. In 2010, the aforementioned countries had current account deficits worth 2–10% of GDP, and their combined trade deficit amounted to EUR 167 billion. At the same time, Germany had a trade surplus of EUR 154 billion and a current account surplus of 6% of GDP.

Different countries suffered a loss of competitiveness for different reasons. In Greece, Portugal and Italy, the culprits were budget deficits or very high levels of public debt. Spain and Ireland, which before the financial crisis complied with the Maastricht debt and deficit criteria even better than Germany, fell victims to an enormous expansion of private debt that propelled the construction sector and increases in wages.

To repair their trade balances and liquidate their current account deficits, Greece, Portugal, Italy and Spain need to bring wages down by 20–30%. Such a rapid improvement in competitiveness could be accomplished by a currency depreciation like the one in Poland, a member of the EU, but not of the eurozone. At the height of the world financial crisis between autumn 2008 and spring 2009, the Polish zloty depreciated by 30%. Largely thanks to this, the trade balance improved by 3% of GDP, which was possibly the most important factor that enabled Poland to be the only EU country to enjoy economic growth in 2009.

The eurozone countries in crisis cannot improve their competitiveness by simply letting their currencies depreciate because they do not have their own currencies. In consequence, and following the general advice of the European Commission, the European Central Bank (ECB) and the International Monetary Fund, these countries are trying to restore competitiveness by reducing government expenditures and increasing taxes, which they hope will decrease prices and nominal wages. Nowadays this type of policy is called ‘internal devaluation’, but it is really just an ordinary deflation policy executed using fiscal tools.

As a method to improve a country’s competitiveness, deflation is far less effective than currency depreciation. An exchange rate adjustment automatically and directly generates a fall in wages denominated in foreign currencies, and therefore provides a quick boost to competitiveness that stimulates domestic output. Contrary to that, the effects of deflation are indirect and occur with lags. To be effective, deflation policy has to initiate thousands or millions of changes in individual prices and employment contracts. To this end, deflation policy has to first generate a fall in output and employment through a decrease in demand. Decisions to lower prices are not made until firms encounter a barrier to demand manifested in shrinking sales; employees only begin to accept wage cuts when the unemployment rate rises considerably. In the process of deflation, a fall in wages and prices denominated in foreign currency is not as automatic and broad based as it is in the case of an exchange rate correction. When the trade deficit needs to be urgently reduced, a smaller and slower restoration of competitiveness via deflation policy entails greater costs in terms of employment and output than an adjustment carried out via currency depreciation.

3. Selected case studies of deflation and devaluation policies

In the era of gold standard,1 which was introduced in the second half of the nineteenth century and functioned until the outbreak of the First World War (WWI) in 1914, deflation was the main instrument of restoring economic competitiveness. A country that encountered problems with financing its trade deficit via an inflow of international capital suffered an outflow of gold from the reserves of the Bank of Issue (the Central Bank), which was obliged to exchange currency into gold at a fixed parity. In these circumstances, and to avert the threat of a reduction in its ability to exchange currency into gold, the central bank increased the discount rate, thereby limiting the supply of credit to the economy and generating deflationary pressures. Deflation, in turn, lowered demand for imported goods, boosted competitiveness and improved the trade balance. Polanyi (1944), and subsequently Eichengreen (2008), devoted a lot of attention to explaining why deflation was an effective adjustment mechanism before WWI and ceased to be one in the interwar period. According to Eichengreen (2008), central bank policy before WWI was hostage to maintaining gold reserves at a level that guaranteed currency convertibility into gold at fixed parity. Therefore, the central bank did not hesitate to pursue deflation policy if needed, and no other issue apart from maintaining convertibility was taken into account. The implementation of deflation policy was facilitated by the absence of a reliable economic theory that explained the influence of central bank policy on the economy and the unemployment rate. Moreover, unemployment emerged in economic discussions as a clear economic category only at the turn of twentieth century. In those days, the franchise was restricted, and in most countries only the wealthy could vote. The unemployed, therefore, not only had no idea of the linkages between central bank policy and their fate, but were also unable to voice their interests under such a political regime (Eichengreen (2008, p. 30). Labour unions and work regulations were in their infancy, and therefore wages were relatively flexible and deflation policy was successful in decreasing them (Eichengreen, 2008, p. 230).

The situation was quite different in the interwar period. All social strata had the right to vote, labour unions grew stronger, unemployment gained importance as an economic category and political problem and the link with central bank policy became clearer. The activity of labour unions and regulations governing work limited wage flexibility. Therefore, to achieve a given amount of demand slack in the economy, unemployment had to rise more than in the case of more flexible wages. A conflict started to be commonly perceived between keeping the economy externally balanced and sustaining domestic business activity.

A spectacular example of these differences in conducting deflation policy was Great Britain’s failure to sustain an overvalued pound sterling in 1925–31. After being suspended after the outbreak of WWI, convertibility of the pound sterling into gold was restored in 1925. Prewar parity was restored, but by that time prices in Great Britain were higher than before the war. At the time, that move was opposed by John Maynard Keynes, one of the experts consulted by Chancellor of Exchequer Winston Churchill. In a pamphlet entitled ‘The Economic Consequences of Mr. Churchill’, Keynes (1925) estimated that restoring the gold parity would overvalue the pound sterling by 10–15%, and would thus lower the competitiveness of British exports and would entail a rise in the already high unemployment. According to later estimates quoted by Eichengreen (2008, p. 57), the overvaluation was less severe, but still around 5–10%. The decision to restore the overvalued parity is commonly perceived as a major reason for the low economic growth and high unemployment in the second half of the 1920s. At that time, as noted by Ahamed (2009, p. 376), France restored gold convertibility at an undervalued parity and enjoyed much higher economic growth and lower unemployment. For six years, the British economy and society suffered enormous costs in the defence of an overvalued currency. To protect the trade balance and limit the outflow of gold from the country, the Bank of England had to suppress the supply of credit, while the government had to implement increasing fiscal austerity. While the deflation policy was damaging the economy, the problem of the overvalued currency remained unresolved. Finally, plagued by a 20% unemployment rate, Great Britain left the gold standard and allowed the pound to depreciate by 30%.

Two conclusions, highly relevant for the current eurozone crisis, may be drawn from the British experience of the 1920s. First off all, this example shows that deflation policy as a tool aimed at restoring competitiveness under a fixed rate regime is hardly effective despite its substantial economic and social costs. At that time, a six-year policy of deflation was unable to correct prices overvalued by 5–10% and failed to restore the country’s competitiveness. Is it really possible that such a policy will be successful now, when price levels in the relevant countries are overvalued by 20–30%?

Second, this example illustrates the magnitude of the economic, social and political costs caused by the dogmatic economic thinking of economic and political leaders. It was common at that time to assume that the gold standard was the only system underpinning sound currency, and that the pound’s prewar gold parity was a prerequisite for sustaining the credibility of the British monetary system. Until the last moment, high British Treasury officials reacted with indignation to suggestions that Great Britain might abandon the current pound sterling gold parity (Ahamed, 2009, pp. 429–430). In the spring of 1931, Montagu Norman, the then Governor of the Bank of England, sought a loan from the Great Depression-ridden USA that would prolong the convertibility of the pound sterling at the defended parity. When these efforts failed, Montagu complained that the ‘U.S. was blind and taking no steps to save the world and the gold standard’ (Ahamed, 2009, p. 383).

Identifying the fate of the world with the gold standard was a mistake. According to Eichengreen (2008), clinging to the gold standard was the key factor in the deepening and spreading of the Great Depression internationally that almost led to a collapse of democratic order in the world. This 80-year-old experience should also give food for thought to contemporary European leaders who are tied to the dogma that the EU and the Single European Market’s future is tied to the Euro project. It is worth remembering that one of the most important decisions made during the first year of Franklin Delano Roosevelt’s presidency was – besides putting in order the banking sector – suspending the dollar’s convertibility into gold and devaluing it by 40% in 1933.

The abandonment of the gold standard by Great Britain and the United States marks the beginning of the period in which various countries used currency depreciation for boosting competitiveness. Such policies were seen as controversial because currency devaluation increased one country’s competitiveness at the expense of its trading partners, often forcing them to devalue as well. According to Eichengreen (2008, p. 87), such arguments cannot obscure the fact that currency devaluations in the 1930s were effective and constituted a part of the solution to the Great Depression, but were not its cause. Drawing on those lessons, the IMF’s articles called for ‘fixed but adjustable parities’.

The experience of Argentina is also instructive. Argentina introduced a currency board in 1991, legally and permanently binding the peso to the US dollar. This policy was initially successful in reducing inflation and fuelling economic growth. However, at the end of the 1990s, some serious problems with competitiveness emerged that can be linked to a mix of external and internal factors. They caused a recession and an increase of public debt. At first, abandoning the currency board was not an option for political leaders. Rather, they decided to use deflation policy (based on fiscal restraint) to combat declining competitiveness and mounting debt. However, such a policy did not bring about the expected results. After three years of recession, bloody riots forced the president and the government to step down. Argentina defaulted on its debt and abandoned the currency board. The peso was devalued by 70%. The economy and the banking system underwent serious turbulence, but the economy soon began to grow again and the gap in the trade balance closed. During the next six years, the Argentine economy achieved annual growth rates ranging from 7% to 9%.

The Argentinian example illustrates three truths. First, a country that enjoys a favourable macroeconomic situation and creates a seemingly sound institutional framework may, for unexpected reasons, fall into problems with competitiveness. Second, in a fixed exchange rate regime, restoring competitiveness via deflation has little effect and can lead to social unrest. Third, it is currency depreciation that constitutes a strong adjustment instrument. And even if it takes place in circumstances of political and economic depression, it may allow a country to swiftly enter a growth path.

The effectiveness of currency depreciation has also been confirmed by South Korea, Thailand and Indonesia in the aftermath of the 1997 crisis, and also by Russia after the crisis of 1998. In all cases, currency depreciated in an environment of a deep economic and banking crisis. It seemed that these economies would be unable to escape their predicament given the banking crisis and massive business bankruptcies. However, after currency devaluation, they were quickly able to embark on a growth path.

Currency depreciation also of course entails serious problems. While it is a cheap and effective (socially and politically) instrument for restoring competitiveness in the short run, it does not directly affect the physical process of production of goods and services, which is decisive for competitiveness in the long term. On the contrary, the availability of currency devaluation often tempts politicians to accept easy fiscal policy and to avoid tougher, more socially and politically complicated reforms aimed at long-term improvements in competitiveness. There are numerous examples of countries, especially from South America and southern Europe, which in the second half of the twentieth century kept on using currency devaluation as an instrument for improving competitiveness, which was being systematically undermined by inflation. However, if accompanied by an adequately restrictive macroeconomic framework, currency depreciation may bring more durable improvement in competitiveness and at the same time, provide a progrowth stimulus which can serve to counterbalance, to some extent, the recessionary effects of fiscal and monetary tightening. According to Blejer and Ortiz (2012), all successful adjustment programmes in Latin America included a deep currency devaluation at the start that lowered unit labour costs. Exchange rate adjustments also played a significant role in Poland’s macroeconomic policies during its successful economic transformation after the collapse of the communist system in 1989.

Although not a miraculous solution that can substitute for sound macroeconomic policy, there are emergencies in which getting the economy back on track without a currency devaluation is very difficult or even impossible.

4. Is fiscal union a cure for competitiveness problems?

Many observers claim that the primary mistake made at the time of introducing the euro was the creation of a monetary union without first having a fiscal union. They then often advise correcting this flaw by creating institutions at the EU or eurozone level, which would be allowed to tax and issue debt, and establishing enforcement mechanisms for a common fiscal policy at the country member level. The followers of this line of thinking seem to expect that creating a fiscal union would eliminate the major problems connected with the functioning of the euro area.

Doubts about the success of such an experiment usually focus on the question of whether a fully fledged fiscal union in the EU is politically feasible. Currently, the EU budget makes up only 1% of the Union’s GDP, whereas at the outbreak of the recent financial crisis, the federal budget constituted 20% of the US GDP, and the central budgets of various EU countries typically ranged from 14% to 43% of their respective GDPs.

Setting aside for a moment the feasibility of creating a fiscal union, it is worth noting that a fiscal union may limit the risk of irresponsible budget policy, but will not prevent problems with competitiveness from other sources. Competitiveness problems caused by, among others, overly expansive credit creation for the private sector, the inflow of foreign capital (including in the form of EU transfers) financing investment in non-export sectors, temporarily high proceeds from the exploration of natural resources, faster improvements in competitiveness in trading partners and by technological or demographic changes will certainly emerge in the future in some countries.

It is likewise unjustified to expect that larger inflows of funds from the EU (or the eurozone’s) central budget would be able to solve problems of insufficient competitiveness in some countries. The doubtful efficiency of structural and fiscal policies in boosting competitiveness in underdeveloped regions within the common currency area is confirmed by the examples of East Germany and southern Italy. At the time of unification in 1990, East Germany’s wages were converted from eastern German marks into western German marks at 1:1. At a stroke, such a parity made the lion’s share of the East German economy uncompetitive compared with the West. Since unification, East Germany has enjoyed fiscal transfers which amounted to a cumulative EUR 2,000 billion by 2009. This sum is comparable to 80% of Germany’s 2010 GDP and 700% of East Germany’s GDP. Annual transfers totalled on average to more than 4% of German GDP and more than 25% of East Germany’s GDP.2 Convergence occurred only in the first half of 1990s; later on the process stopped. The share of East Germany’s GDP in Germany’s total GDP has held steady since 1996, whereas East Germany’s per capita income has been increasing as a result of a shrinking population in the eastern Länder, which decreased from 27% of that of the western Länder at the beginning of transformation to 21% in 2007. As pointed out by Seitz (2009), young and educated people migrate from East Germany because of unemployment, which for several years has been twice as high as that of West Germany, and the overall lack of prospects.

Southern Italy has been a beneficiary of structural policies aimed at bridging the competitive gap vis-à-vis the north of the country for several decades. Current annual transfers amount to 4% of Italian GDP, equivalent to 16% of southern Italy’s GDP (Franco, 2010, p. 5). Some closing of the development gap took place in the 1960s. But subsequently, the convergence process did not continue and for 40 years, southern per capita GDP has oscillated around 55–65% of the northern level (Iuzzolino et al., 2011, p. 67). Private GDP per capita in the south is only 46% of the northern level and the value of per capita exports (excluding petroleum products) is only 18%. The southern unemployment rate is twice as high as that in the north (Franco, 2010, p. 3).

These examples show that structural policies within a common currency area are so ineffective and expensive that they cannot contribute significantly to boosting competitiveness in problem eurozone countries. It is hard to assume that non-competitive eurozone countries could permanently receive annual transfers worth 25% of their GDP – like in East Germany – or worth 16% of GDP – like in southern Italy.

5. Empirical cases allegedly supporting hopes for the success of an ‘internal devaluation’ policy

In this section, we discuss some natural experiments, which are often quoted to justify hopes for the success of an ‘internal devaluation’ policy in the eurozone. The first one happened in Latvia, a country with a population of 2.3 million, which is not a eurozone member, but has had its currency pegged to the euro at a fixed rate for many years. Before the world financial crisis, Latvia enjoyed high economic growth, propelled by a credit boom originating from loans that Scandinavian parent banks granted their Latvian subsidiaries (Purfield and Rosenberg, 2010). In consequence of high wage growth that exceeded labour productivity growth in the tradable goods sectors, competitiveness eroded rapidly. The current account deficit reached an exorbitant 22% of GDP in 2007. In 2008, the flow of foreign financing suddenly stopped and the real estate market collapsed. Latvia was forced to regain competitiveness quickly and to close the current account gap. The government decided to keep the current exchange rate peg and instead embarked on an ‘internal devaluation’ policy. In 2009–10, Latvia implemented deep cuts in public sector wages, pensions and other government expenditures, and also increased some fiscal revenues. Fiscal austerity amounted to 15% of GDP. In 2008–10, GDP dropped by 21%, but afterwards, in 2011, the economy returned to a growth path. Despite implementing such a harsh economic programme, Prime Minister Valdis Dubrovskis enjoyed re-election in general elections in October 2010 and also kept his office in the subsequent snap elections in September 2011. Latvia’s case is therefore said to be an example showing that ‘internal devaluation’ can successfully restore competitiveness, and a government implementing such a policy need not lose the support of its voters.

It is useful to compare the Latvian experience with the case of Iceland. Before 2008, Iceland (population 320,000) enjoyed, similar to Latvia, a rapid growth of bank assets financed by the inflow of foreign capital, and an expansion of the construction sector. Before the crisis, the current account deficit in both countries reached more than 20% of GDP. At the outbreak of the financial crisis, both countries lost access to the capital that financed their growth, underwent a deep contraction in the construction sector and suffered a financial shock; the scale of the latter in Iceland was far greater than in Latvia. Both countries implemented deep fiscal adjustments and were supported by the EU and the IMF. Both countries recorded GDP growth in 2011 after the breakdown in 2008–10.

However, adjustment costs in Iceland were far lower than in Latvia. Its GDP contraction in 2008–10 was half as severe. The fall in employment in Iceland amounted to 5%, compared with 17% in Latvia. The reason may be that Iceland’s currency depreciated and this improved the country’s competitiveness. Iceland had a floating currency regime and the currency depreciated by 50% in nominal terms in 2008. A further fall was averted in part by implementing capital controls. According to Darvas (2011), part of the competitive boost was eaten up by depreciation-led inflation, but in the end, in 2011, Iceland’s currency was 30% weaker in real terms than at the outbreak of the financial crisis. In effect, wages denominated in foreign currency fell, which increased the competitiveness of Icelandic goods. The situation was different in Latvia. The government substantially reduced wages in the public sector, which in 2010 were about 20% lower than 2008, but wages in industry fell by only 2% (Darvas, 2011). In light of these data, Latvia is actually a clear case for the ineffectiveness of ‘internal devaluation’ as a method of improving the economy’s competitiveness. Current account adjustment in Latvia was accomplished, not by improved competitiveness, but by a deep fall in employment and GDP.

Examples of a possible expansionary effect of fiscal tightening, i.e., situations in which fiscal austerity does not limit growth but stimulates it, are rather rare and there is little hope for such effects to emerge in those eurozone economies currently in crisis. In the cases analysed by Perotti (2011), expansionary effects of fiscal tightening occur when the demand contraction caused by fiscal tightening is accompanied by strong progrowth factors, such as currency depreciation or a fall in inflation and interest rates. Substantial currency depreciation, which boosted competitiveness and exports was a stimulus for economic expansion after fiscal tightening in Ireland in 1987–89, Finland in 1992–98 and Sweden in 1993–98. In Ireland, currency depreciation occurred immediately prior to fiscal tightening, in Finland and Sweden it came about during the tightening. In Denmark (1983–86), it was a fall in inflation (from high levels) that accompanied fiscal tightening and a reduction in interest rates (also from substantial levels) that stimulated growth. In the case of the eurozone economies in crisis, the aforementioned factors are unlikely to emerge as those countries do not have their own currencies and room for a fall in inflation and a reduction in interest rates is limited (the former is at a moderate level at the moment and the latter are very low).

6. Optimum community level for one currency area: Europe vs. the United States

Supporters of the single currency area in Europe often point to the United States of America. The United States is similar to the EU in terms of total area, population and level of economic development, but the single currency area in the United States functions without disruptions. Therefore, it has been concluded that a single currency can also circulate successfully in Europe, provided the scope of fiscal integration is strengthened and any obstacles to capital and labour force mobility are removed. We think, however, that one of the major factors that allows a single currency to function properly in the United States is that the currency area overlaps with the area of the United States itself, which constitutes the major focus of citizens’ identity. It is worth remembering that a crucial step of building the aforementioned identity and transforming the union of independent states into a homogenous country was the ruinous American Civil War of 1861–65. Today, a common American spirit is supported by a common official language, common traditions and common recognition of the federal government’s legitimacy. A common language also facilitates labour mobility. The competitiveness problems of some states are to a considerable extent mitigated by emigration to more competitive ones. Americans moving to other states within the United States neither feel nor are perceived as ‘Gastarbeiters’. Interstate migration does not threaten the cohesion of the American people, but rather strengthens it.

Unlike the United States, Europe consists of countries with different languages characterized by different historical and cultural traditions. The nation states constitutes the major source of citizen identity; they also serve as sources of government legitimacy. According to Wnuk-Lipiński (2004), the nation states that form the European Union are not losing their identity and nothing suggests that they will lose it in the future in favour of some new European identity.

Competitiveness problems have totally different dimensions depending on whether they concern regions within countries or whole countries. There are regions in many countries that have been non-competitive for prolonged periods. In Poland, the Warmińsko-Mazurskie province (voivodship) may be an example of such a non-competitive region, as its unemployment rate is the highest in the country, currently exceeding 21%. Young people from that region who think of a professional career leave for metropolises such as Gdansk or Warsaw located in other provinces. At the same time, land in the Warmińsko-Mazurskie province is being bought by prosperous citizens from elsewhere. According to long-term forecasts, the province will experience continuous outward migration to other parts of the country. However, nobody is suggesting creating a separate currency area to improve this province’s competitiveness. Similarly to Americans migrating within the United States, people leaving the Warmińsko-Mazurskie for other parts of Poland are not considered ‘Gastarbeiters’ because they remain in their own country, with their own tradition, culture and language. The aforementioned outflow of people from the Warmińsko-Mazurskie province does not constitute a threat to the community with which those people identify the most, i.e., the nation state.

Is it reasonable to assume that the competitiveness problems of Greece, Spain and Italy could be resolved via mass emigration to other European countries? This is unlikely for economic and social reasons. Migration of a large number of people of productive age from, for example, Greece would leave behind a substantial population of the unemployed and the retired. That would deepen the deficit of the social insurance sector. Germans accept large transfers by supporting the social insurance sector in East Germany, and in Poland, no one cares about the scale of such transfers to Warmińsko-Mazurskie. But it is hard to expect that European countries as a whole would be willing to permanently finance the deficit of the social insurance sector in another European country.

The lack of prospects for whole countries, and the situation in which its citizens are forced to spread across Europe as ‘Gastarbeiters’, can lead to more serious tensions, especially in countries as large as Spain and Italy. This can also easily happen in the future in other eurozone countries that, for reasons unforeseeable today, may run into competitiveness problems. On the other hand, a large number of ‘Gastarbeiters’ may lead to conflicts and a dangerous revival of populist and nationalist tendencies in host countries.

It is worth remembering that the European Union is the result of an integration process that was assumed to be an antidote against the national conflicts that led to two disastrous World Wars. The EU and its institutions were created by member countries to increase their wealth and security. Integration up until now has been based on respecting the needs of all members and on the philosophy of only accepting solutions that served everyone and threatened nobody. It was this philosophy that allowed the European Union and Single European Market to succeed.

Introducing the common currency paradoxically threatens the previous philosophy of European integration. Member countries were deprived of a very effective and mostly irreplaceable adjustment tool that can be used in emergency situations – namely, the exchange rate. At the same time, no other instrument exists that could successfully substitute for the lack of one’s own currency. In effect, member countries that for some reason lose competitiveness or are forced to close the current account gap in a short time can be condemned to economic, social and civilizational degradation, without the possibility of changing this situation. Some observers claim that this situation may accelerate the creation of a cosmopolitan European society. We think that the current lack of conflicts between major nations within the EU does not stem from the fact that national identity was lost somewhere, but from the premise that the framework for cooperation between member states was regarded by them as useful. In a situation where a single society realizes that is condemned to social and economic degradation within the current EU/eurozone framework (while at the same time this framework is benefitting others), nationalist and populist sentiments may arise in full force. It is worth noting that economic stagnation, high unemployment, lack of prospects and a sense of injustice at being treated as inferior by the ruling powers has, in the past, nourished the growth of radical movements that undermined democratic order and peace in Europe.

As exchange rate adjustment is an effective and basically irreplaceable adjustment mechanism that in emergencies improves the competitiveness of a given currency area, it is rational that the power to use this instrument should be located at a level of the community at which citizens identify most, and to which they are prepared to delegate responsibility for their fate. In the case of the European Union, the optimal community level is the member state. Depriving member countries of their currencies may – contrary to intentions – menace the future of the EU instead of fostering further European integration.

7. How to dissolve the eurozone?

Many observers agree that the creation of the eurozone may have been a mistake but – at the same time – they think it was a path of no return.

Dissolving a currency union in a stable environment where member countries are at comparable levels of competitiveness is not hazardous. One example is the Czech Republic and Slovakia in 1993, after which Czechoslovakian crown was replaced by Czech and Slovak crowns respectively. The process took place without any significant perturbations.

Things look different when the competitive positions of member countries differ significantly. A non-competitive country leaving the eurozone would face bank runs. Citizens would rush to withdraw bank deposits to avoid their conversion into the new national currency and subsequent devaluation. It would entail the collapse of the banking sector. Any attempts to prevent such a scenario by temporary bank holidays or limits on deposit withdrawals would be very difficult and enormously risky. It has to be taken into consideration that planning such an operation and the introduction of a new currency takes time and keeping it secret in a democratic country is nearly impossible. Moreover, freezing deposits for some weeks or months also does not seem possible. In addition, freezing deposits with the prospect of their devaluation along with currency depreciation creates a high risk of social disorder.3 In addition, in the case of an exit from the eurozone by a non-competitive country, depreciation of the new currency vis-à-vis the euro would result in a substantial leap in the value of euro denominated foreign debt in relation to the country’s GDP.

The situation looks different if a country like Germany, enjoying a stable competitive position, leaves the eurozone and introduces a new currency. We assume that all domestic contracts are converted into a new currency while all contracts with foreign parties (including bank deposits by non-residents and loans to non-residents) remain in euro. Domestic depositors in German banks would not be afraid that they would lose through devaluation when the euro was replaced by the German mark. They would rather expect their deposited wealth to move with the new currency, which is likely to appreciate towards the euro. Therefore, it is possible to dismantle the eurozone in a controlled manner via the gradual and jointly agreed exit of its most competitive countries. The euro may then remain – for some time – the common currency of the least competitive countries.4

The exit from the eurozone by the most competitive countries would improve the competitiveness of the countries in crisis by weakening of their currency vis-à-vis the new currency (or currencies) of the strongest European economies. The value of the foreign debt of the countries in crisis would not jump up, while the ability to service that debt, both private and public, would increase significantly. However, that does not mean that all the countries suffering from insolvency now would quickly become solvent again. At least in some of these countries, debt reduction (a haircut) would be necessary. The scale of reduction and the cost to creditors would be smaller, although, than in a situation where these countries stayed in the current eurozone and their economies suffered below-potential growth and high unemployment.

8. Currency coordination after dismantlement

Along with the dismantlement of the eurozone, it will be necessary to create a new mechanism for currency coordination in Europe. A non-orthodox floating rate regime5 with monetary policy targeting inflation, and with synchronized fiscal and monetary policy within the EU, seems a natural candidate for the new exchange rate mechanism.

The perception of floating rate regimes has gone through different phases in the literature. In the interwar literature, mainly on the basis of the French experience from the 1920s, a floating exchange rate was believed to be inherently unstable; it was also seen as an amplifier of the initial balance of payments disequilibria. Later research concerning the same French experience has led some economists, including Milton Friedman, to revise this criticism and to conclude that high exchange rate volatility in a flexible rate regime was a reflection of the instability and unpredictability of the fiscal and monetary policies being pursued (Eichengreen, 2008, pp. 49–55). Therefore, when fiscal and monetary policies are reasonable and consistent, a flexible exchange rate mechanism may function well.

An important step towards getting accustomed to the flexible exchange rate was the birth of direct inflation targeting in the 1980s, in which a central bank publicly announces the desired level of inflation and pursues it as a top priority via interest rate policy and other instruments dedicated to monetary policy. Inflation targeting mitigates the inconvenience of a flexible exchange rate regime, namely the lack of a point of reference for private entities’ expectations. Specifying an inflation target creates a necessary point of reference, without the need to subordinate monetary policy to defend a given exchange rate level. Barry Eichengreen (2008, p. 232) ends his monograph on the international currency system by stating that: ‘A floating exchange rate is not the best of all worlds. But it is at least a feasible one’.

A system of non-orthodox flexible exchange rates in different countries can be supplemented by the coordination of macroeconomic policy in the EU, in particular coordination of fiscal policy (by setting ceilings for the deficit of the general government sector in a given country) and coordination of inflation targets and of the instruments used by central banks to achieve them. In such a framework, a flexible exchange rate would serve as a tool for the rapid correction of balance of payments disequilibria. The coordination of fiscal policy and inflation targets would limit exchange rate volatility stemming from the unpredictability and inconsistency of macroeconomic policy, as well as the possibility of running overly expansive monetary or fiscal policies.

A flexible exchange rate, as a primary tool for exchange rate adjustments in Europe, would not rule out the possibility of pegging the exchange rate of a given country to the currency of a strong trade partner. An example of such a policy was the pegging of the Austrian schilling and the Dutch gulden to the German mark before the introduction of the euro, and the currently fixed exchange rate between the Danish krone and the euro. This solution provides the possibility of emergency abandonment of the fixed exchange rate or the option of a one-off correction of the parity. It is obvious that to implement such abandonment of the peg without economic disruptions, the existence of systemic solutions that prevent the direct denomination of local contracts in the currency of a foreign partner is crucial.

Another possible exchange rate mechanism after the dismantlement of the eurozone may be one based on the European Monetary System (EMS) from 1979. Such a framework would allow currency volatility to be reduced by introducing currency bands, or by defending a given exchange level (or rather preventing the further weakening of a soft currency) by obliging hard currency partner countries to offer unconditional support in the form of currency intervention (or even for a transfer of currency reserves, something which failed to materialize in the original EMS). Such a system would allow for periodic change – as in the original EMS – of currency bands under certain conditions (e.g. balance of payments disequilibria, or acceleration of inflation).

An option worth considering is preserving the role of the ECB as the central bank for all current 17 eurozone member countries, even if some of those countries replace the euro with new currencies. It would facilitate the implementation of a robust currency coordination mechanism among former eurozone countries and would also demonstrate that the segmentation of the eurozone is organized in a controlled manner. In particular, it would facilitate and make more credible the necessary arrangements to prevent the new German currency from appreciating excessively in the interim period.

Preserving the role of the ECB would also buy more time to resolve the problem of existing claims and liabilities in Target 2 (interbank gross settlement system operated by the Eurosystem) as analysed by Sinn and Wollmershaeuser (2012). A controlled dismantlement of the eurozone would prevent the further rise of Target 2 imbalances, however, the existing balances would continue to be serviced under the auspices of the ECB. Once the economic prospect of eurozone countries now in crisis starts to improve, capital will begin to return to these countries’ banks and post-Target 2 imbalances will diminish. Once the situation in Europe stabilizes, the remaining post-Target 2 claims, if any, will have to be settled or restructured in an agreed upon manner.

9. Arguments against euro area dismantlement

Some believe that dissolving the eurozone may lead to economic disaster. Experts from the Swiss bank UBS (Deo et al., 2011) estimate that losses incurred by leaving the eurozone would total 40–50% of GDP in the case of PIIGS6 countries and 20–25% in case of an economy as strong as Germany. These estimates assume that a eurozone break-up would also destroy the Single European Market (or would exclude a departing country from its benefits) and would cause a dramatic collapse of trade. However, the conclusion would be different if the dismantlement of the eurozone were accompanied by the preservation of the Single European Market. Moreover, Deo et al. (2011) do not compare the costs of leaving the eurozone with the costs of remaining. For example, in their calculation of a German exit, they take into account the cost of a 50% reduction in the debts of Greece, Portugal and Ireland as if those costs would be incurred only in the case of Germany’s leaving. Yet if the eurozone is preserved, the costs of PIIGS insolvency will still have to be incurred and may be far higher than those entailed by the scenario in which Germany leaves the eurozone.

The UBS economists also assume that overcoming the current eurozone crisis is possible and that the defence of the single currency does not threaten the future of the European Union and the Single European Market. This assumption is questionable to say the least. Rather, owing to the lack of effective adjustment instruments, the probability of a successful solution of the current crisis without a thorough overhaul of the eurozone is small. Moreover, we think that even if the most optimistic scenario becomes reality and the eurozone survives for the moment, it will be prone to other costly perturbations in the future.

Another argument that appeals to many observers is that abandoning the single currency would weaken the EU vis-à-vis such economic powers as the United States, China and India. The euro is currently one of the most important world reserve currencies and it is doubtful that the currency of any individual European country would share the same status. Deo et al. (2011) claim that after the break-up of the eurozone, even the largest European countries would barely be noticed on the international arena.

This notion that abandoning the single currency would weaken Europe’s standing in the international arena implies that there would be a lesser degree of downgrading otherwise. However, a multicurrency EU, but with a good performing Single European Market and with principles of cooperation that generate prospects for the sound development of every member state, will be stronger than an EU with a single currency, but paralysed by economic stagnation, internal problems and conflicts.

10. What may happen in different scenarios

The continuation of the ‘internal devaluation’ policy is set to cause the economic death of endangered eurozone economies. Gomułka (2012) estimates that fiscal tightening in Greece, which is the one strict condition of continued external help, will probably trigger a GDP decline of 20% and will raise the unemployment rate to 20–25% for some years.7 Feldstein (2011) claims that forcing current account rebalancing in Italy, Spain and France by ‘internal devaluation’ would entail a decade or more of high unemployment and falling GDP, which would be a politically dangerous policy that wastes economic resources.

Recession in the crisis economies will worsen their prospects for debt repayment; there will be continued financial support programmes or a continuation of indirect ECB involvement in Greece, Portugal, Spain and Italy. Political and social tensions within endangered countries and between countries will rise. Societies enjoying current account surpluses (mostly Germany) will express discontent with the incapability of deficit countries (Greece, Portugal, Spain and Italy) to tidy up their economies. Deficit countries, on the other hand, will blame surplus countries for profiting from their problems while, at the same time, being at their root. The next step of crisis escalation may be extending the list of countries in crisis to include Belgium and France.

In addition, the political dynamics of the crisis may get out of control in particular countries, as well as at the level of the eurozone and the European Union. Endangered countries may lose the ability to continue the ‘internal devaluation’ policy as a consequence of new elections or government collapses triggered by riots, as it was in the case of Argentina in 2001. Other countries will have to accept some softening of the conditions for further support or accept consecutive insolvencies in crisis countries. Those insolvencies will trigger losses in bank balance sheets and make further public support for the banks necessary, leading, in turn, to a deterioration of the financial standing of other countries. Bank losses and problems with their capital base will trigger another round of credit tightening, leading to a further deceleration of growth and the spread of recession. There will be more and more pressure for ECB involvement, in an environment of mounting resistance in German public opinion. Such a situation may lead to chaotic exits from the eurozone on the basis of unilateral national decisions either by countries in crisis or by the most competitive European economies. This is the most dangerous scenario, which may lead to a breakdown of the Single European Market, disintegration of the European Union, as well as deep economic depression and military conflicts.

But, there is also a chance that the Euro will survive. Even though the current methods of solving the eurozone debt crisis seem unlikely to improve the competitiveness of crisis countries and repair their balance of payments fast enough to avoid a deepening of the recession and an escalation of the debt crisis, there is a survival scenario, which could result from various positive factors. These include external growth stimuli stemming from a faster global economic upswing than expected, or a trade surplus generated for the eurozone as a whole as a result of the depreciation of the common currency as indicated by Feldstein (2011), or better effects of restoring competitiveness of economies in crisis via the ‘internal devaluation’ policy than we expect.

However, even if the eurozone survives, it does not mean that the ongoing crisis is the last one. Problems with competitiveness may occur in different countries in the future. And one thing is certain: the fate of the country that loses competitiveness while staying in the eurozone will never be one to be envied. A potential eurozone exit may end with a bank panic, whereas staying in may be equivalent to a long-lasting recession. Awareness of such traps limits the chances for further eurozone expansion, even in the optimistic case in which the current crisis is overcome. Only some small countries that already have their currencies pegged to the euro may be interested in joining the eurozone in the near future. As long as the eurozone exists, EU members will remain divided into three groups: (1) eurozone members in crisis and suffering economic stagnation, (2) eurozone members regarded as reasonably competitive and asked to help those in crisis and (3) countries outside the eurozone and not hurrying to join.8 It will be a ‘three-speed Europe’. Controlled dismantlement will free the countries caught in the trap, prevent the unforeseen consequences of a chaotic eurozone break-up, allow the preservation of the EU and the Single European Market, and enable Europe to focus on new challenges. As for the latter, the big push may be a result of the creation of a customs union with the United States as proposed by Świeboda and Stokes (2012).

A controlled segmentation of the euro area could take place as soon as European elites and public opinion become accustomed to the idea that the euro and the European Union are not one and the same thing, and that the European Union and the Single European Market can exist without the euro and still offer advantages to their members. Also, rules for a new European currency regime have to be established. Until that happens, policy-makers should stick to actions that prevent the current situation from getting out of control.

  1. System in which the bank of issue guaranteed the convertibility of a given currency into gold at fixed parity.

  2. According to Jansen (2004), in years 1991–2002 annual net transfers amounted to 4.6–7.7% of Germany‘s GDP and 26–45% of East Germany’s GDP.

  3. Freezing bank deposits in Argentina in 2001 provoked riots that forced the president and the government to step down. A default was announced as well.

  4. The idea that Germany should leave the eurozone to help restore the competitiveness of the periphery was put forward by Panicos Demetriades (2011) who later, in May 2012, became the Governor of the Central Bank of Cyprus and consequently a European Central Bank Governing Council member.Hans-Olaf Henkel (2011) suggested that Austria, Finland, Germany and the Netherlands should leave the eurozone and create a new currency which would lower the value of the euro, improve the competitiveness of the remaining countries and stimulate their growth.German historian Hans-Joachim Voth (2011), while answering to the question how Europe would look in five years, says: “I can imagine a world where there will [be] a left-over euro: with France, Italy, the Mediterranean countries, perhaps Belgium as well. Apart from that the old Deutschmark zone will return, comprising Germany, Austria and the Netherlands, perhaps Denmark as well, perhaps Finland, which have no problems conducting the same monetary policy as Germany. We had a similar system during the European Exchange Rate Mechanism ERM. That was the optimal system, and then we gave it up for the euro”.The idea that Germany should leave the Euro to help to resolve the eurozone crisis was also argued by Griffin and Kashyap (2012).

  5. “A non-orthodox floating rate regime” means a flexible exchange rate regime, in which the central bank may engage in currency intervention.

  6. Acronym coined from the capital letters of the following countries: Portugal, Ireland, Italy, Greece and Spain.

  7. Gomułka (2012) claims that such socially costly developments would also have positive effects: restoring competitiveness through a reduction in labour costs, an improvement in the trade balance, and they would ‘instill in the memory of the nation and its political elite concern for financial responsibility’.

  8. Currently, of 27 EU countries with 503 million inhabitants, six countries with 134 million inhabitants belong to the first group (PIIGSs plus Cyprus), 11 countries with 199 million inhabitants belong to the second group and ten countries with 174 million inhabitants belong to the third group.


  • Ahamed, L. (2009), Lords of Finance. The Bankers Who Broke the World, The Penguin Press, New York.
  • Blejer, M. and G. Ortiz (2012), ‘Latin Lessons’, The Economist. 18 February.
  • Darvas, Z. (2011), ‘A Tale of Three Countries: Recovery After Banking Crises’, Bruegel Policy Contribution 2011/19. December.
  • Demetriades, P. (2011), ‘It is Germany that should Leave the Eurozone’, Financial Times. May 19.
  • Deo, S., P. Donovan and L. Hatheway (2011), Euro Break-up – the Consequences, UBS Global Economic Research, London.
  • Eichengreen, B. (1995), Golden Fetters. The Gold Standard and the Great Depression 1919–1939, Oxford University Press, New York and Oxford.
  • Eichengreen, B. (2008), Globalizing Capital. A History of the International Monetary System, Princeton University Press, Princeton.
  • Feldstein, M. (2011), ‘Weaker Euro will Help Solve Europe Deficit Woes’, Financial Times. 19 December.
  • Franco, D. (2010), ‘L’economia del Mezzogiorno’, in: L. Cannari, D. Franco and R. Bisceglia (eds.), ‘Il Mezzogiorno e la politica economica dell’Italia’, Seminari e convegni, Banca d’Italia, pp. 1–13.
  • Gomułka, S. (2012), ‘Perspectives for the Euroland, Short Term and Long Term’, Polish Quarterly of International Affairs 25 2, 5–26.
  • Griffin, K. C. and A. K. Kashyap (2012), ‘To Save the Euro, Leave It’, The New York Times. 26 June.
  • Henkel, H. O. (2011), ‘A Sceptic’s Solution – A Breakaway Currency’, Financial Times. 29 August.
  • Iuzzolino, G., G. Pellegrini and G. Viesti (2011), Convergence among Italian Regions, 1861–2011, Quaderni di Storia Economica, Banca d’Italia.
  • Jansen, H. (2004), ‘Transfers to Germany’s eastern Länder: A necessary price for convergence or a permanent drag?’, ECFIN Country Focus (Economic analysis from European Commission’s Directorate-General for Economic and Financial Affairs) 1.
  • Keynes, J. M. (1925), ‘The Economic Consequences of Mr. Churchill’, in: J. M. Keynes (ed.), Essays in Persuasion, Macmillan and Co., London 1933, pp. 244–270.
  • Perotti, R. (2011),’The ‘Austerity Myth’: Gain Without Pain?’, NBER Working Paper No. 17571.
  • Polanyi, K. (1944), The Great Transformation, Reinhert, New York.
  • Purfield, C. and C. H. Rosenberg (2010), ‘Adjustment under a Currency Peg: Estonia, Latvia and Lithuania during the Global Financial Crisis 2008–09’, IMF Working Paper No. WP/10/213.
  • Seitz, H. (2009), ‘The Economic and Fiscal Consequences of German Unification’, Technical University Dresden, Germany, Faculty of Business and Economics, Institute for Applied Public Finances and Fiscal Policy. Presentation at the conference on German Unification University of Haifa, 21–22 January.
  • Sinn, H.-W. and T. Wollmershaeuser (2012), ‘Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility’, International Tax Public Finance 19, 468–508.
  • Świeboda, P. and B. Stokes, eds (2012): The Case for Renewing Transatlantic Capitalism, Warsaw, March, Report by a High Level Group convened by demosEUROPA– Centre for European Strategy (Warsaw), the German Marshall Fund of the United States (Washington DC), Notre Europe (Paris), Stiftung Wissenschaft und Politik (Berlin) and European Policy Centre (Brussels).
  • Voth, H.-J. (2011), ‘The Euro Can’t Survive in Its Current Form’, Interview by Alexander Jung and Gerhard Spörl, Spiegel Online,1518,783281,00.html (accessed August 31, 2011).
  • Wnuk-Lipiński, E. (2004), Świat międzyepoki. Globalizacja, demokracja, państwo narodowe, (Inter-epoch World. Globalization, democracy, national state), Wydawnictwo ZNAK, Instytut Studiów Politycznych PAN, Kraków.