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For euro zone, breaking up is just too hard to do

Source: Reuters - Wed 1st Dec 2010

That may seem a reckless notion to advance just as Ireland becomes the second highly indebted member of the 16-nation single currency area to require a bailout, following Greece, and as bond markets close in on Portugal and Spain.

But the cost to any country of leaving the euro zone would be so high, and the damage that an exit would inflict on the currency and the remaining members so great, that no government would rationally choose to secede, or to push another out.

Argentina's 2001-2002 economic crisis and $100 billion (64 billion pounds) bond default, which reduced millions of people to poverty, would pale in comparison with the likely chain reaction across Europe.

"There would be chain bankruptcies. A run on the banks would be certain. It would be far worse than Argentina" said Jean Pisani-Ferry, director of the Brussels economic think-tank Bruegel.

The "costs of the non-euro", as they are sometimes called by Brussels insiders, would be multiple: political, economic, social, reputational and strategic.

The common currency launched in 1999 is the apex of half a century of European integration. Even a partial breakup would be a momentous setback for the European Union, including for the 11 member states that have not, or not yet, joined the euro.

The 27-nation EU, which struggles to make its voice heard in a world where emerging powers are challenging U.S.-led Western hegemony, would suffer a devastating loss of prestige.

It is hard to imagine the EU's single market in goods, services, capital and labour, the foundation stone of European prosperity, remaining intact if countries quit the euro, triggering disorderly devaluations and chaotic financial flows.

The exit of a state such as Greece, Ireland or Portugal, or the imagined departure of economic giant Germany, would cause immense bitterness and could revive national conflicts that European unification was meant to bury forever.

Germany, which sells more than 50 percent of its exports to the euro zone, would lose vital markets and likely end up with a overvalued currency that would impede its international economic competitiveness.

"The political consequences would be dreadful. There would be almighty recriminations. A country that left the euro would no longer be friends with the others" Pisani-Ferry said.

U.S. economist Barry Eichengreen, who authored a classic 2007 paper arguing that the single currency could not be undone, reaffirmed that belief in the midst of the Greek crisis.

"Adopting the euro is effectively irreversible" he wrote in an article on the economics website Vox.

"Leaving would require lengthy preparations, which, given the anticipated devaluation, would trigger the mother of all financial crises" said Eichengreen, a professor at the University of California, Berkeley.

Households and companies would shift deposits to other euro zone banks or countries to protect their savings, starting a system-wide run on banks, capital outflows and asset sell-offs.

Fleeing investors would create a bond market stampede.

Since foreign debt would still be denominated in euros, a seceding state would almost automatically default, causing acute solvency problems not only for its own banks but for banks across Europe. It might be shut out of international capital markets for years and have to balance its budget immediately.

Domestic debts would either be converted to a devalued national currency, inflicting severe losses on creditors, or repayable in euros, bankrupting debtors.

The administrative and legal costs and complications of recreating a national currency would be enormous. Businesses spent billions over several years to prepare for the changeover. Any country leaving would have to start again from scratch.

"Households would probably try as much as possible to hoard fiduciary euros and resist converting them into the new national currency" economist Gilles Moec of Deutsche Bank wrote this year. "This would probably drastically reduce current spending."

Any attempt to fix a new exchange rate would likely come under immediate attack on currency markets, while a float would initially trigger an uncontrolled depreciation of the new money.

Trade flows would be severely disrupted. Business costs would become unpredictable, inhibiting investment. Labour unrest and social strife would be inevitable as citizens faced mass unemployment, inflation and brutal public spending cuts.

That would far outweigh any potential boost to exports or tourism revenues from a devaluation.

"But what if the bank runs and financial crisis happen anyway?" Nobel prize-winning economist Paul Krugman asked on his blog last week, citing a slow-motion run on Irish banks.

An exit that is neither planned nor chosen but imposed by irresistible market forces would dramatically reduce the marginal cost of leaving the euro, Krugman contended.

That economic logic underestimates the political will that has driven European monetary union since its inception.

The creation of the euro was a triumph of politics over economics. Don't bank on that being reversed now.

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