Author: Wim Boonstra, Senior Vice President,Special Economic Advisor and Economist at RaboResearch Global Economics & Markets.

Original Text has been edited

The ‘Muddling Through’ scenario

  • Europe muddles along with an accommodative but increasingly less effective monetary policy
  • Economic growth remains limited and unemployment declines at a slow rate
  • No powerful boost to spending, but budgetary discipline declines
  • The Stability and Growth Pact continues to exist on paper, but is increasingly less effective
  • The Single Market becomes less efficient as border controls increase
  • Brexit degenerates into a messy divorce, and the UK enters a slower growth trend
  • Difficult progress on Brexit makes other countries less inclined to leave the EU
  • The refugee problem continues to be a divisive issue
  • Neither the Banking Union nor the Capital Markets Union will be completed, and there will be no European DGS
  • High unemployment in some Member States will undermine support for ‘Europe’
  • Over time, the situation will become unsustainable

The ‘Further Integration’ scenario

  • Europe finds itself again just in time
  • A weak economy and Brexit lead to calls for more decisive action
  • EU budgetary rules will be temporarily stretched to encourage investment
  • Economic growth and lower unemployment lead to rising expectations for inflation
  • Interest rates rise, yield curves become positively sloped
  • The Banking Union and the Capital Markets Union are completed. An EMU-wide DGS is established
  • Surplus countries ease policy, economic reforms are implemented
  • Gradual convergence of rates and base for corporate income tax
  • Convergence between the Member States increases, as their prosperity levels grow towards each other
  • Strong growth in cross-border labour migration
  • The eurozone develops into an optimal currency area
  • Post-Brexit, the UK increasingly underperforms

The ‘Disintegration’ scenario

  • The Brexit negotiations do not go well and lead to differences of opinion within the EU
  • Cooperation between EU countries deteriorates further, and anti-EU sentiment rises
  • Some Member States leave the eurozone, and their currencies depreciate heavily
  • Financial chaos: the departing countries remain in default on their government debt
  • The Banking Union falls apart, with some countries being forced to nationalise several major banks
  • A decision is taken to dissolve the euro, and this involves capital restrictions
  • The Single Market disintegrates, leaving only a rudimentary customs union
  • Political cooperation ceases; the European Parliament is disbanded, Brussels becomes a ghost town

The ‘two-speed’ scenario

  • The EU Member States decide to review their cooperation
  • Some countries (the ‘periphery’) will leave the eurozone in a process controlled by the ECB; they will remain in the Single Market; depreciation of peripheral currencies will remain limited, with no bankrupt governments
  • The remaining countries (the ‘core eurozone’) intensify their cooperation economically, politically and militarily
  • The core eurozone will strive to become an optimal currency area; the Single Market will be expanded
  • Schengen will continue, but its area will contract.
  • After an initial depreciation against the dollar, the core euro will increasingly strengthen
  • Slower growth and a deflationary shock in the core euro area will lead to budgetary easing
  • The EU Member States outside the core eurozone gradually fall behind, making it increasingly difficult for them to join the core eurozone
  • The European Commission will increasingly become an executive body, and political power will rest with the Member States
  • Dissatisfaction will decline in the core countries; in the periphery it will rise

Economic Effects

The muddling through scenario in which cooperation is faltering but the EU continues to strive to maintain or even bring about further political integration - is not a sustainable scenario in the longer term. The reason for this is that the desire in broad swathes of society for less European integration has little or nothing in common with the current situation in which the government has ceded sovereignty within the eurozone/EU. Many eurosceptics see the European Union as a monolith that fails to take account of national interests: a ‘one-size-fits-nobody’. This situation can only be resolved by either further and more rapid integration or a step backwards for European integration. In the case of further integration, the Member States will adjust to the European norm, with further diminishing sovereignty for the individual Member States, leading to ‘one-size-fits-all’. A step backwards means more powers being returned to the Member States, so that more ‘sizes’ are possible, of which the two-speed scenario and the disintegration of the Union are two examples. Each scenario thus has its financial and economic consequences.

The economic transmission channels

It is important to realise that each scenario has its advantages and disadvantages. While the following analysis concentrates on the financial consequences of a complete or partial unravelling of European cooperation, there are also costs associated with the scenarios of ‘muddling through’ and ‘further integration’. In all cases, account has to be taken of the unsustainable debt of a number of Member States, Greece in particular, whereby the other Member States will be faced with costs. This may be done willingly or unwillingly and in the form of debt restructuring and/or the straightforward bankruptcy of debtors in weak Member States. Membership of the EU also means that resources have to be transferred to ‘Brussels’ and for the countries participating in the euro of course formal lack of autonomy with respect to monetary and exchange rate policy.

The other economic costs of the various scenarios will come through the following transmission channels:

1) The effect on international trade

First of all, the economic effects of European integration or disintegration will be felt through trading relationships between the countries. This is not surprising, given the deep economic interrelationship between the various EU Member States. The conclusion from this is that the scenario in which the Single Market falls apart (‘disintegrates’) will entail the highest cost in terms of economic growth and employment losses. Trade between the Member States has been an important source of prosperity for all the EU Member States. This also means that if this trade were to contract due to European disintegration, there would be very negative consequences for growth and prosperity in the EU Member States. This applies especially to the smaller countries with relatively extensive international trade in proportion to the size of their economies.

One important conclusion from this is that if people prefer to move towards ‘less Europe’ for political reasons, it would be sensible to look for ways of doing this that harm cross-border trade as little as possible. There is also the point that smoothly operating international trade agreements between the countries involved also require an institutional framework so that compliance with these trade agreements can be monitored. Without such institutions, cross-border trade will be seriously damaged.

2) The Single Market can also operate without a common currency

The Single Market is older than the eurozone. It is a fact that cross-border trade can also take place without a common currency. Importers and exporters will be exposed to greater currency risk, which will make trade more difficult. Hedging this risk will involve costs for business operators. The European market will also become less transparent in case of a return to national currencies, since conversion to different currencies will be required. At the same time, with current technology webshops may be expected to be able to quote prices in various currencies in real time. So the absence of a common currency and continuing with national currencies will have much less effect on market transparency than it would have had in 1999. Nevertheless, for countries that also traditionally enjoyed highly stable mutual exchange rates before the introduction of the euro, there will be little point in abandoning the common currency. The break-up of the euro and a return to national currencies could also entail very high costs.

3) The costs and benefits of breaking up the euro

There are countries that joined the eurozone primarily for political reasons without realising the economic consequences of this step. The possibility for a country to restore its competitive position if necessary by devaluing its national currency was sacrificed for the simple reason that Member States no longer have a national currency. The participating countries also failed to make proper policy agreements. The much-discussed Stability and Growth Pact consists only of agreements on government finances, and does not include anything on real convergence between countries. Furthermore, there were no agreements in relation to the division of the adjustment cost between surplus and deficit countries in the event of unsustainable balance of payments positions. This adjustment cost when cases arose thus fell fully on the deficit countries, meaning that the system was even more rigid than the Gold Standard or the Bretton Woods system. Where necessary therefore, joining countries had to initiate a radical reform policy to improve their competitive position and keep this at a higher level. In a number of cases they failed to do so, which led to the euro crisis spiralling so far out of control. Participation in the eurozone has thus delivered little economic benefit to the countries concerned, leading to an increasing perception that it would be better to abandon the euro.

But one cannot turn the clock back. Unfortunately, it is not the case that if a country exits the euro and introduces a national currency that all the disadvantages of eurozone membership will immediately disappear. There have now been years of financial integration between the Member States, so that exit from the eurozone could involve high or even very high costs

a. Domestic financial stability will be the first to suffer

The full or partial break-up of a currency union such as the eurozone is a complicated task. It should not happen in a hurry, as this could lead to serious shocks in the financial markets. At the same time, it should be clear that any indication that a country is considering its options with respect to leaving the euro may lead to serious unrest among the population. Certainly in countries where the newly introduced currency is expected to sharply depreciate, one may assume that people will prefer to hold their bank balances (and savings) in physical cash in the hope of making a profit in due course. Only a rumour that a country intends to leave the euro could therefore result in a bank run and the suspension of free movement of capital. The authorities will introduce this measure to prevent massive transfers of funds held at banks to other countries. From the moment the first rumour appears therefore, financial stability will be under pressure.

4) Effects of exchange rates on the economy

If a country faces a sharply rising exchange rate on a trade-weighted basis, this will initially have a negative effect on the economy, as a direct consequence of a worsening international competitive position for its industry. This will be reflected in falling export growth, or even a contraction of exports. Import prices will at the same time fall, which will dampen the rate of inflation or even lead to deflation (a decline in average prices). The net effect of these two forces cannot be predicted in advance. Weaker growth of exports will depress economic growth, but falling prices (in the first instance, for as long as incomes do not fall) will lead to higher purchasing power and possibly to higher consumer spending. This will in turn increase imports, thus worsening the country’s external position further. Lower inflation will also lead to low interest rates, which will pressure the coverage ratios of pension funds, which have already had to absorb large capital losses. The effects described above are indeed typical for a strong country. This is the situation in which the Netherlands and Germany could find themselves if the euro completely or partially breaks up.

The reverse will apply to the weaker countries. A weak new currency raises the competitive position and encourages exports (assuming that the country in question has an export business of significant size). Import prices will increase sharply, pushing up inflation and interest rates, and, if the country has sizeable foreign debt, a default to a greater or lesser extent will be likely.

One has to conclude that leaving the euro will entail huge costs. In some Member States, many economic problems will unfairly be attributed to the euro, while their real cause lies in poor domestic policy. Return to a national currency can never be an alternative to pursuing a sound economic policy. Any leavers will soon realise that the need for economic reforms and a sound budgetary policy is as pressing as ever. 

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