Too European to Fail

BERLIN – Among investment bankers, there is renewed speculation about the possibility of a country leaving European Monetary Union – or being pushed out. Rating agencies have downgraded Portugal, Greece, and Spain, owing to their poor prospects for economic growth and weak public finances. Ireland has been assigned a negative outlook and could soon suffer a downgrade as well.

With fears mounting that one or another euro-zone country may default, yield spreads on government bonds between EMU countries have reached record highs. For some time now, Greek ten-year government-bond yields have been about 300 basis points above German yields. This is a sign that investors now see a significant risk of a Greek default or of Greece exiting from EMU and redenominating its government bonds.

But the panic that EMU may disintegrate is overdone. Rather than a default and subsequent exit from the euro zone, the member states are more likely to overrule a fundamental principle of EMU and bail out a fellow member state.

Leaving EMU would be a costly option for weak-performing countries. Of course, regaining the exchange rate as an instrument for competitive devaluation could help overcome competitiveness losses due to soaring unit-labor costs. As Argentina showed after its default and devaluation in the winter of 2001/2002, such a move can reignite exports and economic growth.