Thoughts on an (unlikely) exit for EMU

There have been more talk in recent days that a current member of EMU will look for an exit. Greece is serving as the lightening rod, with 10-year bond yields soaring 23 bp today. Many observers have referring to the risk as being in the PIIGS countries-- (Portugal, Italy, Ireland and Greece).

Some of the market talk focuses on the near-term--this year. We think those arguments are largely spurious. Thomas Schelling, the Nobel prize winning economist, talked about different negotiating positions in the context of game theory. He called one set "burning bridges". Under this tactic, one would demonstrate one's resolve by denying alternative course. For example, in the game of chicken where two people drive their cars at each other and the first one to turn loses; if one wants to convince one's adversary that one will not turn, Schelling suggests throwing one's sterling wheel out the window.

Similarly, in EMU, there is not a plan B in case monetary union does not work. EMU members have in effect thrown its steering wheel out the window. Business people are familiar with cost of entry, but what we are talking about here are the costs of exit and they still seem to be prohibitive.

What would happen if a country were to leave EMU? Interest rates would like rise dramatically. The new currency would likely be weak. Even though the introduction of a new currency might actually be positive for GDP, it would unlikely be sufficient to offset the other negative shocks and the economy would risk a deep contraction. Inflation would likely rise sharply. The debt to GDP ratio would blow out and credit ratings may be slashed. The economic fallout could potentially be so severe that the political elite who made the decision could be turned out of office. This would seem to undermine the very reason that a country would ostensibly drop out of the euro zone.

That said, over time the cost benefit of being in rather than being out may change. No member of the euro zone has been able to match Germany's limited gains in unit labor costs. This means that within EMU, countries, especially those that have extensive use of indexing (tying price of some goods, but especially wages) to inflation, continuously see their competitiveness erode against Germany. At the same time, some countries, like Ireland and Greece who may compete in third markets with non-EMU members, are being squeezed by the depreciation of sterling and, say, some east European countries' currencies.

At some juncture, the risk-reward may shift from staying in to leaving. However, we would argue that this is not the case presently. In fact, we continue to argue that EMU will have another member before one leaves. The most likely candidate now is Estonia. Of course, the chances of a western European country joining, like the UK, Switzerland, Sweden, Denmark or Norway seems unlikely over the next several years, though opinion polls in Sweden and Denmark seem a bit in flux.