We haven’t seen too many prominent voices saying what many people are thinking – why don’t some of these smaller less competitive countries just leave the Euro? Well, that’s exactly what Paul Krugman is saying in a piece today. It’s rather simple really as Dr. Krugman states:
“So here it is: yes, Cyprus should leave the euro. Now.
The reason is straightforward: staying in the euro means an incredibly severe depression, which will last for many years while Cyprus tries to build a new export sector. Leaving the euro, and letting the new currency fall sharply, would greatly accelerate that rebuilding.”
The math here is simple. Cyprus, like most of the other peripheral countries is a chronic current account deficit nation. That means more income goes out than comes in via trade. In a normal currency environment with floating exchange rates the trade imbalance would largely rectify itself through exchange rates as the Cypriot Pound falls against the Euro and makes Cyprus more competitive. Obviously, they don’t have that option since Cyprus is a user of the Euro. Cyprus also can’t prop up domestic demand by printing money. So the only way to fight deflation is by letting it run its course. That’s what’s basically occurring across most of peripheral Europe right now and it’s extremely devastating from an economic perspective. The deflation adjustment is a much longer and slower process than being able to drive down your currency or just print money. So that’s the 30,000 foot view.
Now, the tricky part is that the Germans run the Euro system. And they know damn well that they’re the beneficiaries of being the trade surplus nation within a single currency system like this. But Germany’s Bundesbank mentality also doesn’t want to allow money printing for the periphery. So that’s a no go. And if you allow nations to leave the Euro then Germany’s strength via trade is diminished. In a worst case scenario Cyprus leaves, then Greece leaves, then Portugal leaves, etc. And as all these nations bring back their old currencies their recitified imbalance becomes Germany’s loss. In other words, Germany will suffer by allowing nations to leave the Euro. So that’s why you’re seeing Germany do everything they can to keep that first domino from falling.
I think there are options here, however. Personally, I think Europe should move more towards a United States of Europe with a central Treasury and Euro Bonds. Europe is getting smaller in my opinion and proximity makes unification via the monetary system an increasingly necessary and practical move. But the different cultures aren’t quite ready for such a swift change so we’re seeing major roadblocks. That’s understandable, but they’re fighting an inevitable trend in my opinion. Moving back to the old currency design is a potentially painful and regressive step in Europe’s history. But if Germany won’t move forward then Cyprus has no real option other than to do what’s in the best interest of its people and that could mean leaving the Eur0.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.