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Four scenarios for Europe: the economic effects

Economic Report


To overview page future scenarios for Europe

  • Each scenario has its economic advantages and disadvantages, but the differences are significant
  • For the Netherlands, membership of the Single Market is of the utmost importance. If the Single Market falls apart, the effect for the Netherlands will be disproportionate
  • The euro is less important than the Single Market, but exit from the eurozone will also involve high costs for the exiting countries
  • The key economic transmission channels are: foreign trade, exchange rates, the pension funds and presence of foreign companies in the Netherlands

The above shows immediately that the current situation - 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 rest of this paragraph gives a general description of the main effects and how these will affect the economy (the transmission channels) and their 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 de euro of course formal lack of autonomy with respect to monetary and exchange rate policy. The purpose of the following analysis is thus above all to identify the items needed for a proper cost/benefits analysis.

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

1) The effect on international trade is crucial for a trading country like the Netherlands

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. Over the years, the Netherlands has focused heavily on transport and logistics, has positioned itself as a major international trade hub and is also the location of many European head offices of large corporations. The Netherlands thus has a lot to lose if the EU disintegrates, and more than most other countries. This is an undeniable fact (Teulings et al., 2011).

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 in 2016 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, as explained below.

3) The costs and benefits of breaking up the euro

As we said in our introduction, there are countries that joined the eurozone primarily for political reasons without realising the economic consequences of this step. Joining the eurozone means joining a monetary union with two of the world’s most competitive economies, Germany and the Netherlands. 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. This is nothing new: it was extensively explained by economists in the years prior to the euro’s introduction (see for instance Jonung & Drea, 2009). 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 (Teulings et al., 2011). We will attempt to clearly explain these potential costs in the rest of this paragraph.

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.

b. Exchange rate effects on the international asset position


Figure 1: Dutch securities holdings abroad (ultimo 2014, bn EUR)
Figure 1: Dutch securities holdings abroad (ultimo 2014, bn EUR)Source: DNB.

The Member States of the EU and certainly those in the EMU have built up large mutual claims over the years. The figure below illustrates the gross amount of Dutch financial  assets held abroad and how this is distributed between countries. In one scenario (‘disintegration’), in which the Netherlands will proceed with its own currency that will be linked to the currency of Germany, there is a good chance that the new Dutch currency will appreciate relative to the currencies of other EU Member States and that the Netherlands will suffer serious exchange rate losses on its foreign assets. At the end of 2014, the Netherlands had more than 500 billion euros in investments alone in holdings in the other euro countries (excluding Germany, where the Netherlands had additional investment holdings in excess of 200 billion euros). If the new currency of the German/Dutch bloc appreciates by 10 per cent on average relative to the other EU Member States, one can expect losses due to exchange rate movements alone to amount to around 50 billion euros. It should be noted that this figure only concerns currency effects on its securities holdings. It does not include the potential losses on direct investments. Changes in value as a result of movements in the stock and bond markets are also not included. There will also be losses on claims on other European Member States, including the balances in the Target2 payment system and the obligations entered into in recent years in the context of European rescue operations.

The above is also subject to numerous uncertainties. Most of the mutual financial claims and liabilities are in euros. The mutual contracts are in euros, and – in advance – it is not clear what currency will be the legal successor of the euro.

Box: How will euro contracts be settled after the eurozone breaks up?

The importance of this issue can be illustrated by the following theoretical example. Let us assume that Greece leaves the euro and introduces the New Drachma (ND), that the ND declines 20 per cent against the euro and that German investors hold 10 billion euros in Greek government bonds. The Greeks will want to redeem the obligations in ND at the rate of EUR 0.8 per ND. German investors will then receive the equivalent of 8 billion euros and incur a loss of 20 per cent. From the other point of view, the Germans will insist that the contracts are in euros and therefore are still worth EUR 10 billion. This would mean that the Greeks would have to pay 12.5 billion ND, and from their point of view their debt would have increased by 25 per cent. It should be obvious that such sharply conflicting interests are a recipe for lengthy and acrimonious legal battles. One way or the other, the German investors will have to take their losses in this example. For it is highly likely that the Greek government would default on its debt if its debt level were to rise by 25 per cent relative to the Greek economy, asthis would in turn mean that Greece would have no further access to the international capital markets to fund new deficits.

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. For a country such as Italy, which still has a strong industrial base and no excessive current account deficit, a controlled return to a national currency could in theory turn out rather well. However, this needs heroic assumptions, such as a smooth transition, no serious problems at the Italian banks and that Italian policymakers suddenly pursue a sound policy after leaving the euro. For countries such as Portugal and certainly Greece on the other hand, which have no industrial base worthy of mention and a weak external position and in the case of Greece weighed down by a huge burden of debt, the costs will by definition have the upper hand and there will be the danger of financial chaos.

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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Wim Boonstra
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 5128 1405
Martijn Badir
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
Elwin de Groot
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 1389 2916
Carlijn Prins
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 1929 6455
Daniel van Schoot
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
Maartje Wijffelaars
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 2257 0569
Nic Vrieselaar
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 2216 2257

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