Fears over a French franc return
Europe’s fading will on integration
by Stephen Cecchetti in Boston and Kim Schoenholtz in New York
Wed 22 Feb 2017
In 2012 the European Central Bank stood up to a mortal threat to the euro. Fears of redenomination – the reintroduction of domestic currencies – were feeding a run away from banks in the euro area periphery and into German banks. Mario Draghi, the ECB president, pledged in London in July 2012 that the ECB was 'ready to do whatever it takes to preserve the euro'. Since then the ECB has done things that once seemed unimaginable, helping to support the euro and secure price stability. Since March 2015, the ECB has acquired more than €1.3tn in euro area government bonds, bringing its total assets close to €4tn.
So far, it has been enough. But can the ECB really do 'whatever it takes'? Ultimately, monetary stability requires political support. Without fiscal co-operation, no central bank can maintain the value of its currency. In a monetary union, stability requires a modicum of co-operation among governments.
Developments in France have revived concerns about redenomination risk and the future of the euro. If Marine Le Pen, leader of the National Front, wins the presidential election in May, the plan reportedly is to withdraw from the euro and reintroduce the French franc. France would then convert the bulk of its €2.1tn in government debt into the new currency, and engineer a depreciation to make repayment easier and improve the country's competitiveness.
Representatives of S&P and Moody's, the ratings agencies, have said that this would be a default – by far the largest sovereign default in history. Le Pen is leading in some recent polls, and bookmakers give her around a one-in-three chance of becoming president. One should recall that the odds of a Donald Trump victory were no higher a few months before the US elections.
To understand the consequences – just of the heightened risk, not the realisation – consider how other euro area countries would react if France left the euro. Small peripheral economies – Cyprus, Greece, Portugal – might be inclined to depart quickly. If, as we suspect, Italy and Spain also follow, the euro as we know it would be finished.
Italy deserves some focus. The Italian banking system is weak and needs recapitalisation, as do banks in other parts of Europe. Addressing this capital shortfall is a question of how, within the context of the rules of the EU Recovery and Resolution Directive, to come up with the tens of billions of euros needed to keep Italy's banks afloat. Yet, unless policy-makers seriously miscalculate, this is not an existential challenge for the euro.
French redenomination is different. The stable political relationship between France and Germany is at the core of the euro and the European Union. A French government that abandons the euro would be a far greater political shock than Britain leaving the EU.
European economic and monetary union has never been primarily an economic endeavour. Its founders viewed EMU as a step towards political union. Some (and perhaps many) EMU advocates understood that a common currency would lead to stresses – financial, economic, and political. Yet their experience with the disaster of 20th century European nationalism and with the policy developments that preceded the euro led them to expect that these stresses would push future European leaders to make greater sacrifices of sovereignty to save and advance political union. As we wrote two and a half years ago, that outcome was never pre-ordained. Now, it seems, the public’s will to continue is more uncertain than ever before.
When asked, the British voted to leave the EU. Will the French, when they are given the opportunity in a few months, opt to leave the euro? Will the nationalism that led to repeated 20th century catastrophes resurface? We surely hope not. But markets price risk, not hope.
This is the first in a two-part article by Stephen Cecchetti and Kim Schoenholtz. The original version appears on the authors’ website, Money & Banking. Cecchetti is Professor of International Economics at the Brandeis International Business School. In 2008-13 he was Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements. Kim Schoenholtz is Professor of Management Practice in the Department of Economics at New York University’s Leonard N. Stern School of Business and Director of NYU Stern’s Center for Global Economy and Business. He was Global Chief Economist of Citigroup in 1997-2005.
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