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Should Germany Leave the Euro?

December 2, 2010

While much of the fear of the disintegration of the euro has been based on the idea of members having to leave the euro, the BBC posted an interesting blog on Tuesday about the possibility of Germany leaving the euro.  The logic had been that countries such as Greece would need to exit the Eurozone and adopt its own currency in order to regain competitiveness through devaluation.  If two countries use the same currency, then competitiveness is based on productivity, but when using different currencies, the exchange rate could change to help the less productive country still compete on price.

However, Stephanoimics examines the opposite idea—maybe the Eurozone would be better off by shedding some of its most productive members, such as Germany.  The Germany economy is doing much better than many of the other Eurozone members (see “The Ties Between Growth and Currencies” and “Comparing the Plight of the American and European Economies” for more information).  In addition, while exports are Germany’s economic engine, many of its exports are products where quality is more important than price.  After all, Germany’s exports to the U.S. rose by 12% in the first half on 2011 compared to the same time last year, despite the euro’s wild ride this year.

A German exit from the euro would in turn cause their new currency to appreciate while the euro would depreciate, meaning that states with lower productivity would then be able to produce more competitive products compared to Germany and hence help their economies grow.  To illustrate the point, imagine that a German firm and a Greek company each produce steel at €1,000 a ton.  Now imagine that Germany leaves the Eurozone.  Its new currency (which we well call the *) would initially have an exchange rate of *1 = €1 with the euro, but the euro would quickly depreciate–let us assume that the rate falls to *1 = €1.50.  As a result, while the Greek steel still costs €1,000 to produce (as Greece still uses the euro), but it can now sell its steel in Germany for *666.67 a ton (€1,000/ton multiplied by *1/€1.50).  Thus the Greek steel would be much cheaper to a German consumer than before.  Of course, while Italian cheeses, Spanish villas, and Greek vacations would now all be cheaper for Germans, German cars would become more expensive in Spain et al.

In addition to hurting the German exporter, this appreciation would also hurt German banks and investors, since they would still have a lot of assets valued in euros which would suddenly be worth less.  Now, imagine that a German bank is holding a €100 bond from Ireland.  Again, assume that Germany’s new currency is *1 = €1.50.  As a result, while the €100 is still worth €100, it is now worth only *66.67, meaning that the German bank’s asset has lost a third of its value simply due to the introduction of a new currency.

As a result, it is in Germany’s best interest to stick with its neighbors and ensure that not only does the Eurozone survive, but no one defaults.  After all, German banks are stretched across Europe and have a large exposure to debt in many of the countries now threatened with default.  Also, for those German exports who do produce products which are sensitive to exchange rate fluctuations, a devalued euro helps them.

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