Glad to see Krugman and his circle have finally caught up with what some of us have been saying for months, Andrew. As I wrote in the American Spectator last November:
A few weeks ago I bet the brilliant economist David R. Henderson that Greece, Italy and Spain would be out of the euro by March 2013 (for avoidance of doubt, we agreed that whatever currency union Germany was part of then would count as the euro). David agreed with me that the currency union would break up, but did not believe it would happen as fast as I thought. On his side, he cited Milton Friedman’s observation that his predictions were always right in terms of direction, but wrong in time – free-marketers, it seems, have a habit of predicting things to happen sooner than they actually do.
My reasoning, however, was that any break-up of the euro would happen extremely quickly. The problem, as I see it, is that as soon as the dam breaks, the deluge will be devastating. If Greece goes, then who is to say that Italy or Spain, both suffering the same sort of fiscal problems as Greece, won’t be next? The result is likely to be that there will be a flight to safety, with investors withdrawing their money from institutions in those countries, and taking it to Germany. Such a flight would be a tremendous shock to Spain and Italy, and bring utter ruin to them. They could not survive in the eurozone, and would default out of it. Chaos would ensue.
I therefore suspect that the Germans, along with the French, will not allow this. For the sake of prudence, I would suspect a sudden, surprise reduction in the size of the eurozone, with Spain, Italy and Greece (and perhaps others) returning to their national currencies almost overnight, leaving a New Euro zone consisting of the more stable economies of the current eurozone.
This will, of course, be a real shock for the former eurozone members. Bad as it will be, however, it will not be as disastrous as the alternative. Expulsion will be better than collapse. Moreover, there will be an upside for the former members. They will once again have control of their monetary policy. Wages and internal costs will contract, but this should provide a comparative advantage within the EU that they currently do not have. Their export trade will boom.
Moreover, these countries have an innate advantage in that they are excellent tourist destinations. The disadvantage of having to change money will quickly be outweighed by much more affordable holidays. The influx of foreign money from tourism will be most welcome to these countries. Assuming that they also take the opportunity to cut back their bloated public sectors, investing in more sustainable parts of the economy instead, the future will look rosy for these newly liberated economies. Europe will become a region of competitive federalism, much more like the United States (even if it lacks a single currency).
That is why the euro was always a bad bet for Europe. The economies of the eurozone were too diverse to be marshaled together under a monetary union. The strains were bound to show eventually. The only question remaining is whether these strains are going to lead to clean or violent breaks.
This could all happen extremely quickly. The fact that the Target-2 system increases strain on Germany in the event of capital flight just reinforces that. The current stasis in Greece at least allows some breathing room while reelections are held. I also have to adjust my remarks from last year in light of the French elections — I cannot now see France being part of the New Euro, 50 years of Franco-German entanglement notwithstanding. If it does play out this way, the question now is whether the EU itself can survive.