The future of the euro: to integrate or disintegrate?

Partial or total disintegration is often seen as a likely outcome, though it should be avoided to prevent economic chaos, says Robeco Chief Economist Léon Cornelissen. “We can imagine a number of different ways in which the Eurozone may disintegrate,” he says. “These include the rise of populism, tensions between member states, growing economic divergence, the collapse of a national banking sector and government debt spiraling out of control.”

“One country that is probably more threatening to the Eurozone’s existence than others is its third biggest economy – Italy. The Italian economy has hardly grown since it joined the euro, its debt ratio is massive, its banking system is weak, and the Eurosceptic Five Star Movement is currently a frontrunner in the polls.”

Cornelissen says the Brexit showed it is possible to leave the EU, but no nation has ever left the Eurozone. “In the case of an exit-vote win, the country in question (such as Italy) could immediately initiate steps to unilaterally leave the euro, and this would set off a number of adverse reactions.”

“Severe capital restrictions would have to be implemented immediately to stem the flow of capital leaving the country and try to save the banking system. Banks would probably need to be nationalized. And trade would be badly hit. The economic costs of this scenario would be unbelievably high for all countries involved.”

The extreme economic and political costs are the main reason why there will always be a drive towards the other option – moving forward with integration – says Lukas Daalder, Chief Investment Officer of Robeco Investment Solutions.

“One idea that is often mentioned is the creation of European bonds: bonds issued on a supranational rather than national level,” he says. “These bonds would certainly end the possibility of speculation of a break-up. A complete banking union is another potential step, but one which is much less discussed nowadays. A European-wide deposit guaranty would prevent a bank run, if a sovereign issuer appears to be running into financial trouble.”

Although these steps help reduce speculative attacks, ultimately, measures should be taken to make the Eurozone more of a real single currency, he says. The euro’s main problem is that as something shared by 19 disparate economies and cultures, it isn’t an optimal currency area. For that you need to meet four criteria: full labor and capital mobility; symmetrical business cycles and a fiscal transfer mechanism.

So what about maintaining the status quo? “In itself, there is no real reason why we can’t continue with the current let’s-not-fix-anything-and-hope-for-the-best approach in the short run,” says Daalder. “If the central bank is more than committed to it, then doing nothing – although it’s not the best solution – may still be enough.”

“Having said that, there may be a limit to the ‘whatever’ Draghi has mentioned. The rising imbalances in the Target2 system which processes euro transactions mean that the financial stakes are increasing. As we have seen in the case of Switzerland, even a central bank can decide that the financial risks become too big.”

“Additionally, looking at the rise of populism we have seen in recent years, it is also clear that ignoring the wishes of the people and not changing anything is not a sensible approach either. What will eventually prove enough to ensure the Eurozone’s survival in its present form for the next five years remains to be seen.”

This article is a summary of one of the five special topics in our new five-year outlook.