The Independent Market Observer

Special Report: Europe and the Euro (Part 5)

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Aug 17, 2012 9:27:42 AM

and tagged Europe

Leave a comment

Should Countries Stay or Go?

Today, we’ll explore why countries would stay in the eurozone, the consequences to them if they were to leave, and what would cause them to exit.

Germany has big incentives to remain in the euro that are both economic and political. I will not cover the political incentives here, as I discussed them in an earlier post. The economic incentives relate to Germany’s large export sector, which constitutes a great deal of its employment structure.

Exports benefit from market access, a weak currency, and competitive cost structures. Within the eurozone, Germany hits the trifecta: the eurozone provides full market access to its member countries, the euro is weaker than a new Deutsche mark would be, and Germany is much more productive and efficient than any of the other eurozone countries. Many of the same benefits apply to its exports outside the zone as well.

Conversely, exiting would reverse all of these benefits. Protectionism would very probably rear its head in the aftermath of a euro collapse. The new German currency would immediately become one of the strongest on the planet, and with the freedom to devalue their new currencies, the other eurozone countries would become more competitive. Because exiting the euro would promptly hit the key areas of the German economy, the internal economic incentives are overwhelmingly in favor of Germany staying.

The external economic factors, historically, have also supported Germany remaining with the euro—but that is changing. The benefits of the euro are significant to Germany, and until the past couple of years, the costs were largely borne by other countries. As Germany has had to provide cash to support other countries, however, the costs have risen to the point where some analyses suggest that it may be cheaper for Germany to leave. The argument is not clear-cut, but the fact that it is even being discussed is potentially a game changer.

France is the other core country that defines the eurozone. Unlike Germany, however, France is suffering economically. It still benefits from the euro, but much less on an economic basis than Germany does. Much of the benefit France has derived from the European Union and the euro has been political; as a result, there has been little economic benefit to offset the rising costs, and the economic costs have been mostly irrelevant to the internal discussion of whether to remain. This can be seen in the recent election results; right after the election, the new Socialist president announced measures calling for increased public spending and a reduced retirement age—the direct opposite of what is being prescribed for the countries that are in trouble. Clearly, France is marching to its own drummer on economic matters.

France is rapidly approaching a point, however, where it, too, will have to decide whether to reduce wage and labor costs or leave the euro and devalue. Current spending is not sustainable, and the problem will get worse. While France, itself, would probably not crash the system in the next couple of years, it is rapidly becoming too weak to be part of the solution; as such, France will continue to lose its influence and bargaining power in deciding how the process moves forward.

Politically, France has placed itself so it cannot afford to leave; economically, it has placed itself so it (literally) cannot afford to stay. Which perspective prevails is what will determine the end results. The economic costs of staying will be reduced wage and labor costs: lowering state benefits, decreasing labor wages and protections, raising retirement ages, and cutting pensions and other spending—in other words, being much less French and more German. Perhaps the biggest cost of leaving would be the political loss of status as one of Europe’s leading powers. The economic costs of leaving would involve a new (and much weaker) French franc that would either make servicing the existing euro debt and liabilities much more expensive or require repudiating and renegotiating those obligations—including with Germany.

Spain and Italy are in similar positions to France, but they are two to three steps closer to the endgame. Spain’s economics are eroding so rapidly that we can expect a rescue to be necessary soon. Italy is economically more sound, but it is politically weaker and faces a different set of problems with the same ultimate result. Economics demand that, for these countries to stay in the eurozone, they must conform to German demands. They have two options as well: reduce their wage and labor costs and fit themselves into a German-led federal United States of Europe or leave the eurozone to be free to devalue.

Subscribe via Email

New call-to-action
Crash-Test Investing

Hot Topics

New Call-to-action



see all



The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.


Please review our Terms of Use

Commonwealth Financial Network®