Germany can save the euro by bringing back the Deutsche mark

The euro is the official currency of the eurozone. It is used by the institutions of the European Union and by 19 of its 28 members. Globally, it is the second-most traded money and reserve currency, used by around 400 million people. It was introduced as a unit of exchange in January 1999, and as a physical currency in January 2002.

Beginning in 2009, a sovereign debt crisis emerged in the eurozone. Principally affected were Ireland, Portugal, and Greece, all of which required financial assistance from the European Financial Stability Facility (EFSF). Other countries, including Italy and Spain, also saw a sharp rise in their government’s cost of borrowing. Portugal and Ireland have been stabilized, and Greece’s economic problems, while not resolved, have been contained so they no longer threaten the stability of the EU’s banking sector.

{mosads}A second problem has been brewing, however. The Cyprus banking crisis was a preview of the steady rise of nonperforming loans, now over one trillion euros, in the eurozone’s commercial banking sector. Italy is ground zero. Of Italy’s 500 banks, 114 are technically insolvent with bad loans exceeding their entire capital base. Even more significantly, all but one of Italy’s five major banking groups have bad loans amounting to 90 percent or more of their equity. In total, Italy’s banking sector has at least 360 billion euros of bad loans, the final number may be closer to 500 billion, against 225 billion in capital.

The Italian banking crisis is symptomatic of a larger problem, especially across the EU’s Mediterranean states — the growing noncompetitiveness of their economies. Persistent inflation, often underreported, high unemployment, high consumer debt, and a lack of investment and credit have all combined to create low growth economies. While Italy is the poster child of the problem, the same issues affect many other EU states.

Purchasing power parity (PPP) is the idea that a unit of currency should buy you the same amount of goods regardless of where you are. Discrepancies between countries are an indication of exchange rate imbalances that over the long-term will be evened out. In the case of Italy and Germany, for example, a euro will buy you 10 percent more goods in Germany than it will in Italy. If you adjust for different wage rates, an average unit of labor in Germany buys you 59 percent more goods than in Italy.

Before the euro, individual countries could adjust for persistent inflation by devaluing their currencies. Italy went through a period of steady devaluations from the 1970s through the 1990s during which the lira dropped by 75 percent against the US dollar. Those devaluations kept Italian industry competitive despite consistently high inflation.

In the eurozone, however, Italy is stuck with whatever exchange rate the euro trades at. Italy, like any country in the eurozone, has the option of leaving and returning to its old currency. Given Italy’s current economic problems, the new lira would trade at a discount to the euro, effectively creating a devaluation of the currency.

The rate would reflect the current level of prices in Italy as well as expectations of future inflation, political stability and current concerns about the liquidity of the banking sector. A PPP comparison between Italy and the rest of the eurozone would suggest that the new lira would probably trade at a 10 percent to 20 percent discount to the euro, but the rate would likely be highly volatile. PPP is a good indication of the direction in exchange rates over the long-term, but a poor guide to determining equilibrium points.

A de facto 20 percent devaluation would spur Italian economic growth, drive exports up even faster (they have been growing faster than imports, but not enough to spur economic growth beyond an anemic one percent plus). The downside is the trillions of euro-denominated debt, both government and private, which would now have to be paid back in more expensive euros. It is unlikely that the Italian economy, and the commercial banking sector, could take such a shock.

There is another alternative, however, Germany can leave the eurozone and return to the Deutsche mark. Judging from PPP comparisons, the Deutsche mark would probably trade at about a 25 percent premium to the U.S. dollar and around a 30 percent to 40 percent premium to the euro. Post exit, the euro would probably fall to about 0.90 US dollars, while the Deutsche mark would trade around 1.25 US dollars. Exchange rates would be volatile as financial institutions, including central banks, rushed to dump euros and buy Deutsche marks.

Italy and the other members of the eurozone would benefit from a cheaper euro. German consumers and industry would get a windfall; paying off euro denominated debt with more valuable Deutsche marks. How big a windfall would depend on where the initial exchange rate was set. German exporters would have to deal with higher export prices, but they would have the benefit of lower import costs as well as the benefit of a de facto debt reduction. Switching to the Deutsche mark would be deflationary for Germany, more reason to set the exchange rate low and give German consumers more buying power.

Managing an appreciating Deutsche marks would be a challenge for the Bundesbank and for German exporters. It’s a challenge that Germany has successfully faced before the introduction of the euro. Other countries, most notably the UK, have managed to thrive in the eurozone without adopting the euro.

Germany now generates the largest balance of payments surplus of any country in the world. In 2016, it reached roughly 300 billion dollars — bigger even than China’s. Those surpluses are simply unsustainable over the long-term. An appreciating euro would lower that surplus but at the price of depressing economic growth elsewhere in the eurozone.

Germany will have to choose between continuing to participate in an increasingly dysfunctional eurozone, and all the financial obligations that come with that, or trade from outside with a more stable and competitive eurozone. That doesn’t mean that Germany would leave the EU, just the euro. German voters, who are among the most pro-EU in europe but increasingly unwilling to financially support other eurozone members, would likely support the return of the Deutsche mark. Only by exiting the eurozone does Germany have any hope of saving the euro.

Joseph V. Micallef is managing editor of Antioch Press and a regular columnist for Military.com. He’s been a commentator for Fox News, Fox News Radio, and CNN and has spoken extensively on military and international affairs around the world, including the Institute of Strategic Studies in London and the NATO Defense College in Rome.

The views expressed by contributors are their own and are not the views of The Hill.