McKinsey Germany

The future of the euro

An economic perspective on the eurozone crisis
The future of the euro
3

The future of the euro

An economic perspective on the eurozone crisis
The future of the euro
Executive summary 5

Executive summary

The eurozone will face significant challenges in 2012. Austerity measures put in place
by some members in an attempt to contain the consequences of the sovereign debt
crisis will lead to a stagnation in GDP or a recession in all countries in the Economic
and Monetary Union (EMU). A number of key economies need to refinance large
amounts of government bonds that come due in the first quarter – Spain and Italy
alone have to roll over €149 billion of bonds. Countries already excluded from capital
markets will need additional funds from the European Financial Stability Facility (EFSF),
the International Monetary Fund (IMF), and the European Commission. While reduc-
ing public debt levels and reversing the trend of diverging competitiveness within the
eurozone need to be key priorities for policymakers, the near-term development of the
eurozone depends on resolving acute refinancing and liquidity issues.

We see three possible broad scenarios for 2012.1 Most likely, some governments will
have to pay high premiums for newly issued debt or even struggle to find buyers. The
European Central Bank (ECB) may therefore need to scale up its Securities Market
Programme and play a stronger role than before. In an optimistic scenario, the liquidity
squeeze would prove temporary and investors would begin to regain confidence in the
solvency of all EMU members and start reinvesting. However, we cannot rule out events
continuing to erode the trust of investors, making debt rollover impossible. If not coun-
teracted by adequate liquidity support, this might lead to the break-up of EMU.

CEOs need to think carefully about how events in the eurozone might unfold and how
they should respond. This paper explores the benefits that the euro has brought to
EMU member countries, but also stresses fundamental flaws in the way EMU oper-
ates. It discusses scenarios for how policy might evolve and what we believe is neces-
sary to return the eurozone to stability and growth. Finally, it offers some thoughts on
how companies should think about positioning themselves.

Our key findings include:

Significant benefits. Four levers have brought substantial benefits to EMU members:
the removal of nominal exchange rates within the eurozone lowered transaction costs,
trade within the eurozone increased, competitiveness rose as firms benefited from
economies of scale and scope, and investment and consumption were boosted by low
interest rates. Together, these levers brought an estimated €330 billion in additional GDP
in 2010 – 3.6 percent of eurozone GDP that year. However, the 17 EMU members ben-
efited to different degrees, with almost half of the overall benefits accruing ­to Germany.

Fundamental flaws. The eurozone has lacked sufficient adjustment mechanisms to cope
with the diverging performance of its members. Without the possibility of currency devalu-
ation, members face an uphill battle to balance any loss of competitiveness due to increas-
es in unit labour costs. Alternative options should have been deployed. These options are
highlighted in Optimum Currency Area theory, which finds that workable monetary unions
need flexibility in real wages and a high degree of capital and labour mobility to cope with
temporary and asymmetric shocks. Alternatively, fiscal transfers between member coun-

1
McKinsey & Company’s German Office prepared this paper, based on in-house research,
extensive discussions with clients across industries, and a large number of interviews with
leading academics and economists.
6

tries can help to reduce economic imbalances. None of these mechanisms are sufficiently
in place in the eurozone, and this has resulted in diverging competitiveness. Large and
eventually unsustainable current account imbalances have emerged, particularly between
Northern and Southern EMU members.

Markets created the illusion of permanently easy access to funds. Before the
sovereign debt crisis became critical, sovereign bond yields declined and risk premi-
ums of individual EMU members fell virtually to zero. Access to funds was apparently
unlimited and inexpensive, creating the illusion of cheap money. Without taking a judg-
ment on whether this is appropriate or not, markets have returned to pricing risk at
levels similar to those seen before the introduction of the euro.

Scenarios. This paper discusses four scenarios for how policy might evolve:

ƒƒ Monetary bridging. This scenario focuses on short-term policy action and par-
ticularly the provision of liquidity – essentially reactive crisis management that
does not address achieving long-term fiscal stability or restoring competitiveness
and growth. This scenario would not, in our view, regain the trust of the financial
markets and would merely buy time for additional policy efforts aimed at putting in
place a sustainable solution in the medium term.

ƒƒ Fiscal pact plus. This scenario builds on the fiscal pact as agreed at the December 9
European Union (EU) summit, but complements this with three aspects that are
essential to return the eurozone to stability. First, a more effective structure for EMU
governance has to be created in order to ensure the coordination of economic pol-
icy, the consistent implementation of common regulatory rules and the supervision
of pan-EMU financial institutions, the restructuring of the eurozone banking sector,
and the monitoring of extensive structural reforms in highly indebted EMU member
states. Second, investment in growth-supporting infrastructure and education, as
well as in renewal, is necessary to strengthen the eurozone’s productive capacity.
This requires targeted fiscal stimulus in some countries to encourage new industries
to develop and become front runners in innovation. Third, the EMU needs to re-
establish investor confidence in the bond markets. To do so, it needs to support illiq-
uid but solvent member countries in returning to a sustainable path with a new sta-
bilisation facility – either with IMF backing or in the form of a newly created European
Monetary Fund (EMF) with direct access to ECB financing – while at the same time
enforcing strict conditionality on governments that receive support.

ƒƒ Closer fiscal union. This scenario takes fiscal coordination beyond the arrangements
on which Europeans have agreed. Countries in violation of debt and deficit limits
would concede some of their fiscal sovereignty. Ultimately, this might also entail
joint and several liabilities, elements of EMU-level taxation, the issue of eurobonds,
an enlarged degree of joint economic government, and a substantial move towards
more fiscal federalism, including increased permanent transfer payments.

ƒƒ Northern euro/euro break-up. This scenario assumes that struggling economies

leave EMU, leading to an immediate default, overshooting devaluation, and an
implosion of the financial system. The remaining members might form a Northern
euro – the N-euro. They would face the challenge of a substantial currency appre-
ciation as well as a capital-strapped financial sector in need of bailout support. ­
A break-up would have prohibitive costs.
The future of the euro
A challenging 2012 ahead 7

The first scenario would not lead to a sustainable outcome. We believe that EMU will
need to move in the direction of the second or third scenario. Failing to implement nec-
essary changes may lead to the break-up of the euro – the most undesirable option
with very high economic and social costs.

Corporate response. The four scenarios can be a good starting point for a company-
specific analysis with the caveat that events are moving quickly and that these scenarios
may need to be adapted. There is no standard recipe for how to deal with the euro crisis,
but companies should assess two broad questions. First, from a precautionary per-
spective, how would the unlikely but possible event of a eurozone break-up affect their
operations, and what emergency measures should they take? Second, to what extent
should companies revise their medium-term operational and strategic planning in light of
the likely difficult economic conditions facing the eurozone under all scenarios?

A challenging 2012 ahead

In order to substantiate our perspective for 2012, in this section we briefly review
the main measures on which policymakers have so far decided, up to and including
agreements taken at the December 9 summit.

October 26. Addressing challenging market conditions was the focus of the October 26 EU
summit at which several measures were agreed with the aim of containing immediate pres-
sure. The summit decided on a 50 percent haircut on Greek sovereign debt for private inves-
tors, a further leveraging of the EFSF, a second Greek rescue package, and a mandatory
bank recapitalisation (to achieve a 9 percent core capital ratio by June 2012).2

December 9. In principle, the summit was an important step towards addressing the prob-
lem of structural deficits. Private sector involvement has been shelved, and the Greek case will
be treated as an exception. A new fiscal rule was agreed (almost unanimously) by EU member
states, including those outside the eurozone. The new fiscal rule states, “General government
budgets shall be balanced or in surplus; this principle shall be deemed to be respected if, as
a rule, the annual structural deficit does not exceed 0.5 percent of nominal GDP. Such a rule
will also be introduced in member states’ national legal systems at constitutional or equivalent
level. The rule will contain an automatic correction mechanism that shall be triggered in the
event of deviation.” This is essentially a reinforced Stability and Growth Pact with a quasi-
automatic corrective arm. Moreover, EMU members, some of them very reluctantly, intend,
via their national central banks, to increase their contributions to the IMF for further support of
current liquidity needs of individual EMU member countries. However, given that the agree-
ment is purely intergovernmental, serious issues – especially with regard to the implementa-
tion of the agreed fiscal rule – remain. With an exclusive emphasis on austerity, these meas-
ures may fall further far short of supporting the way back to a sustainable growth path. Yet
returning to growth is necessary to achieve the required primary surpluses in public budgets.

What does this mean for 2012? The most likely case is that we will see a continued liquidity
squeeze in a number of EMU countries. While Greece, Portugal, and Ireland are already
relying on the EFSF, the IMF, and bilateral loans for their refinancing, other eurozone coun-

2
Since then, additional steps have been taken to address concerns about the rollover risk,
such as moving up the start of the new European Stability Mechanism (ESM) by a year, to
July 2012.
8

tries – especially Spain and Italy – will have to pay high premiums to roll over maturing
debt. In 2012, Spain and Italy have to refinance record levels of €148 billion and €327 billion
respectively (€36 billion and €113 billion of which is due in the first quarter). This would be a
substantial drain on the stability facility’s remaining funding power of €395 billion and may
necessitate an extension of the EFSF/ESM.3 Moreover, rising spreads in interbank money
markets between unsecured and secured funds, and increased use of the ECB’s deposit
facility are signs that liquidity has also become an issue for financial institutions. All of this
indicates that the ECB may have to decide further measures in addition to those that it
already has taken.4 In an optimistic scenario, the liquidity squeeze would prove to be tem-
porary and investors would regain trust in the creditworthiness of the currently fragile EMU
members so that they could once again issue bonds at comparably attractive coupon
rates. In such a case, the economic outlook would gradually improve, in particular in the
liquidity-squeezed economies, with positive ripple effects in Northern Europe.

However, uncertainty is still substantial, and the reluctance to invest in some EMU
countries’ sovereign debt remains significant. Political support for the new fiscal pact
or measures announced by some governments may waver. Moreover, unsustain-
able fiscal policy and the urgent need for medium-term consolidation in a number of
Western economies might add further problems. One should therefore be prepared
for deficit targets not being achieved. All this could increase pressure – and call for
ever bolder intervention or eventually trigger a break-up of EMU.

The reform the euro needs and why it is worthwhile

Over its first ten years, EMU membership brought significant benefits. The removal of
nominal exchange rates lowered transaction costs and boosted trade within the euro-
zone; competitiveness rose as firms were able to profit more from economies of scale
and scope; and interest rates were low, stimulating investment and consumption.

But alongside these economic benefits, it is clear that EMU has fundamental flaws.
The eurozone has lacked sufficient adjustment mechanisms to cope with heterogen­
eity and to rebalance divergence among its constituent economies, shortcomings that
could impose large costs on the single currency area.

The benefits of the euro

Being part of the EMU has significantly contributed to higher growth in the euro-
zone countries, fundamentally by driving and buttressing the integration of markets

3
The EFSF still has €396.3 billion at its disposal but has already made large commitments,
including up to €100 billion for a second Greek aid programme.

4
In view of the systemic dearth of liquidity, the ECB has responded with a number of drastic
measures, including continuing its full-allotment-at-fixed-rate policy, renewing a swap facility
with the US Federal Reserve and other central banks, and extending the duration of its
repo facilities for up to three years. The ECB has further cut the policy rate to 1 percent and
loosened the eligibility criteria for collateral to less secure assets (accepting single-A-rated
collateral for refinancing). In addition, the ECB has purchased more than €200 billion of GIIPS
(Greece, Italy, Ireland, Portugal, and Spain) government bonds in secondary markets. This is
done to support the transmission of monetary policy, but it might also entice banks to invest
more of this liquidity in European sovereigns.
The future of the euro
The reform the euro needs and why it is worthwhile 9

Membership of the euro brought an overall benefit of ROUGH ESTIMATES

€330 billion in 2010 – distributed unequally among countries

Positive GDP effect, € billions, 2010 Percent of GDP, 2010

Levers EMU-17 France Germany Italy

Technical 37 ~ 0.4 8 ~ 0.4 11 ~ 0.4 6 ~ 0.4

Trade 100 ~ 1.1 9 ~ 0.4 30 ~ 1.2 4 ~ 0.3

Competitiveness 0 ~0 -21 ~ -1.1 113 ~ 4.6 -31 ~ -2.0

Interest rate 195 ~ 2.1 18 ~ 1.0 11 ~ 0.4 68 ~ 4.4

Total 332 ~ 3.6 14 ~ 0.7 165 ~ 6.6 48 ~ 3.1

Focus on Focus on Focus on

interest rates competitive- interest rates
Note: Numbers may not add due to rounding
and trade ness
SOURCE: Eurostat; European Commission (AMECO); IMF DOTS; IHS Global Insight; academic research; McKinsey
Exhibit 1

for goods and services that had been emphasised with the EU’s Single Market
Programme. By increasing price transparency and doing away with the need for
hedging, a common currency effectively reduces economic distance, thereby mak-
ing the exchange of goods and services easier and creating consumer surplus. With
increasing economic proximity, markets integrate and trade intensifies. The abolition
of exchange rate uncertainty and the introduction of common payment systems have
increased the functional proximity between the economies of the eurozone.

We undertook a comprehensive retrospective analysis of the possible benefits of

the euro since its introduction.5 The result is a quantitative estimate of the economic
benefits of the euro. Despite a great deal of discussion, such a calculation has been
attempted only to a limited extent until now.

We estimate that the total benefits to the eurozone amounted to an annual €330 billion
in 2010, or 3.6 percent of eurozone GDP in that year (Exhibit 1).6 To arrive at this figure,
we considered four levers in particular detail.

1. Technical lever. Eurozone economies have received benefits from the reduction of
transaction and hedging costs that effectively operate like a tax on trade, reducing the
profitability of exports and imports. Eurozone countries have benefited, in aggregate
by about 0.4 percent of GDP – around €40 billion.7

5
We have supplemented our analysis with conversations with a large number of business
leaders, business economists, politicians, and academics.

6
This number is to be interpreted as the additional GDP compared with a growth path in a
scenario without the introduction of the euro.

7
M. Emerson, D. Gros, A. Italianer, J. Pisani-Ferry, and H. Reichenbach, One market, one
money: An evaluation of the potential benefits and costs of forming an economic and
monetary union (Oxford: Oxford University Press, 1992).
10

2. Trade. Currency unions potentially create and divert trade. While initial estimates of
the boost to intra-EMU trade were very high indeed, we concur with recent evidence
pointing to a 15 percent increase in intra-EMU trade as a result of the introduction the
euro. Putting this into perspective, this 15 percent increase accounts for half of the
overall increase in intra-EMU trade volume of €600 billion since 1999. The rest is likely
to have come from the further development of the EU’s single market, more intense glo-
balisation, and strong growth in the wake of the EU’s enlargement to Eastern Europe.
Intra-EMU trade increased in particular because countries specialised in production
processes that best fit their respective strengths. Such specialisation generates effi-
ciency gains that increase output beyond the levels attainable when countries produce
a broad range of goods that are not necessarily aligned with their relative strengths.8 In
total, gains from additional trade contributed about €100 billion in additional GDP.

3. Competitiveness. Several effects are at work here. In Northern Europe, in particu-

lar, companies redesigned their value chains, investing in fellow eurozone economies.
This strategy, which was strongly supported by the vanishing of exchange rate uncer-
tainty, allowed them to reap the benefits from economies of scale and scope. Smaller,
highly specialised companies benefited from a stable market that allowed them to
export products easily on a larger, more cost-effective scale. In addition, some euro-
zone economies, such as Germany with its Agenda 2010, were able to boost their
productivity by embarking on structural reform processes, especially with an eye to
enhancing the flexibility of labour markets.9 The gains in competitiveness that such
economies have achieved were not offset by an appreciation of their currency against
their trade partners, as would have been the case under flexible exchange rates.
These factors resulted in higher output overall compared with the pre-euro era, as
increased competition has set incentives to raise productivity in all EMU countries.
The subsequent output gains that are common to all eurozone countries are not
reflected in the small average change in the overall eurozone current account bal-
ance. Therefore, this figure underestimates the impact on competitiveness.

4. Interest rate. Since the euro was launched, rates on ten-year government bonds of
eurozone economies have never been higher than around 6 percent, with very small
differences among EMU countries. While this low level of interest rates (and interest
rate volatility) reflected a general trend of low inflation as well as the so-called Great
Moderation, spreads amongst single EMU member countries declined significantly.10
Pre-euro, Greece’s ten-year bonds had yields of up to 25 percent, while German gov-
ernment bond yields were nearer to 8 percent. These spreads reflected exchange rate
risks, expected divergences in inflation rates, and differential creditworthiness. From
2001 onwards, the spread between government bonds shrank virtually to zero. Quite
obviously, eurozone sovereigns’ liabilities were treated as almost perfect substitutes.
The no-bailout clause, Article 125 of the Treaty on the Functioning of the European

8
To calculate the effect of increased trade within EMU, we used a trade-to-GDP multiplier
to transform additional trade volumes into increases of GDP, consistent with the approach
taken in academic literature.
9
Germany’s Agenda 2010, introduced by then-chancellor Gerhard Schröder in 2003, has been
the cornerstone of German reforms to regain its competitive position. It included action to
make Germany’s social system and labour market more flexible, which leant considerable
support to wage moderation. Moreover, in response to the financial crisis, German companies
managed to hang on to labour by adjusting hours worked rather than employment levels.
10
The Great Moderation refers to a period of low volatility in economic output and inflation,
spanning from the mid-1980s to the late-2000s.
The future of the euro
The reform the euro needs and why it is worthwhile 11

Union, was judged as not enforceable given the drastic consequences of a sovereign
default on financial institutions. In total, the relative interest rate advantage delivered around
€195 billion in additional GDP.

Looking at the geographical distribution of the benefits, a breakdown of data shows that
all EMU countries felt a positive impact but to very different extents and based on differ-
ent levers. The clear winners included Austria, Germany, Finland, and the Netherlands.
Germany received half of the total benefits from the first decade of the euro’s exist-
ence. Its euro membership contributed to an increase of an estimated 6.6 percent of
Germany’s 2010 GDP. This economy has felt the largest benefit from enhanced com-
petitiveness and, to a modest degree, additional intra-EMU trade. Most other countries
benefited from the euro, too, but to a much smaller extent. In Italy, euro membership was
responsible for an estimated 3.1 percent of 2010 GDP. Italy enjoyed lower interest rates
than would have been possible outside the single currency, delivering a benefit of an esti-
mated 4.4 percent of GDP in 2010. However, this plus was cut to 3.1 percent because of
Italy’s weak competitive performance. The overall benefit to France was only 0.7 percent
of GDP in 2010. France has benefited most from a lower interest rate than would other-
wise have been the case and additional intra-EMU trade. Counteracting these positive
effects was a loss of competitiveness equivalent to 1.1 percent of GDP.

The first and second levers are comparatively stable and have the potential to increase
further, while the third and fourth levers are contingent on policies pursued. They could
therefore reverse for any individual member of the eurozone. We should also note that
the benefits we have estimated are a snapshot of 2010. They do not take into account the
potential additional costs of keeping the eurozone together. In order to understand the
underlying reasons for these costs, we now turn to a discussion of the fundamental flaws
of the eurozone.

The euro’s fundamental flaws

Over the past decade, and even after the collapse of Lehman Brothers in 2008 and the
bailout of AIG, there was a widespread perception that EMU was a success. However,
the start of the sovereign debt crisis, triggered by Greece’s confession that it had falsi-
fied its sovereign debt statistics, has brought into the spotlight fundamental flaws in the
construction of Europe’s Economic and Monetary Union – in particular a lack of sufficient
adjustment mechanisms to cope with the diverging performance of its members.

Before the introduction of the euro, countries could potentially balance any loss of
competitiveness due to increases in unit labour costs by a depreciation of their nominal
exchange rate. With no ability to compensate for differences in country-specific price and
cost developments through exchange rate adjustment, EMU needs to rely on other forms
of adjustment that are well known in the theory of optimal currency areas. Three main
mechanisms exist, none of which is present sufficiently in the eurozone (Exhibit 2).

Flexibility of real wages. If wages in a member country of a currency union are per-
fectly flexible, they fully reflect the relative productivity of that country. In economies with
below-par productivity growth, real wages would fall in relative terms in order to maintain
the level of competitiveness. In the eurozone, the development of wages has not been
aligned with that of productivity over the past decade. Unit labour costs (a useful gauge
of competitiveness) have diverged. Between 2000 and 2010, for instance, unit labour
costs in Greece increased by 35 percent, compared with only 2 percent in Germany. This
12

EMU lacks the adjustment mechanisms necessary to compensate for the

loss of exchange rate flexibility

… but alternative mechanisms have not been activated

Increase in unit labour costs, 2000–10
Flexibility of real Percent
wages and industry Germany 2
adaptability1
Greece 35

EMU has re- Interstate immigration, 2008

moved floating Percent
exchange rates Capital and
EU 0.18
as an adjustment labour mobility
mechanism ... US 2.80

Fiscal transfers, 2009

Percent of GDP
Fiscal transfers EMU 0.1
US 2.3

1 Countries in EMU relying on globally less competitive industries have not been able to reorient activities towards more attractive sectors
SOURCE: European Commission; Eurostat; OECD; US Census Bureau; Tax Foundation; Bureau of Economic Analysis; McKinsey
Exhibit 2

amounts to a decisive disadvantage, in particular in price-sensitive industries. There

is, therefore, a close link between the flexibility of real wages and the adaptability of
industries to changing demand and supply. Some EMU countries have historically
been strong in labour-intensive industries, such as shipbuilding and textiles, that are
exposed to intense price competition and are thus particularly sensitive to exchange
rate effects. The euro introduced a hard currency to all countries and emphasised the
need for wage restraints to restore competitiveness in these industries – often beyond
levels that can be reached realistically in developed economies. Consequently, the
euro caused an imminent need for structural change towards new industries that are
less focused on cost to avoid price competition with emerging low-cost countries.

Capital and labour mobility. EMU has led to a high degree of capital mobility and con-
sequently deep integration of capital markets. As a consequence, intra-eurozone capital
flows have increased substantially since the introduction of the euro. To the contrary, cross-
border mobility of labour is low. Labour mobility means that unemployed migrate from
low-growth regions to those that are booming, effectively redistributing labour to areas that
can best absorb it and reducing unemployment in less competitive regions. The additional
labour in well-performing areas eases upward pressure on wage inflation and preserves
their competitiveness. However, in 2008, just 0.18 percent of the EU working population
moved between member states, compared with 2.8 percent in the United States.

Fiscal transfers. A high degree of intra-regional labour mobility and adequate

adjustment of wages to evolving productivity should be largely sufficient to prevent
imbalances from arising within a single currency system. In reality, however, all last-
ing monetary unions in history have also used fiscal transfers to compensate for
regional divergences and to deal with temporary imbalances. However, as EMU
currently stands, transfers from the EU budget are too small to work as an adjust-
ment mechanism. In 2009, eurozone members made gross contributions to the EU
budget of €77.2 billion but net transfer payments among EMU members totalled
The future of the euro
The reform the euro needs and why it is worthwhile 13

Current accounts have diverged between Northern and Southern EMU

members, creating imbalances
€ billions, 2010
Current account balances with the rest of the world,1
1995–2010
Percent of GDP Introduction of the euro,
10 January 1999 Financial crisis
8
6 Germany 143.6
Netherlands 30.1
4
Austria 9.1
2
EMU-17 9.9
0
-2 France -43.3
-4 Italy -53.7
Spain -47.3
-6
-8
-10 Portugal -16.8
-12 Greece -28.0
-14
-16
-18
1995 96 97 98 99 2000 01 02 03 04 05 06 07 08 09 2010
1 Net exports of goods and services plus net primary income from the rest of the world plus net current transfers from the rest of the world
SOURCE: European Commission (AMECO database); McKinsey
Exhibit 3

only €6.9 billion, or less than 0.1 percent of eurozone GDP – much smaller than con-
ventional wisdom might suggest.11 Transfer payments in other currency unions are
significantly higher. In the United States, net transfers between states account for
2.3 percent of GDP.12

The three missing adjustment mechanisms have led to increasing heterogeneity

among the countries of the eurozone, particularly in terms of their competitiveness,
and this has been reflected in the development of the current accounts of EMU mem-
bers. Large current account imbalances have emerged in the eurozone, particularly
between North and South (Exhibit 3). In the Netherlands, Germany, and Austria, the
average surplus between 1999 and 2010 was 6, 4, and 2 percent of their respective
GDP. Meanwhile, Greece, Portugal, and Spain had average deficits of 12, 10, and
6 percent of their respective GDP.

Not every current account deficit is an imbalance. If capital inflows, filling the gap
between regional savings and capital expenditures, mainly serve to fund produc-
tive investment, this is a gainful activity. Debt that is accumulated over time can be
serviced with revenues generated by these investments. However, if deficits are
mainly run to fund consumption, public or private, or real estate expenditures, such
deficits are less benign. Ultimately, deficits translate into ever-increasing net external

11
Net contributions to the EU totalled €20 billion, of which €6.9 billion can be ascribed
to EMU countries, assuming that contributions are split up proportionately among net
receiving countries.
12
There are two forms of fiscal transfers, both of which include a significant redistributive
element. The first is an insurance mechanism aimed at temporarily balancing out asym-
metric shocks to specific regions. These transfers are intended to support adjustment and
might refer to a common unemployment insurance scheme or a monetary-union-wide
fund to cope with regional banking crises. The second is redistributive fiscal transfers that
permanently increase public spending and infrastructure provision in structurally weak
regions. Fiscal transfers of the first type are practically non-existent within EMU.
14

debt, which may become unsustainable. This has happened in Southern European
countries. In Greece, consumption was responsible for 92 percent of GDP growth
between 2000 and 2008, compared with 72 percent in Northern European economies
during the same period. Southern Europe had large, mainly private, foreign debts.
Private debt levels increased even more dramatically than public debts, but, as the
global banking crisis unfolded, a great deal of this private debt became public due to
public bailouts of ailing financial institutions aimed at containing systemic externali-
ties. Sovereign debt levels, which had been relatively stable before the banking crisis
and, in some cases, even improved, now increased strongly. Some countries were
more severely affected than others. For example, in Ireland, where the government
was forced into a large-scale bailout of the severely hit financial sector, public debt
increased from less than 30 percent to more than 90 percent and is likely to reach
more than 110 percent in 2012 (Exhibit 4).

The financial and economic crisis of 2008 and 2009 triggered increasing
public debt ratios in the eurozone

Public debt to GDP over time

Percent of GDP Greece revises
debt figures
150
Lehman Greece 144.9
140 bankruptcy
130 Beginning of
sub-prime crisis
120 Italy 118.4
110 Ireland 94.9
United States 94.2
100
Portugal 93.3
90
Germany 83.2
80 France
82.3
70 United
79.9
Kingdom
60
Netherlands 62.9
50
Spain 61.0
40
30
0
2003 04 05 06 07 08 09 2010

SOURCE: Eurostat; OECD; McKinsey

Exhibit 4

Today, almost all economies of the eurozone no longer meet the debt and deficit cri-
teria laid down in the Stability and Growth Pact. In 2010, the weighted average fiscal
deficit was 6.2 percent – more than double the 3.0 percent upper limit of the Stability
and Growth Pact. Average debt in the eurozone was 85 percent of GDP, compared
with the prescribed ceiling of 60 percent. This is, however, in line with what one would
expect in response to a deep banking crisis.

The markets return to considering country risk

Capital markets have put a considerably lower price on risk on investing in the euro-
zone – and all its member countries – over the past decade than they did prior to 1999.
Before the introduction of the euro, spreads on the bond yields of different European
governments were high, reflecting inflation rate differentials and the perception that
default and exchange rate risks were very different, depending on the European coun-
try. Greek bonds were trading 17 percentage points higher than German bonds in
The future of the euro
The reform the euro needs and why it is worthwhile 15

1993.13 But, remarkably, this country risk premium almost ceased to exist when EMU
came into being. Given the fact that exchange rate risk was significantly lower – or
even absent for investors within the eurozone – a smaller country risk premium was
understandable. It is less easy to justify a zero-risk premium. This was apparently
based on the perception that, in a crisis, eurozone governments could not, given
the self-defeating consequences, abide by the no-bailout clause in the Treaty on the
Functioning of the European Union. An immediate upshot of this non-pricing of dif-
ferential default risk – treating every sovereign indiscriminately the same – engendered
the illusion of cheap money, particularly in Southern Europe, leading to a real estate
investment boom, strong consumption, and rising debts relative to income (Exhibit 5).

Capital markets did not account for different credit qualities, creating the
illusion of permanently cheap funds

Yields on ten-year government bonds

Percent, monthly
34 Greece
32
30
28
26 EMU entry of Lehman
24 Greece bankruptcy
22
Germany and
20 France breach
18 Introduction Stability and
16 of euro Growth Pact
14 Portugal
12
10 Ireland
8 Italy
6 Spain
4 France
2 Germany
0
1990 92 94 96 98 2000 02 04 06 08 10 2011

SOURCE: Thomson Reuters Datastream; Eurostat; McKinsey

Exhibit 5

It can be argued that, in response to the sovereign debt crisis, financial markets are now
pricing risk at more adequate levels. Ireland, Portugal, and Greece, with their highly indebt-
ed economies, were the first countries to experience sharply higher rates from the autumn
of 2009 onwards. But the contagion has now spread to other very large eurozone econo-
mies, including Italy, Spain and, although on a reduced scale, France. Tensions in sover-
eign debt markets are also reflected in interbank money markets where spreads between
unsecured and collateralised funds have been widening strongly. Moreover, instead of
taking out loans to other banks, many financial institutions are making increasing use of
the deposit option at the ECB and accepting opportunity costs that are non-negligible.
This behaviour illustrates that financial markets have lost confidence in the stability of the
eurozone and are now assessing the underlying solvency of individual states within EMU.
Regaining the trust of investors will take time. Governments will need to prove the cred-
ibility of their respective consolidation packages. Austerity alone will probably not do.
Solvency requires a convincing medium-term growth perspective.

13
This, however, does not take into account differences in inflation, which had been
considerable in some countries prior to joining EMU.
16

The future of the euro: Possible destinations and ways of getting there

Despite the considerable benefits that membership of the single currency has brought
in aggregate over the past ten years, the crisis has placed a large question mark over
the form EMU might take in the future and what its institutional underpinnings should
look like. Based on our analysis of the fundamental flaws in the way EMU operates
today, we find three key issues that the eurozone needs to address. These issues form
the basis of the four scenarios we discuss in this section.

Stabilisation of government bond markets and interbank lending. To be cred-

ible, a no-bailout rule requires that externalities are manageable at reasonable costs.
In particular, this implies a robust, European-wide bank restructuring and resolution
scheme. A common regulatory rule book, including mechanisms for prompt corrective
action, as well as the coordinated and consistent implementation of these supervisory
rules are also required. However, without a backstop facility to prevent a liquidity prob-
lem from becoming a solvency issue, it will be difficult to restore trust in eurozone gov-
ernments’ ability to honour their debt. Despite potential moral hazard, policymakers
therefore need to establish some form of lender of last resort for governments or issue
jointly guaranteed public debt. Otherwise, volatility and interest rates will remain high
and funding liquidity for government bonds low.

A robust line on public finances. Governments need to take a robust and smart
line on public finances. This means simultaneously addressing requirements for the
stabilisation of short-term output and long-term sustainability issues. Consolidating
public debt will not suffice in most cases, unless eurozone governments aim collec-
tively to achieve primary surpluses on an unprecedented scale. Fiscal health requires
long-term efforts to cut implicit and explicit public liabilities relative to GDP. To achieve
this, belt-tightening should be complemented by strategies to support growth.

We have developed four possible scenarios for the future of the euro

Monetary ▪ Continued reactive crisis management, incl. Focus only on liquidity

bridging – Liquidity support packages (e.g., EFSF, ESM) (buying time, no long-
– Potentially expanded ECB involvement term solution)

Fiscal ▪ EMU economic government coordination with Focus on

pact plus emphasis on strict austerity measures ▪ Structural reforms
▪ IMF-style monetary support and economic ▪ Liquidity provision
programmes to support structural changes ▪ Debt reduction

Closer ▪ EMU economic government as long-term target As in the fiscal pact plus
fiscal ▪ Increased fiscal transfers and taxation on EMU scenario, but focus on
union level potentially with jointly issued eurobonds integration of fiscal policies
(incl. transfers)

Northern ▪ GIIPS countries leave EMU ▪ Large short- to medium-

euro/euro ▪ Remaining countries adhere to a strict Stability term costs
break-up and Growth Pact and form new “Northern euro” ▪ Potentially severe social
consequences

SOURCE: McKinsey
Exhibit 6
The future of the euro
Possible destinations and ways of getting there 17

Governments also need to commit to sustainable long-term public finances by, for
example, introducing constitutional or other credible forms of debt brakes and clear
implementation plans to reassure markets.

A competitiveness and growth agenda to address the structural flaws of the euro-
zone. The critical issue of structurally renewing those EMU economies that have lost signifi-
cant competitiveness over the past years is being overlooked.14 Beyond reducing deficits,
restoring industry competitiveness by increasing productivity is the core challenge to over-
come the crisis. Governments need to design and pursue a growth agenda that encourages
new industries to develop and become front runners in innovation. Governments would
need to invest in growth enablers including education, R&D, and infrastructure, and to reform
labour markets, regulation, and tax and social security systems. Moreover, institutional
change will be necessary, including, as we have discussed, a common framework to put
in place adjustment mechanisms to rebalance differences in regional performance as they
occur, as well as a consistent implementation of financial market regulation and supervision.
Addressing these structural problems would help not only to improve the competitiveness
of struggling eurozone economies, but also to restore market confidence and reduce sover-
eign debt levels and deficits through potentially higher growth.

The four broad scenarios we outline show the range of potential directions EMU could
take (Exhibit 6). Each involves different policy combinations. We examine the implica-
tions of each (Exhibit 7).15

The four scenarios have different macroeconomic implications – with a

Northern euro/euro break-up scenario having prohibitive costs
GDP growth Public debt Inflation Core countries

Percent Percent of GDP Percent GIIPS

Monetary 4 150 6
bridging 2 4
100
0 2
-2 0 0

Fiscal 4 150 6
pact plus 2 4
100
0 2
-2 0 0
4 150 6
Closer
fiscal 2 4
union 100
0 2
-2 0 0

Northern 150
10
euro/euro 0
break-up 100 5
-5
0 0
2011 15 2020 2011 15 2020 2011 15 2020

SOURCE: Oxford Economics; McKinsey

Exhibit 7

14
In the decade from 2000 to 2010, Greek unit labour costs increased by 35 percent, Italian
costs by 31 percent, and Spain’s by 29 percent. In contrast, the OECD average increase
was 19 percent, with a 13 percent increase in Poland, 15 percent in Sweden, and 17 per-
cent in the United States.
15
We carried out extensive macroeconomic simulations in conjunction with Oxford Economics.
18

Scenario 1: Monetary bridging

This scenario is characterised by ineffectual implementation of existing agreements

and reactive crisis management that tries to address ad hoc liquidity problems and
budgetary deficits. This scenario does not focus on long-term fiscal stability or on
restoring competitiveness and growth. Instead, governments introduce reforms of
short duration that address only the most acute problems. The fiscal pact in its cur-
rent state will not – or only to a limited extent – be ratified, and slow-growth, high-debt
eurozone economies will not be able to meet tough limits on deficits.16 The interven-
tions of the EFSF and ESM will not be sufficient to reassure market participants, and
this would force the ECB to increase its intervention to stabilise markets, a position

Inflation effects

The ECB is clearly a decisive player in efforts to stabilise the eurozone. It is not
entirely implausible that circumstances could arise in which the ECB may have to
ponder a rather unpalatable choice: either to use its ability to create unlimited funds
and to deploy them in secondary markets, or to let the euro fall by the wayside. But
would an ECB intervention lead, by necessity, to higher inflation? The ECB could
control the monetary base (currency and bank deposits) in particular through its
repo financing or sterilisation measures.17 It is important to note, of course, that not
any increase in the stock of central bank money is inflationary. A larger monetary
base only leads to a commensurate increase in money supply, as for example
measured by the broad monetary aggregate M3, if banks extend more loans.18
Currently, the monetary wherewithal to fund inflation is not available (the money
multiplier has been decreasing substantially). At the same time, as soon as an infla-
tionary threat lurks, the central bank has the capacity to shrink its supply of central
bank money, at least when it is independent or autonomous, as the ECB is. If there
were a threat of bank lending outpacing the eurozone economies’ ability to increase
their productive capacity, sterilisation could be conducted to align the growth of
money with the growth of output. Such sterilisation would become more demand-
ing as the volume of purchases increased. Indeed, the non-inflationary capacity to
create money, based on a simple discounting formula, is between €2 trillion and
€3 trillion.19 Over a short-run perspective, inflation largely depends on the economic
environment. The existence of very substantial output gaps, further accentuated by
current austerity measures as well as the attempts of banks to deleverage, makes
inflation over the foreseeable future highly unlikely.

16
Applying the deficit rule retrospectively in 2009, for example, would have required eurozone
countries to reduce fiscal deficits by €370 billion. This shows that any deficit rule can be
meant as a long-term instrument only to revert budgets to sustainable levels.
17
In reality (and under normal circumstances) modern central banking is of course about
controlling short-term interest rates, the so-called policy rate. With interest rates at almost
zero liquidity management, as an unconventional policy, became important in order to
stabilise money markets.
18
M3 is the broadest definition of money supply provided by the ECB and, according to
monetarist theory, decisive over the longer-run (low-frequency data) for inflation perspectives.
19
See also Willem Buiter (Citibank) and Goldman Sachs. These are rather conservative
estimates, based, for example, on an inflation rate of 2 percent.
The future of the euro
Possible destinations and ways of getting there 19

that is difficult to align with the central bank’s statutory obligations. Important aspects
of the discussion on the role of the ECB relate to inflation and currency effects (see text
box “Inflation effects” on the left page).

Our analysis finds that, in this scenario, interest rate volatility would remain high and
access to markets fragile. This would compromise consumer and industry confi-
dence and constrain future economic growth. We think that the eurozone could
experience volatility as high, and consumer and industry confidence as low, as they
were in 2008 and 2009 after the bankruptcy of Lehman Brothers and the unravelling
of the sub-prime mortgage bubble. Eurozone GDP growth would be weak, with aver-
age annual growth of 0.6 percent from 2011 to 2016. Debt levels would increase to
an average of 89 percent of GDP in 2016 in the core countries and to an average of
113 percent in the GIIPS countries. Unemployment in the eurozone would increase to
11.4 percent in 2016.

In our view, financial markets still appear to be deeply uncertain about whether eurozone
governments can do enough, despite the different monetary measures taken. Uncertainty
remains high and investors critical. We believe that this scenario merely buys time, but with
diminishing effectiveness, and that, at some point, politicians would need to agree on a
path towards a logically consistent and economically sustainable solution. This would be
a bifurcation point since it would either imply going down the road of a “fiscal pact plus” or
closer fiscal union, or accepting the exit option of the break-up of the eurozone. The next
three scenarios can be considered to offer stable end states for the eurozone.

Scenario 2: Fiscal pact plus

This scenario builds on the current policy proposals that focus on the so-called fiscal
pact of the December 9 summit, including strict limits on budget deficits and propos-
als for strict enforcement for the eurozone. Countries are expected to observe a limit
on cyclically adjusted deficits of 0.5 percent of GDP and to introduce constitutional
debt brakes. Each country remains responsible for its own budget. However, the
details still need to be hammered out. In this scenario, we complement the status quo
with three aspects that are essential for attaining a sustainable, holistic solution. These
are the promotion of policy coordination, the provision of liquidity, and a long-term
growth agenda based on structural reforms to regain competitiveness (see text box
“Lessons from Nordic countries” on the next page).

Effective EMU governance. Given the interdependence of EMU member countries,

a higher degree of policy coordination is needed. In this scenario, adjustment mecha-
nisms to compensate for diverging regional developments are strengthened largely by
sufficient cross-border labour mobility and by adequate flexibility of real wages. Given
its integrated financial markets and institutions, EMU also needs pan-European tools
for the common supervision and restructuring of the banking sector. Such arrange-
ments would still fall short of the level of policy integration that has underpinned all
other working monetary unions.

A monetary and stabilisation mechanism. This mechanism would address liquid-

ity and public finance issues, ensuring that countries that can plausibly respect their
inter-temporal budget constraints do not become insolvent when temporary liquidity
problems occur. Because of conditionality advantages, one solution would be for the
eurozone to rely on IMF support, an approach that the EU was discussing at the time
20

Lessons from Nordic countries

Nordic countries all faced financial and subsequently economic crises in recent
decades.20 But today Sweden, Finland, Denmark, and Norway are among the most
robust economies in Europe. Even Iceland is on its way to recovery. The steps
taken by Nordic governments provide examples of what a European policy mix may
include. As in our fiscal pact plus scenario, Nordic governments’ policy measures
focused on re-establishing market confidence, reducing fiscal deficits over the
medium term, and supporting economic growth. Finland and Sweden, for instance,
proved that even large fiscal deficits of up to 12 percent can be removed over a three-
to four-year period. Quick decisions and fair burden sharing were key elements in
their reforms. The determination of governments to return to sustainable debt levels
convinced investors and eased market uncertainty, and this partly offset the nega-
tive impact of austerity measures on domestic demand, as did currency devalua-
tions, which are, of course, not available in the eurozone case. Spending cuts and
tax increases were supplemented with investment specifically aimed at promoting
growth. Finland, for instance, increased R&D funding by 80 percent in the midst of its
crisis. While emergency measures can help to stabilise a financial crisis, the example
of Nordic countries demonstrates that a macroeconomic and sovereign debt crisis
necessitates fundamental reform.

of writing. Alternatively, the eurozone could develop its EFSF/ESM mechanism into
a full EMF.21 In contrast to the IMF, this fund would have a clearly defined European
remit and the capacity to act in ways that would not conflict with non-European inter-
ests. Such a fund could provide loans to liquidity-constrained, but solvent, countries.
Receiving countries would have to agree to tailor-made adjustment programmes.
The fund could be equipped with a bank license giving it access to ECB funding. This
would provide it with more capacity to intervene than the current EFSF/ESM mecha-
nism. In the long run, funding would come from contributions made on the basis of
fiscal discipline, rather than GDP. Countries with higher deficits and debt levels would
contribute more as the probability increases that they would receive money from the
fund. The fund could use – incrementally – a range of credible enforcement mecha-
nisms, from cutting off non-compliant countries to preventing countries from access-
ing EU structural funds. In terms of its governance, such a fund would be similar to the
IMF in that it would limit veto powers and direct government involvement.

Investment in growth and renewal. Investment in growth and renewal serves two pur-
poses. First, it creates trust in the long-term sustainability of current nominal debt levels.
Second, it provides the basis for the future growth and prosperity of the eurozone in a
competitive environment. Areas for such investments would be productive infrastructure
that reduces the user cost of capital, and education that increases the skill base and inno-

20
Denmark experienced a crisis in 1982, Norway in 1992, Sweden and Finland in 1993, and
Iceland in 2008.
21
The idea of an EMF was first floated in a 2009 paper published by Daniel Gros, Director
of the Centre for European Policy Studies (CEPS) in Brussels, and Thomas Mayer, Chief
Economist of Deutsche Bank. The authors calculated that, if such a fund had been
launched alongside the euro in 1999, it would have accumulated €120 billion by now.
The future of the euro
Possible destinations and ways of getting there 21

vation capacities. One form this investment could take would be subsidised restructuring
programmes for reviving eurozone economic growth – a new version of the Marshall Plan
for Europe’s reconstruction after World War II. Such a plan could start with existing unused
funds at the European Commission to build a “seed fund” of around €200 billion. This
growth fund could become the nucleus of a new European growth agenda to strengthen
the eurozone’s ability to thrive in an era of increased global competition.

This scenario would address the entire spectrum of essential issues. In particular, it
would combine short-term liquidity provision and efforts to produce long-term sus-
tainability that would allow the eurozone to outgrow current debt levels. An IMF-style
institution could provide sufficient liquidity to reassure markets in the short term and
soften what would otherwise potentially be a very hard landing.

Nevertheless, growth in the near term would be weak, particularly in those eurozone
economies that have adopted, or will adopt, austerity measures. In this scenario, we
would expect annual average GDP growth from 2011 to 2016 of 1.5 percent in the euro-
zone, with only 0.7 percent in the GIIPS countries and 1.9 percent in the other eurozone
countries. However, in the medium to long term, we see higher growth than in any other
scenarios in all eurozone countries, with an annual average growth rate of close to 2 per-
cent in the eurozone between 2011 and 2021.22 Strict conditionality, in addition to incen-
tives to spur fiscal discipline, would help to keep overall debt levels at 89 percent of GDP
by 2016 (still higher than the 80 percent of 2010 but lower than in the monetary bridging
scenario), and unemployment would be at approximately 11 percent in 2016 after a peak
of 12.6 percent in 2014 (driven by temporarily higher unemployment in the GIIPS coun-
tries). Policy coordination on a common growth strategy and the sustained implementa-
tion of adjustment levers would help to ensure stable growth.

Scenario 3: Closer fiscal union

Monetary unions usually form when countries do – from the United States to the politi-
cal union of England, Scotland, Wales, and Northern Ireland – and they are comple-
mented with fiscal unions. But EMU is a monetary union among nation states that
continue to maintain control over their own national budgets and taxation policy. During
the current crisis, discussion of a European fiscal union is now commonplace. Outside
the eurozone, fiscal union means a single national budget. Our view is that full fiscal
union, where power over national budgets shifts completely to the supranational level,
is a non-starter in Europe for political reasons. On the grounds of “no taxation without
representation”, eurozone electorates may oppose such a shift of powers to the supra-
national level. We would therefore envisage that any move towards closer fiscal union
would, for political reasons, entail a gradual process. While fiscal unions can take a vari-
ety of forms, this scenario describes a relatively fully-fledged type of fiscal union that is
markedly different from the fiscal arrangements described in the other scenarios.

Beyond the EU summit’s proposed fiscal discipline measures that would require countries
in violation of debt and deficit limits to concede some of their fiscal sovereignty, a number
of elements would strengthen the integration of the eurozone substantially. These ele-
ments may include, over different time horizons, joint and several liabilities of EMU mem-

22
Economic projections based on the scenarios described have been provided by Oxford
Economics.
22

bers, an enlarged degree of joint economic government, elements of EMU-level taxation,

the issue of eurobonds, and a move towards more fiscal federalism, including higher per-
manent transfer payments.

The degree of fiscal integration in this scenario would be much greater than that we
envisage in a fiscal pact plus case. From a temporary transfer scheme, the eurozone
would evolve towards a permanent redistribution system (see text box “Fiscal transfers”
below). If we look at current transfer volumes in Switzerland, the United States, and
Germany, eurozone transfers could be in the range of €70 billion to €300 billion. While
the fiscal pact plus scenario maintains individual liability except under EMF conditions in
the case of liquidity constraints, the path towards closer fiscal union would finally imply
collective liability for at least some sovereign debt. Thus, fiscal union would integrate
national budgets. While a fiscal pact plus scenario would leave budget responsibility at
the national level as long as a country did not infringe budgetary and imbalance rules,
under a closer fiscal union there could be an EMU-wide tax to build a pool for transfers.
While a fiscal pact plus scenario could be implemented through treaty negotiations, the
degree of fiscal integration called for in this scenario would likely need constitutional
changes and therefore entail referenda in many member countries.

While transfer payments may further help to reduce debt in highly indebted eurozone
countries, this would involve redistribution from those economies with stronger fis-
cal positions. Experience shows that a permanent redistribution system would pro-
vide no lasting incentive for structural reforms and therefore hinder higher growth.
Nevertheless, it is clear that financial markets would welcome the clarity of this sce-
nario and in particular the commitment to bailing out members that run into trouble.

We judge the closer fiscal union scenario to be slightly less positive for the eurozone
economy than the fiscal pact plus scenario. With a closer fiscal union, we see the
overall average annual growth rate between 2011 and 2016 being 1.3 percent but
only 0.8 percent in the GIIPS countries. In this scenario, we would see debt levels at
91 percent in 2016 for the eurozone as a whole compared with 80 percent in 2010
and 89 percent in the fiscal pact plus scenario. With a projected level of 11.3 percent,
unemployment levels in 2016 would be similar to the ones in the fiscal pact plus sce-
nario but still higher than the 10.1 percent of 2010.

Fiscal transfers

Fiscal transfers can take two forms. The eurozone could introduce an insurance-
based fiscal transfer mechanism that would be appropriate to deal with temporary
shocks. Such a mechanism should support adjustment processes. Eurozone-wide
unemployment schemes (with differentiated benefit levels) or funds to deal with
banking crises fall under this heading. Insurance-based mechanisms can be effec-
tive in addressing regional asymmetries with relatively low resource requirements.
More ambitious would be a bigger eurozone budget, which could act as an auto-
matic stabiliser that effectively recycles tax revenues from high-performing parts of
the monetary union to those that are underperforming. While in place in the United
States, such an automatic stabiliser would be a highly contentious issue among
Europe’s publics.
The future of the euro
Possible destinations and ways of getting there 23

Scenario 4: Northern euro/euro break-up

The fourth scenario is a break-up of the EMU as struggling economies are closed off
from access to funds and therefore forced to leave. Those that remain form a Northern
euro – the N-euro. Different constellations are possible, but we assume that the new
eurozone would include Germany, France, Luxembourg, Belgium, Austria, Finland, the
Netherlands, Estonia, Slovakia, and Slovenia.23 We assume that an N-eurozone would
substantially strengthen the provisions of the Stability and Growth Pact. Limits on debt
as a share of GDP would be codified in members’ constitutions, and violations would
be identified by an independent authority such as Eurostat, the EU’s statistics agency.
Whichever independent authority was chosen to play the role would automatically
implement sanctions, and these would be legally enforceable at the European Court
of Justice. Also codified into constitutions would be a no-bailout rule. A mechanism
or procedure would deal with macroeconomic imbalances between member states.
Even if the N-eurozone was much more economically homogeneous than today’s
EMU, the currency zone would need workable mechanisms for economic adjustment
in case of asymmetric economic shocks.

However, this scenario would come at prohibitive costs, not least because of the pro-
nounced interdependence of the assets and liabilities of European financial institutions.
Governments would have to engage in significant bailout schemes to rescue the heavily
damaged financial sector. A break-up would be a very significant shock to the non-
financial corporate sector, too. In the long term, it would mean irreversibly lost opportu-
nities mainly at the microeconomic level. It would reduce the effective size of the market
in which a shared currency acted as a catalyst for more trade and closer economic and
business integration. The result would be lower economies of scale and higher costs of
managing integrated supply chains. It is by no means certain that the degree of integra-
tion that Europe has attained through the single market mechanism – including coun-
tries outside the eurozone – would remain. Uncertainty would be reintroduced.

Of the four scenarios, the Northern euro has the most negative effect on eurozone
growth and – depending on the magnitude of the shock to the financial sector – could
be even worse than the effects we describe. Our analysis suggests that a break-up
would be followed by a severe recession, with GDP falling by more than what was
witnessed during the recession of 2008 and 2009. In this scenario, the average annual
growth rate for N-euro countries between 2011 and 2016 would be minus 0.9 percent,
with a severe recession in 2012 and 2013. Average annual growth in GIIPS countries
between 2011 and 2016 would be minus 2.7 percent, with a severe recession last-
ing until 2015. Government debt in 2016 would be an estimated 110 percent of GDP
compared with 80 percent in 2010 for N-euro countries but 129 percent for GIIPS
countries compared with 98 percent in 2010. The unemployment rate would reach
unprecedented highs in GIIPS countries at approximately 24 percent compared with
13.4 percent in 2010. This scenario would also cause a liquidity crisis similar to or
worse than the one that unfolded in the wake of the Lehman bankruptcy. Governments
would therefore need to bail out the financial sector, and this would lead to a further
build-up of public debt.

23
We assume that the exit of single countries would lead to strong contagion effects and the
eventual exit of all GIIPS countries.
24

  

Compared with the other three scenarios, a monetary bridging scenario does not
solve any fundamental issues and is therefore not sufficient to foster stability. In con-
trast, either the fiscal pact plus or closer fiscal union scenario could potentially provide
sustainable solutions. If neither of these two stable outcomes can be achieved, the
eurozone may find itself in a break-up scenario. If we compare the respective merits of
the fiscal pact plus and closer fiscal union scenarios, our view is that the former is pref-
erable because it has a stronger focus on growth and incentives and would be much
less difficult to implement from a political perspective. None of the four scenarios
would bring about a significant reduction in debt levels.24 The process of deleveraging
will be prolonged and, while it continues, growth in the eurozone is likely to be weak.
It is, therefore, very important to put in place monetary measures that re-establish
confidence quickly. Governments adopting austerity agendas should pursue competi-
tiveness and growth policies in parallel that can provide a platform for an exit out of
recession. This combination, incorporated in a fiscal pact plus scenario, would, in our
view, be a framework that could prepare the eurozone for the challenges of increasing
global competition.

How companies should respond

The implications of the 2008 global financial crisis differed significantly among indus-
tries and regions in Europe. While European financial institutions felt a sharply negative
impact from a drop in liquidity and large write-downs, the real economy suffered from
lower private and public spending. The euro crisis, too, will have a variety of implica-
tions for companies, depending partly on the industry and the region where they are
operating. It is vital that managers understand the potential industry- and company-
specific implications of the euro crisis. Doing so could help companies to conceive
strategic responses that can reduce their risks and improve their competitive position.

The four scenarios we have presented can be a good starting point for a company-
specific analysis, although, given how fast events are developing, these scenarios
may have to be adapted. Some companies have already compiled their own sce-
narios that could be equally useful for an impact assessment that is most relevant to
the profile of their particular business.

Given the high degree of uncertainty about future developments, there is no stand-
ard recipe for how to deal with the euro crisis. Nevertheless, it is strongly advisable
that companies assess two broad questions. First, how would a break-up of the
eurozone affect their operations, and what emergency measures should they take?
Second, to what extent should companies revise their medium-term operational and
strategic planning?

Nevertheless, it should be noted that the trend of increasing sovereign debt is clearly
24

reversed in the fiscal pact plus scenario.

The future of the euro
How companies should respond 25

Implications of a eurozone break-up

At the time of writing, a break-up of the eurozone still appeared to be highly unlikely,
given considerable political will to avoid such a development. But we cannot rule out
this possibility. In a break-up scenario, the GDP of the eurozone is expected to decline
sharply, and the repercussions of this contraction on companies would be immense.
Managers should therefore be prepared and assess the potential implications of a
break-up for their businesses.

Relevant questions to ask include what impact the reintroduction of national curren-
cies would have, whether, and to what degree, investments in eurozone countries
would need to be written down, and how refinancing rates would be affected. A break-
up could, at minimum, have an impact similar to the 2008 financial crisis, during which
refinancing rates increased significantly – to a point at which capital access for some
organisations became impossible. In particular, this meant a drying-up of trade finance
that subsequently led to an unprecedented implosion of cross-border trade in the
final quarter of 2008 and the first half of 2009. Analysing a company’s value chain can
reveal further issues. For instance, companies sourcing input factors from countries
outside their sales markets would suddenly be exposed to a return of exchange rate
fluctuations. The introduction of capital controls to avoid capital flight from countries
leaving EMU could further complicate the operations of multinational organisations.
Finally, a break-up would certainly trigger long-lasting legal disputes as most contracts
are not designed for such an eventuality.

Understanding the business implications of a eurozone break-up is important. But

companies should go one step further and assess the potential measures they can
take. A number of options can help companies to reduce their exposure in advance
of a break-up. For example, managers can decide to limit the maximum amount of
assets allocated with a single bank. Another option may be to localise supply chains
to hedge against exchange rate movements. While these measures are precautionary,
companies may also define a set of actions that would be taken only in the case of a
break-up. Such an emergency plan could include the suspension of capital expendi-
ture to ensure that there is sufficient liquidity for a company’s operation, or updating IT
systems so that they can handle transactions in new national currencies.

Medium-term operational and strategic planning

In addition to analysing the break-up case, companies should review their opera-
tional and strategic planning in light of the difficult economic development under all
four scenarios.

To plan future production capacity, it would be relevant for companies to ask what
regional growth in their sales markets looks like, how this translates into demand
changes, and to what extent the crisis affects their suppliers. For example, the threat
of supply chain disruptions may require an increase in inventories. Companies should
also consider looking at the impact of the crisis on corporate pension plans or poten-
tial changes in counterparty risk. Even if a company is operating in relatively stable
markets, the crisis may push its debtors into bankruptcy, requiring a write-down of
outstanding claims. Managers should also assess to what extent a loss of revenue
caused by a decline in domestic demand could be offset through productivity and
wage adjustments.
26

On a broader strategic level, companies need to consider, for instance, the potential
impact of regulatory changes or shifts in competition. While the crisis appears to have
largely negative implications, there may also be some opportunities, such as acquisi-
tion options or potential for new product development. Some companies may even be
able to design strategies to benefit from price volatility.

As with their analysis of a break-up scenario, managers should use their insights
to design concrete action plans and allocate measures to specific business units.
Overall, the efficiency of potential measures differs significantly among companies.
That is why a careful evaluation of individual exposures and impacts is necessary.

  

By carrying out analyses along these lines, companies should have a clearer under-
standing of the specific implications of the crisis for their business and be able to take
action not only to reduce their exposure but also to seize new opportunities. All indica-
tions are that the crisis will not be resolved in the short term. Indeed, we expect the
journey to stabilisation and recovery in the eurozone to be a long one. In this context,
a thorough assessment of the implications for individual companies and the potential
mitigation measures they can take is clearly desirable.
The future of the euro
27
Authors

Frank Mattern is a Director and Managing Partner of McKinsey & Company in Germany.

Dr. Eckart Windhagen is the Leader of McKinsey’s Financial Institutions Practice in Germany and Austria.

Dr. Markus Habbel is a Partner in McKinsey’s Frankfurt office.

Dr. Jörg Mußhoff is a Partner in McKinsey’s Frankfurt office.

Prof. Hans-Helmut Kotz is a Senior Advisor to McKinsey.

Prof. Wilhelm Rall is a Director Emeritus of McKinsey.

The authors would like to thank Charles Roxburgh, a Director in McKinsey’s London office, for his invaluable insights.

Project team: Cornelius Vogel (project manager), Matthias Bodenstedt, Sophie Bremer, Janet Bush, Florian Keppler,
Christoph Pavel, and Dr. Björn Saß

If you have any queries, please contact:

Kai Peter Rath

Phone: +49 (211) 136-4204
E-mail: kai_peter_rath@mckinsey.com

McKinsey Germany
January 2012 – updated version
Copyright © McKinsey & Company, Inc.
www.mckinsey.com