dinsdag 6 maart 2012

"Nederland gaat terug naar de gulden!"

Geert Wilders heeft onderzoek laten doen naar de euro. Wat blijkt is dat wij volgens Geert wilders en Charles Dumas, dat wij Nederlanders geen voordeel trekken uit de euro, maar dat we per Nederlander er 2700 euro per jaar erop achteruit gaan. Bekijk het rapport en breng uw stem uit op onze poll.

Engelse versie

The Netherlands & The Euro
Statement of Purpose: The Eurozone crisis proves the single currency is
flawed. It must change or fragment. The Dutch government faces a momentous
national decision ­ whether to accept change and stay in a possibly shrunken
Eurozone or opt out, alone or with Germany. The choice is political, affecting The
Netherland's and Europe's future for generations. It needs be well-informed.

Lombard Street Research was honoured to be commissioned by the Dutch
Freedom Party (Partij voor de Vrijheid, PVV) to analyse the consequences for The
Netherlands from staying in or leaving the euro. LSR is an independent international
research and advisory company based in London. It has no political or commercial
affiliations and no conflicts of interest in accepting this task. The analyst team was
led by Charles Dumas, LSR Chairman and Chief Economist, supported by Jamie
Dannhauser, Michael Taylor, Dario Perkins and Brian Reading, none of whom is a
member of any political party. We hope our objective analysis helps in the choice to
be made. We do not advocate any of the alternatives. Our task is to inform and not
to decide. We have received no guidance as to any preference the PVV may now

Our full report contains a great deal of statistical material. This digest hopefully
helps the reader to understand our arguments and conclusions without having to go
into all the details, which are available in the full report.

We first consider the benefits The Netherlands has so far enjoyed within the euro
and the costs incurred. Our analysis demonstrates costs that have seriously
outweighed the benefits. We then consider how the Eurozone may evolve if all
current countries stay in. This involves costs to all members from resolving
problems of competitiveness, imbalances, deficits and debts. The euro cannot
survive unless costs are shared by strong as well as weak.

Fragmentation may take different forms. We look at break-up scenarios in which:-
1. Greece followed by Portugal opt or are forced out
2. All other `Med-Europe' countries follow suit ­ notably Italy and Spain
3. Germany and The Netherlands decide to leave EMU jointly
4. The Netherlands leaves on its own.

This Lombard Street Research report is intended
to encourage better understanding of economic policy and financial markets.

It does not constitute a solicitation for the purpose of sale of any commodities, securities or investments. Although the information compiled herein is considered reliable, its accuracy is not guaranteed. Persons using this report do so solely at their own risk and Lombard Street Research shall be under no liability whatsoever in respect thereof. The contents of this publication, either in whole or in part, may not be reproduced, stored in a data retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without written permission of the Managing Director.

Special Report
March 5, 2012

The Netherlands & The Euro
Charles Dumas

The Netherlands & The Euro 1

Summary & conclusions 1

1. The Eurozone so far 3

Benefits 3
Consequences and costs ­ inflation 4
Growth 4
Swedish and Swiss success 5
Dutch and German citizens sowed but did not reap 6
A poor investment in the future 7
It was not all to do with budget deficits 7
Conclusion 8

2. The euro with all current members 9

Greece ­ Sisyphus is no longer a Greek legend, it is today's reality 10
Italy ­ walking wounded 11
Spain ­ banks in big trouble 13
Portugal ­ banks in even bigger trouble 14

3. EMU members leave 16

Break-up scenarios for the euro 17
Only Greece and Portugal leave 17
Spain and Italy leave 18
The Netherlands and Germany leave 19
The Netherlands quits EMU unilaterally 19
The Netherlands & The Euro
Summary & conclusions

While the euro has advantages that in principle are worth a once-off 2-2¼% of
GDP to The Netherlands, these have been heavily outweighed by disadvantages.
Growth of Dutch GDP has slumped from its pre-euro rate, as well as falling well
short of growth in comparable non-euro countries, Sweden and Switzerland.
Moreover, the sacrifice of wages and salaries has deprived Dutch people of
virtually all of the income resulting from such meagre growth as has been
achieved. Under the pre-euro benign regime, wage and salary restraint was
rewarded by the income gains flowing from a rising currency in a very open

Divergence of inflation and growth between countries in the Eurozone has led
directly to the current debt crisis in Mediterranean Europe (Med-Europe) as well as
feather-bedding Dutch industries in a comfort zone of low labour costs, taking away
the spur to innovation and productivity gains. Even before The Netherlands is
presented with the potentially enormous bill for bailing out Med-Europe, it has
suffered a substantial shortfall of net overseas assets.

The losses already suffered by the Dutch economy and people under the euro
1. Shortfall of growth ­ Dutch GDP in the ten years to 2011 grew at 1¼% a
year, versus 3% in the previous 20 years, and annual rates in 2001-11 of
2¼% in Sweden and 1¾% in Switzerland, neither of them slowing from the
previous decade
2. These latter two economies also performed better in terms of inflation,
employment growth, budget balance and overseas surplus
3. Shortfall of consumer spending ­ if Dutch consumer spending growth, a
feeble ¼% a year in the ten years to 2011, had matched its GDP growth
(as did Sweden's and, nearly, Switzerland's) its 2011 consumer spending
would have been 30 billion higher, 1,800 per person. Had GDP growth in
addition matched the Swedish & Swiss experience the extra consumer
spending would be a further 15bn, 900 per person per annum.
4. Wage and salary restraint was supposed to build up foreign surpluses to
provide future income as working-age population falls, but the shortfall of
investment returns on Dutch surpluses has accumulated to 115 billion,
close to 7,000 for each person

Membership of the euro locks The Netherlands into a system in which cost
competitiveness is matched by massive structural overvaluation of costs in Med-
Europe, resulting in deficits that will suck cash out of the core Eurozone. The Greek
crisis has been made worse by the austerity programme, as Greek budget deficits
are higher than before, not less, and its debt is soaring. Current plans for a
"voluntary" write-off are insufficient ­ only a 100% write-off of all its debts will
suffice if Greece stays in the euro. The combination of huge Portuguese business
debts with government debts close to Italian levels means that its debts too will
probably not be repaid if it stays in the euro. In the "All stay in" scenario both Greek
and Portuguese debts will probably have to be written off in their entirety. In the

Special Report - March 5, 2012 1
cash flow table below we assume this is done in three annual parts in 2012-14. The
optimistic case for Italy and Spain assumes only their budget deficits have to be
effectively funded by core Eurozone and its institutions. The pessimistic case
includes refinancing of bond maturities.

If the New Guilder (NG) appreciates or depreciates against the Euro, then the
Dutch exit from the Euro will yield losses or gains respectively on net Dutch foreign
assets. The policy freedom that The Netherlands would gain by leaving the Euro
includes the option of shadowing the Euro, at least to start with. It follows that costs
or benefits on net foreign assets cannot be specified without major assumptions as
to future economic and foreign exchange policy.

If the Dutch policy were to benefit consumers by permitting some appreciation of
the NG the maximum move that would be likely on past experience would be 10%.
In this case the cost to Dutch net foreign assets would be approximately 75bn,
assuming Dutch stocks only appreciate a portion of that 10% in Euro terms. This
75bn would turn the 2012 Dutch saving under the optimistic scenario in the table
above from a saving of 24bn to a net cost of 51bn. However this short term cost
will be outweighed by the savings of at least 37bn and 38bn in the next two
years and 19b in subsequent years.

The Dutch share of future subsidy costs for Med-Europe is set at 10%, its GDP
being one tenth of the core European members that will finance Med-Europe:
Germany, France, Benelux, Austria and Finland. This 10% ratio is clearly an

This digest is organised as follows:
1: The Eurozone so far
2: The euro with all current members
3: EMU members leave

2 Special Report - March 5, 2012
1. The Eurozone so far

The more visionary see the single currency as a further step towards a `United
States of Europe'. The preamble to the 1957 Treaty of Rome made explicit the
commitment to "an ever closer union amongst the peoples of Europe". The
countries of Europe are deeply different in their legal systems, languages, and
national habits on a scale unknown in the United States, which was formed by the
occupation of the bulk of an entire continent by a single polity with, after 1787, a
single constitution. Partly as a result, the flawed single currency has proved a
retrograde step, dividing rather than uniting Europe.

Nonetheless benefits from the euro cannot be dismissed. The four benefits we
have examined are to transactions costs, trade, travel and capital markets. The
best estimate of these one-off benefits is around 2¼% of The Netherland's 600bn
GDP, 13.5bn or some 800 per head of the population.

Transaction costs have unambiguously been reduced. Guilders need no longer be
exchanged for Deutschmarks. Eurozone banks need hold less money balances to
effect foreign exchange transactions. The European Commission estimates this
benefit added a once-off 0.3% to the area's GDP. In Dutch terms this is some

The single currency has enhanced the trade benefits from the single market.
Exports were 62% of GDP in 1998 and are now 83%. Imports were just under 58%
and are now 75%. But the single currency cannot take all the credit for trade
growth. And trade growth alone overstates the economic benefit thereby derived. A
significant share of increased exports has entailed increased imports. The extra
value added is what matters most. The Dutch Central Bureau for Statistics has
pointed out that "the share of GDP employed producing exports has remained a
relatively constant 29% of GDP since 1990", citing competitive Chinese imports as
a cause of the higher gross export and import shares. While the export share of
GDP has increased by 20%, the 29% of Dutch product, ie, value added, used in
producing exports has not: what has increased is the import content of exports.
The gain from increased exports and rapidly rising import content of exports is
difficult to estimate and certainly only a fraction of the 20% of GDP involved.

Taking account of these factors, an EC commissioned study by the British National
Institute for Economic and Social Research gives an order of magnitude of the
gains from EMU for large core countries. It concluded that it was some 2% of GDP.
This is equivalent to 12bn for The Netherlands, the bulk of the 800 per head of
the Dutch population cited above.

The European Commission has looked at the gains from deepening capital
markets, concentrating on the benefits from lower government bond yields for most
Eurozone members during its first ten years. Sadly this has proved to be a spurious
and ephemeral gain, more than wiped out by greatly increased spreads during the
current crisis. Indeed the near-elimination of interest rate spreads was a
contributory factor to the crisis and should now be regarded as a cost.

Special Report - March 5, 2012 3
Consequences and costs ­ inflation

It was hoped that the euro would promote convergence. Instead the single
monetary policy caused divergence ­ reinforcing divergent national inflationary
behaviour patterns. Individual economies went their own separate ways. Labour
costs rapidly diverged. Amongst the six largest economies, at the extreme Spanish
costs rose 37% more than German in the euro's `good years', 1999 to 2007. Italy's
went up 29% more. In the `bad years' since 2007 Italy has lost more ground, now
up 34% but Spain has pulled back to 31% up. Meanwhile the European Single
Market has helped restrain consumer prices. On the eve of the Great Recession
and crisis, Spanish consumer prices were up 20% on German. When costs rise
faster than prices, profits and sales suffer. Lost competitiveness undermines

This has been manifest in trade performance. While the euro's nominal exchange
rates are the same for all members, real rates are not. The growing German and
Dutch cost advantage has translated into a real effective depreciation. While
advanced countries' share of world export markets has fallen by 11% points during
the euro's lifetime (thanks largely to China), The Netherland's share fell by only 1%
and Germany's rose by no less than 12%. By comparison Italy's real effective
exchange rate appreciated and its world export share fell by a disastrous one-third.
Austerity cannot reverse such real rate and cost differentials, except over a similar
time-scale of well over a decade (if at all).


Eurozone growth has slowed dramatically since 2001 (allowing for the lagged
effect of entry). Every major member's output has grown less rapidly during the
past decade. Even in the good years to 2007 Eurozone growth was marginally
slower. The Eurozone shrank in the bad years that followed. The pattern of relative
growth in 2002-07 was affected by three factors. The first is the much greater,
"catch-up" growth potential of poorer countries like Spain and Greece. The second
is the distortion arising in the Eurozone from the common interest rate, "one size
fits none". The third was the fierce austerity programme adopted in Germany in
2002-05 allegedly to recover competitiveness of costs, though export market
performance clearly indicates Germany had no relative cost problem in 1999-2001.

Given differences in inflation, "real" interest rates, ie interest rates minus inflation,
diverged between countries, even though they all had the same nominal short-term
rates, set by the European Central Bank (ECB). Thus Germany's average real
short-term rate in 2002-07 was 2%, versus the Dutch 1.5%, and Spain's 0.6%.
Slow-growth, low-inflation Germany had high real short-term rate of interests, likely
to inhibit growth and inflation even further; fast-growth, high-inflation Spain had the
opposite, overheating artificially its growth and inflation. The structure of the euro
worsened divergences naturally arising from the differences between the countries.
The Dutch and Germans felt poorer than they actually were, the Spanish richer ­
and the low interest rates that were perceived as a benefit became a curse.

4 Special Report - March 5, 2012
The effects of the perverse interest regime were naturally most evident in capital
markets and housing. The natural buoyancy of housing and house prices was
hugely boosted in Spain, and in Greece, Portugal and Ireland, into a housing
bubble. Had they been outside the euro, these economies would quickly have seen
this boom curbed by higher interest rates in their separate currencies, while
Germany and The Netherlands would have enjoyed lower interest rates than those
experienced under the euro. Instead, the common interest rate, and the delusion
that differences between countries would be ironed out quickly by natural economic
forces, underpinned unbridled housing bubbles. Ireland's had already started to
collapse before the US subprime crisis stopped the whole process from mid-2007
onward. In Spain, Greece and Portugal the damage would have been even more
extensive had not the US bubble collapsed.

German policy reinforced already dangerous divergences. Severe wage restraint in
2002-05 held down labour costs ­ with labour cost deflation ­ and cut into
consumer incomes. With a separate currency, its appreciation would have
rewarded workers for their restraint with cheaper imports and foreign travel, as
happened in the 1980s and 1990s. Likewise with separate currencies, the fast-
growth countries like Spain and Greece, as well as having appropriate interest
rates, would have been curbed by rising import costs, and would have had more
cost-competitive exports and buoyant core European consumer markets to sell
into. The crisis simply would not have occurred: individual country adjustment
would have been forced by financial markets at a much earlier stage. But with the
euro the problems were both aggravated and masked by a fallacious, laissez-faire
belief in the Eurozone as a self-correcting continental economy like the United
States. The euro added to the natural divergences between countries, as well as
distorting their growth patterns.

Swedish and Swiss success

The Euro's baneful impact can also be assessed from experience in other
countries. US and UK growth also slowed down in the new millennium as a result
of debt crises after 2007. The root cause was similar, fixed and dirty floating by
China and Japan which gave an illusion of moderation that led to artificially low

Special Report - March 5, 2012 5
interest rates. Sweden and Switzerland were high savings surplus countries like
Germany and The Netherlands, but they retained their own currencies and policy
freedom ­ and the benefits were large.

Increased competitiveness spared Germany and The Netherlands the worst
consequences of sluggish consumer spending. Export-led growth came to their
rescue thanks to the run-up of deficits and debts in southern Europe (China was
similarly rescued by the US and UK). But the imbalances did not conceal much
worse overall performance. While Dutch growth more than halved following the
euro's birth and Germany's already slow growth became more sluggish, Swedish
growth was unaffected in 2001-2011 compared with 1991-2001, and Swiss growth
accelerated. Only wishful thinking could absolve the euro from blame.

Dutch and German citizens sowed but did not reap

Export-led growth is at the consumers' expense. Current account surplus countries
earn more than they spend. Their savings enable deficit countries to spend more
than they earn (or vice-versa). Dutch and German household expenditure virtually
stopped dead: real consumption growth slumped more than GDP to a stagnant ¼%
a year in 2001-11. Swedish consumption matched GDP growth at 2¼%, while
Swiss consumption grew less than GDP, but still notched up 1¼% a year. As the
Dutch population increased by 0.4% a year, real consumption per head actually
shrank. Had Dutch real consumption grown in line with GDP, every Dutch person
would now be 1,800 better off. Had The Netherland's matched Sweden, the
increase would have been 3,500 per head.

Swedish and Swiss consumer gains were not bought at a cost for the rest of their
economies. They created more jobs than the Dutch and especially the Germans.

6 Special Report - March 5, 2012
They enjoyed lower inflation. They were more successful in balancing their
budgets. And they have run larger current account surpluses!

A poor investment in the future

Both The Netherlands and Germany are aging rapidly, facing future declines in the
working-age population. Today's pre-emptive restraint was supposed to create a
treasure chest of foreign assets to be drawn upon tomorrow. This treasure has not
been invested well and wisely. The Eurozone has not run a commensurate current
account surplus. Their euro surpluses have been largely matched by euro deficits,
Italian, Spanish and Greek. Non-euro foreign assets are mainly claims on the UK
and US. Dutch and German thrift have supported consumption in `thriftless' nations
whose aging problems are similar. Their treasure is fools' gold. It will not buy the
expected future income as much has been wasted on Greek and others' junk
sovereign debt and US sub-prime mortgages.

The Dutch have been particularly hard hit. While adding to their foreign fortune it
has been leaking away. In 2000 The Netherlands was an international debtor to the
tune of 64bn. Since then it has earned a cumulative foreign surplus, including
interest at the ECB's repo rate, of 343bn. But it has lost, one way and another, a
third of this, 115bn. Its net foreign assets have risen to 165bn instead of 279bn.
For every 100 saved out of income, 34 have been wasted or nearly 7,000 per

It was not all to do with budget deficits

Euro-spawned divergent growth and inflation caused external payments
imbalances. Government profligacy did not divide `saints' from `sinners'. In the
good years Germany was a near-sinner. Its budget deficit exceeded the Eurozone
average and was a whisker below the 3% Maastricht limit. Spain and Ireland were
saints with budget surpluses. Greece and Italy were the most wayward. Even so,
the burden of their pre-euro debt, over 100% of GDP, was more important. They
failed the 60% Maastricht test and should not have been allowed in. Current
account, not budget, deficits indicated the onset of crisis.

When private sectors save a lot, governments can spend a lot (but less) and avoid
foreign debt difficulties. Their nations lend rather than borrow. German households
and businesses are great savers, 8% more of their joint incomes than they invest.
Germany can afford 3% budget deficits while running substantial current account
surpluses. Budget surpluses did not save Spain or Ireland. Their private sectors
borrowed and spent extravagantly. Slashing excessive budget deficits may be
necessary, but it is no solution to the current debt crisis in Med-Europe, where
debt-satiated households and/or companies seek also to retrench.

The Dutch fiscal position is unique. Dutch households owe almost three times their
annual disposable income, though largely offset by life-assurance policies linked to
mortgages and other accumulated savings. Government debt is not a problem,
around 70% of GDP gross and 40% net. But the 4% budget deficit still requires

Special Report - March 5, 2012 7
pruning to preserve the Dutch AAA rating, given that current austerity programmes
in Med-Europe are worsening the debt crisis. With deep recession in Med-Europe,
weakness in core Eurozone and elsewhere in the world, cash will continue to be
drained from surplus countries. The pressure for easier fiscal policies in the core
will also mount. As long as Med-Europe remains in the euro it will be difficult for the
Dutch to balance their books. France's downgrade may not be the only one ­ other
countries could soon follow and the cut to AA+ only may not be the end of the


While unquantifiable, no spurious counterfactual story is required to show
that EMU membership to date has imposed substantial welfare losses on
Dutch citizens. Their own superior pre-euro performance, coupled with their
subsequent inferiority compared with Sweden and Switzerland, is
undeniable. Wasteful investment and intractable Med-Europe deficits, with
continued dependency, make for a stressful future. It is difficult to see what
explanation there could be other than the euro.

8 Special Report - March 5, 2012
2. The euro with all current members

This is unlikely to be achievable: Greece may default, opt out or be forced out
within months. Including it in this analysis however demonstrates the costs of
maintaining the euro intact. The costs are not limited to Greece. It may be a
stretcher case in need of life-support, but Italy, Spain and Portugal are walking
wounded that need support. In theory they will contribute cash to bail-out funds
provided by the EFSF, IMF and indirectly by the ECB and shoulder their share of
the losses. In practice they will need to take rather than give. The bill will be shared
amongst northern surplus countries ­ Germany, The Netherlands, France,
Belgium, Austria and Finland ­ "Neuro" Europe for short. Their total GDP is 6
trillion, ten times the Dutch 600 billion. The Dutch putative EFSF share is 5.7%.
But with walking wounded excluded, its share rises to 10%.

How long it may take stretcher cases and walking wounded to return to full health?
When will they be able to eliminate budget deficits, which meanwhile require help
in financing? When can they return to markets at affordable interest rates to roll
over maturing debt? Until these tasks are accomplished, their continued Eurozone
membership will require unlimited overdraft facilities from surplus countries, with
much of the debt never to be repaid.

Current account deficits are only a part-measure of post-crisis external funding
needs. Now that the credibility of Med-Europe government debt is on the line, it is
government deficits that will necessitate financing assistance: as long as "All stay
in" the euro, private sector surpluses, which are likely to be large in depressed
Med-Europe, will probably not be altruistically lent to their government, but shifted
abroad to such "safe havens" as exist. Keeping all the Med-Europe countries in the
euro will require financial support from Neuro Europe for both government deficits,
and the refinancing of maturing government debt.

The future change of exports and imports is more important for its effect on growth
than on Med-Europe's financing needs. Improved competitiveness would stimulate
demand for exports and domestic production at the expense of imports. But,
absent devaluation or massive domestic deflation, improved competitiveness
depends on faster demand growth and inflation in the surplus countries, notably
The Netherlands and Germany. If this is excluded, the adjustment in Med-Europe
will consist entirely of deflation of output and real incomes, reducing demand for
both home production and imports, and lowering relative wage costs by slashing
incomes. Prolonged recession or depression could then make worthless most of
their debts to Neuro partners.

In this "All stay in" scenario, the costs to surplus countries such as The Netherlands
are taken initially through the ECB, the EFSF, the IMF, etc., which have been
busily using their strong credit rating, owed to the underlying credit of surplus
countries in the Eurozone, to buy Greek, Italian, Spanish, etc., government bonds

Special Report - March 5, 2012 9
and support their banks. In the scenario for Med-Europe debt presented in this
report, this temporising process will soon give way under the pressure of Greek
failure to achieve its deficit and debt reduction targets, banking crisis in Portugal
and probably Spain as the recession arising from excessive austerity intensifies
into Med-Europe depression, and mounting debt, of not deficits, in Italy.

Greece ­ Sisyphus is no longer a Greek legend, it is today's reality

Sisyphus was compelled to roll an immense boulder up hill, only to watch it roll
back down, again and again in perpetuity. Austerity, intended to cut Greece's
budget deficit, is actually increasing it, as the economy and tax base collapse.

Private creditors already face `voluntary' default on Greek sovereign debt with
nominal haircuts of over 50% and present-value losses much greater. These will
mount to 100% for someone if Greece stays in the euro. There will be no return to
market finance and further official loans will be called for. Government debt is
360bn, over 170% of the recession-shrunk Greek GDP.

Austerity-stricken Greek government deficits and debts are growing. Tax hikes and
spending cuts have deflated the economy, shrinking the tax base and raising the
costs of unemployment and other relief. Last year Greek real GDP collapsed by 7%
and nominal GDP fell 5½%. Greek ministers, international and European officials
said the budget deficit would be cut to 9% in 2011 (the original target in the May,
2010 bail-out being 7½%). Preliminary returns suggest that in fact it was up 1% in
euros, and from 2010's 10.8% of GDP to 11½%, reflecting the slide in GDP.
Greece has been forced to embark on further retrenchment this year. World and
European growth prospects are less healthy. The deficit could again be worse.

Optimistic projections and impossible targets continue to emanate from those who
assert that the euro will be saved intact "whatever it takes". The "primary" budget
deficit ­ which excludes interest payments ­ was 5% of Greek GDP in 2010, and
about 4% last year (versus the IMF target of 2.3%). The IMF predicts a surplus of
4½% by 2014. Improvements of over 3% of GDP each year for three years are no
more likely than a man walking on Mars in 2014. A 120.5% of GDP government
debt by 2020 is equally implausible without default and would anyhow be
insufficient to resolve the Greek debt problem.

Notionally, private haircuts will knock 100bn off Greek debt. But Greek banks who
own most of the debt would need to be recapitalised and a 30bn cash sweetener
will have to be paid. The net debt reduction could be as little as 35-45bn. Greece
will still need loans to pay 3bn a year interest on swapped bonds and a further
10bn a year in the interest due on some 225bn debt already held in official
hands. Moreover the swapped bond capital will have to be paid on maturity and
subsequent maturing debt rolled over. Annual debt service costs will be around
13bn. A further 10bn will be needed to fund continued primary deficits and none
of the existing official debt holdings will be repaid. The running costs of 23bn
mean a 2.3bn a year cost to Dutch taxpayers. But Greek sovereign debt is

10 Special Report - March 5, 2012
worthless if it remains in the euro, so the cumulative and ultimate cost will be

The table below assumes that the final data for 2011, and worsening numbers in
2012 as a result of the renewed collapse of GDP at the end of 2011 and onward,
convince Neuro countries to recognise their losses on Greece. The 100 billion of
written-down debt in private hands is left in place, with its low interest rate, but the
225 billion of remaining debt is written down over three years, from end-2012 to

*2011 debt of 360bn, 167% of GDP, less "voluntary" write-off being negotiated now
**Assumed write-down of remaining debt not written down in "voluntary" write-off

Italy ­ walking wounded

Italy does not have a run-away budget deficit. At 4% of GDP in 2011 it was
moderate and the primary budget, which excludes interest payments, was ½% in
surplus. Its malignancy is in government debt, 128% of GDP on a gross basis
(100% net) and rising. Italy has a history of large budget deficits and debts. But
Italian households and companies are big savers. They help finance deficits and
hold much of the government's debt. Before the euro, debt interest costs were high
to compensate for inflation and currency depreciation which moderated the debt
burden relative to GDP. The euro closed the depreciation fire escape and until the
crisis compensated for this by reducing interest rates to near-German levels. The
inflation escape route remained partly open with respect to Italian holders, but with
pernicious results. The current account was in significant surplus from 1993 to
1999, but moved into a deficit in 2000 which steadily increased to 3½% last year.
Italy's dependence on foreign lenders to finance deficits and roll over maturing debt
has thus been increasing.

Italy is solvent, as things stand, but suffers a liquidity problem. While it retains
access to capital markets the cost is no longer restrained by near-German interest

Special Report - March 5, 2012 11
rates. Such penal market interest rates may be demanded that the liquidity problem
mutates into a solvency crisis. The primary budget surplus required to stabilise the
Italian debt/GDP ratio at its current level depends on the interest rate it pays on its
debt, its nominal GDP growth rate and the current debt ratio. Last year's
government interest bill was 4½% of GDP. This means it was paying on average a
3½% interest rate on its existing debt. Today Italy pays 5½-6% on new and rolled-
over bonds. It had to pay much more before the European Central Bank launched
its Long Term Refinancing Operation (LTRO). More expensive borrowing will
increase the government's interest bill to around 5% of GDP this year.

If debt is to be stopped from rising and creating a downward spiral of Italian
finances, the growth of debt must be less than that of GDP, so the deficit must be
less than Italy's nominal GDP growth rate (the sum of real growth and inflation).
But Italy's growth trend has been nil over the past ten years, and the parallel
requirement within EMU of becoming cost-competitive again means its inflation will
have to be close to nil in future. So the target budget deficit has to be at most 1-2%
of GDP (assuming a small amount of real growth and inflation). With interest of 5%
of GDP this year, these numbers mean a primary surplus of 3-4% is needed just to
stop debt rising: nobody seriously expects Italy's debt ratio to fall significantly.

To get to +3-4% from 2011's small primary surplus, the new Monti government
proposes austerity measures amounting to 4% of GDP over two years, mostly tax
increases. But this drives Italy toward the Greek trap. GDP was already falling in
real terms in the second half of 2011. It could fall sharply this year, even in nominal
terms, as inflation is likely to be minimal. The primary balance could only improve a
little, and rising interest payments mean the continuing budget deficit will add to
debt. Meanwhile GDP is falling, raising the deficit and debt ratios. This could be
repeated in 2013. Net debt by end-2013 could be heading towards 110% of GDP,
gross debt 140%. Austerity will drive Italy into the Greek debt trap.

Eurozone policies to deal with the Greek crisis have had other adverse side effects.
The `voluntary' debt write-off plan, designed to prevent triggering credit default
swaps, made CDS insurance suspect. Together with `subordinating' private
investors' claims on sovereign debt to official holders' claims, these actions helped
push market interest rates for Italy to debt-trap levels. At present and prospective
rates, Italy is being priced out of capital markets. It is a slow-motion version
of the Greek debt-trap and means that, to stay in the euro and avoid default,
official financing must replace all private. This year Italy needs to borrow
305bn to cover its budget deficit and maturing debt and another 175bn
next year. Most, if not all, must come from official lenders, effectively Neuro

Maybe the ECB's LTRO programme will buy time, indirectly helping to finance
Italian debt by bailing out banks (who can make a substantial profit from investing
cheap ECB finance in high yielding bonds). On this favourable scenario bail-out
funds will be needed to cover Italy's budget deficit, some 80bn this year rising to
95bn next. If the worst comes to the worst, a bail-out would need to cover
maturing debt. The table gives optimistic and pessimistic estimates of required

12 Special Report - March 5, 2012
official support. These are immediate cash-flow costs not economic costs (ultimate
losses) that cannot be projected.

Spain ­ banks in big trouble

The Spanish government's 8% of GDP budget deficit is worse than Italy's. Its
public debt, 75% of GDP (less than 45% net) is better: the major debt problem lies
in business. Spain had a comfortable budget surplus in the good years before the
crisis ­ 2% of GDP in 2007. But the current account deficit (foreigners' surplus)
was 10%. This 12% government plus foreigners' surplus equalled the private
sector's deficit, nearly all in business, fed by a tsunami of cheap and plentiful
foreign credit.

Non-financial companies' debt on average climbed to 12 times net cash flow
(pretax profit plus interest) above the 10% "junk" threshold. The new government
has promised 4% of GDP budget cuts this year under the Eurozone pact, almost
certainly leading to a sharp recession. Company profit will suffer ­ it always goes
down most in recessions. Average debt-to-cash-flow ratios will climb. Still elevated
real estate prices will continue to fall. Banks' loan losses will escalate. Additional
capital requirements, set to be met by July (and onerous Basle 3 obligations) will
not be met. To prevent systemic collapse, banks will need official bail-outs. This is
how private sector losses translate into increased government deficits and debts.
(Ireland's budget was balanced in 2006. Bank bailouts pushed this to a 31% of
GDP deficit by 2010).

Markets are unlikely to lend (at other than short-term at penal debt-trap rates) the
Spanish government the funds to finance a 80bn budget deficit this year, roll-over
145bn of maturing debt and whatever is needed to recapitalise Spanish banks.
Much or all the cash-flow bill will end up with the Neuros, whether through the

Special Report - March 5, 2012 13
dependence on them of the EFSF, ESM, ECB, etc, for capital to support financial
operations, or directly. This is reflected below.

Portugal ­ banks in even bigger trouble

Two parts of debt-trap arithmetic are the same for all supplicant countries:
austerity-induced recession and penal market interest rates. The Portuguese
budget deficit is near 6%. Government debt is over 110%. Business debt is 16
times cash flow. Banks face onerous losses. The government deficit and debt is
poised to explode as Ireland's did.

Debt interest already costs 4¼% of GDP in 2011, meaning a primary deficit of
1¾%. Given the current 11% cost of 10-year bonds, debt interest this year is set to
approach 6% of GDP. Real GDP is slumping ­ Portugal is already in recession,
with real GDP down 1.6% in 2011 from 2010, and even nominal GDP down 0.4%.
Assuming a 2½% nominal GDP contraction in 2012, debt must fall by the same
amount to prevent the debt ratio from rising. Starting from 2011's 6% deficit such a
required shift into budget surplus is inconceivable, quite apart from the likelihood of
a banking bailout that will cause government debt to soar further. Such are the fatal
consequences of fiscal retrenchment.

In the following table, the cash-flow consequences from keeping Portugal in the
euro do not include the large but uncertain costs from the banking crisis. But with
minimal long-run real growth and the need, in a euro context, for deflation, its debt
capacity is confined to what can be supported from a primary surplus. Such a
surplus is unlikely, given the starting point of 2011 primary deficit and recession,
and even with a surplus high nominal interest rates on Portugal's debt would
confine its debt capacity to a very small amount. It follows that, as with Greece,
Portuguese debt will at some stage, probably quite soon, be recognised as
worthless. So the cash flows below have it written off over three years, as with
Greek debt.

14  Special Report - March 5, 2012

Maturing debt & write-offs * 70.0 72.0 79.1 0.0

Total required aid from Eurozone 70.0 72.0 79.1 0.0

*assumes 3-year write-off of current & accruing debt
**assumes write-off in footnote above, and excludes large expected bank recapitalisation

Special Report - March 5, 2012 15
3. EMU members leave
Cash-flow costs by country and total give the price Neuro must pay in future years
to keep the euro intact. But within the euro most of the debts will never ultimately
be repaid and subsidies will need to continue, year in and year out. Indeed the euro
can only survive if it becomes a fiscal transfer union with national sovereign debt
subsumed in Eurozone bonds. Moreover structural change must not be confined to
crisis-stricken economies. Given the need for domestic austerity and lower relative
wages in Med-Europe, growth can only be enjoyed in the Eurozone as a whole if
the surplus countries, notably The Netherlands and Germany accept the need for
consumption growth faster than GDP, and higher inflation than the Eurozone
average, presumably at least 3-4%. Failing this, Neuros will be condemned to
waste their savings on worthless assets, and Med-Europe to depression.

Our view is that, assuming The Netherlands stays in EMU for the time being, the
dawning of realism about Greece will cause it to make a negotiated exit ­ willed, if
regretted, on both sides ­ later this year. And that Portugal will have to leave
shortly thereafter. The political thought behind this is that loss of Med-Europe
countries from the euro is most problematic for France of the Neuro countries, its
competitive position being much weaker than The Netherlands and Germany. So a
Greek exit before the French elections are over is unlikely. But Germany has major
elections in autumn, 2013, and would like a "clean run" for the previous year. That
means settling the "Greek problem" for once and for all. However, as we have
demonstrated, the Greek problem will not go away as long as it remains in the
euro. So it will have to go ­ and will be glad to go, given the virulence of the

Once Greece goes, with severe recession meanwhile sapping Portuguese
business and banks, the full force of the financial markets' perfectly proper
scepticism will drive Portugal out in short order. At that point, if not before, attention
will turn to Spain and Italy, both likely by then to be much weakened by the savage
austerity programmes now being implemented. At that point, the Neuro countries
will actually be forced to make the decisions they have ducked in the two-year
crisis so far. The Netherlands and Germany, if they wish to preserve the euro with
Italy and Spain in it, will have to accept deficit budgeting and relatively high inflation
for the foreseeable future, as well as indefinite subsidies of Italy and Spain via
fiscal union and Eurobonds. The alternatives will be exit, either by Italy and Spain,
or by Germany and The Netherlands in tandem. The former would create the
Neuro, the latter would mean a return to the rationality of floating exchange rates.

At any stage in the above possible course of events, it would be open to The
Netherlands to leave the euro unilaterally ­ on the upside, so to speak. Such a
decision would clearly be more profitable the earlier it is taken.

16 Special Report - March 5, 2012
Break-up scenarios for the euro

(a) only Greece and Portugal leave
(b) "contagion" then forces Italy and Spain to leave, leaving behind the
"Neuro", centred round Germany, France, Benelux and Austria
(c) "contagion" after Greece and Portugal leave creates such large prospective
subsidies to Med-Europe that The Netherlands and Germany decide to
quit EMU, effectively returning Europe to floating exchange rates
(d) The Netherlands leaves alone

Only Greece and Portugal leave

Aside from the technicalities of treatment for each category of euro obligation vis-à-
vis Greece, its exit would involve a bridging loan to the central bank to get the new
currency started, presumably (as with IMF-type financing) senior to all existing
loans. It is only reasonable to assume this would eventually be repaid if much of
the remainder of existing Greek debt, including those now mostly to official
institutions, were both written down and denominated in new drachma. This could
be expected to fall drastically, though not the 80% assumed in some quarters. So
for practical purposes, the financial impact of Greek exit later in 2012 would be little
different from the cash flows shown above in connection with keeping it in EMU, an
unchanged negligible present value but with a more immediate write-down. This is
simply the price of having accepted Greece into EMU in 2001 and then treating its
galloping imbalances with complacency for eight years.

Portugal's gross government debt would probably not be a complete write-off if it
leaves EMU this year. The risks from its huge business debt would have to be kept
under some form of control by denomination in new escudos, as with government
debt, at least for that portion owed to Portuguese banks. But a banking crisis is still
likely to require major recapitalisation at government expense. The relatively small
primary deficit means a devaluation could yield primary surplus quite quickly.
Government debt capacity would certainly not be more than half GDP, however,
and half of that might be taken up with bank recapitalisation. In order of magnitude,
Portugal's near-200billion debt, would be cut by three quarters, and then subject
to whatever devaluation proved necessary for the new escudo, probably in the 25-
40% region. That would only leave 30 billion out of the original 200 billion, but
most of that would be borne by existing holders, not Neuro countries. So it would
be much less costly than keeping Portugal in.

This scenario of Greek and Portuguese exit could become more costly in relation to
Italy and Spain, however: financial contagion as exit from the euro becomes
demonstrably feasible. At the least this could bring forward the date at which Neuro
countries would have to finance the gross borrowing requirements of these two
countries, including refinancing of maturing debt. This is one factor behind
current Eurozone policy paralysis.

Special Report - March 5, 2012 17
Spain and Italy leave

In this scenario, the Greek and Portuguese exit costs are the same as in the
previous one. Italy and Spain suffer acute contagion and exit the euro. Sizeable
bridge loans to facilitate exit would be needed. Nonetheless, if implemented
quickly, Italian and Spanish exit from the euro would offer major savings compared
to keeping them in ­ especially after Greek exit. Italy's exit would be more easily
managed than Spain's, as its overall debt ratio is not high, only its government
debt. In Spain, exit involves the double problem of a higher budget deficit and the
danger from a banking crisis induced by huge company debts.

To estimate the cost savings from Italian and Spanish exit is hazardous, as they
get rapidly greater the longer the exit is delayed. It is not realistic, in the current
condition of European politics to expect either country to take a Greek exit later in
2012 as a signal to get out. The whole tenor of recent policy discussion and action
has been to treat Greece as an exception ­ which it is, in that its problems are
more acute. If a Greek exit is followed by these two countries "hanging on", the
cost of supporting them rapidly escalates to the upper end of the ranges presented
above for their finances. Continuing for some years, followed by "throwing in the
towel" and exit, this would become a very expensive scenario, as the badly injured
economies would need to be nursed back to health at major Neuro expense.

Immediate Italian exit would not be very expensive. Foreign banks and other
institutions owning Italian government bonds would lose money as the new lira
descended, and might need some bail-out by the governments. Euro institutions
that have recently loaded up with Italian paper to try to fix the market would lose
some money. But with currency freedom, Italy would quickly enhance its primary
surplus, return to moderate growth, and regain debt servicing capacity, if at the
expense of ongoing inflation and devaluation ­ back to the old days, in fact, and
very welcome for that compared to the past 10-11 years.

Immediate Spanish exit would be more problematic. Its primary government deficit
is nearly 7% of GDP, reflecting the private sector's need for a huge financial
surplus to permit deleverage after the debt orgy in the run-up to 2007. A major
devaluation might put things right, given good export performance in recent years.
Spain needs a large current account surplus (= foreigners' deficit) to provide its
private sector with financial surplus without the government having to run the
offsetting deficit. But Spain is highly internationally connected and a major
devaluation could worsen the banks' difficulties with their assets ­ ie, the excessive
debt load of business. Clearly the sooner Spain exits the better, as going into
severe recession without leaving the euro would bring on a bank crisis anyhow,
without the possibility of putting right the primary budget deficit.

For all these advantages of early exit, which would minimise the cost of Italy and
Spain leaving the euro, this remains improbable, so a high-cost, long-drawn-out
struggle would be likely before the simple realities of recession and massive
unemployment forced exit. This prospect gives rise to the alternative scenario ...

18 Special Report - March 5, 2012
The Netherlands and Germany leave

Here again, the sooner the better in terms of total cost. Realistically, at the earliest
it could be reactive to Greece and Portugal having left later this year, and the
massive contagion in financial markets threatening to raise sharply the cost of
keeping Italy and Spain in the Eurozone. Given the German electoral calendar,
however, and the absence of scepticism about the euro in any major German
political party, it is hard to imagine this option being undertaken this side of autumn
2013 elections ­ even though it would be popular.

In this scenario, the costs for launching independent currencies and monetary
systems in Italy and Spain could be the same, but incurred earlier, much reducing
the total costs, given the large potential annual fiscal support for those two

The chief point of this scenario is that it amounts to a return to floating exchange
rates. In no way would it be likely that France, Italy and Spain would wish to
maintain a common currency. The German and Dutch exchange rates, whether
fixed together or floating separately, the new French franc might be little changed
against the dollar, while the Med-Europe currencies would fall sharply.

For The Netherlands, this would involve the equivalent of strong-euro experience
before the world moved on from the subprime crisis to the Greek start of the euro-
crisis. Relative to the dollar, the Dutch currency would be up, but also relative to
much of former Eurozone, France and possibly Belgium included. In trading terms,
Dutch firms would feel a (possibly badly needed) stiff breeze. In price terms,
consumers would benefit.

When it comes to net Dutch foreign assets, the dissolution of the euro would
require a legacy currency, and role for the ECB in managing it and maintaining
markets and liquidity. Against that benchmark, The Netherlands, if its currency rose
with Germany's, would gain in respect of its non-equity position, which is a net
obligation of 250 billion, with government debt, denominated in euros being about
the same. Pension funds, on the other hand, with net equity positions abroad,
could suffer losses. But such losses would be qualified by the shifts in stock
markets, which tend to offset currency movements. In any case, the government's
gain on its liabilities should be available to compensate pension funds for losses
incurred by a policy serving the general good.

The Netherlands quits EMU unilaterally

To the extent The Netherlands stays in the euro before drawing the conclusion it
ought to leave, it will incur costs, most likely under the "All stay in" scenario. Further
exit costs could also arise if, by the time of Dutch exit, formal commitments to meet
long-term Med-Europe financing needs have been made under the intended ESM
agreement, currently intended for later this year. This timetable argues for early
action if this policy option is preferred. Aside from representing action to deal with a

Special Report - March 5, 2012 19
threat to Dutch finances, it more generally gives The Netherlands freedom of action
in economic policy.

No more than anywhere else can The Netherlands independently set inconsistent
targets for the three chief demand-management policies: budget balance, interest-
rates/monetary, and exchange rate. The risk that most observers would probably
emphasise is a rising new guilder (NG). But it must first be observed that previous
episodes of Dutch real exchange rate strength have not taken it out of a fairly
narrow band of +/- 10%. Nor is this likely to happen in future. The sheer open-ness
of the Dutch economy argues against it. While this is clearly not the equivalent of
the euro rising 10% (to $1.45, say) as that would take up other EMU countries too,
the relatively recent experience of the euro at $1.60, leaving the Dutch economy
unscathed ­ unlike Med-Europe ­ suggests little threat. And a 10% rise is the
extremity of past experience, not the norm: it would almost certainly settle down
again ­ with Dutch consumers gaining all the way through, of course.

Should The Netherlands, at least at the start of unilateral euro-exit, shadow the
euro? If you want budget balance and to shadow the euro, monetary policy will be
forced on you, not freely determined. If the NG were to be strong, that means
interest rates at or close to zero (no great sacrifice perhaps) and possibly
quantitative easing too (buyback of existing securities in the market, eg Dutch
government bonds, financed by, in effect, "printing money"). This policy choice
seems reasonably manageable.

In this scenario as in leaving with Germany, the valuation of foreign assets would
be an issue. But the limitation of any NG move means that at the worst the problem
would be little different from having the euro shift to $1.45, well within recent
experience. Excluding government bonds, net non-equity positions will be close to
zero, the possible losses on net equity assets largely offset by valuation shifts.

20 Special Report - March 5, 2012


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