Saturday, December 4, 2010

How to Quit the Euro Zone

The euro debate is evolving along a well-known path. Individuals and governments confronted to major difficulties tend to start with a denial: the problem does not exist. Then the conservatives claim: yes, there is a problem but not as serious as what you pretend. In the third stage, they recognize that the problem is serious indeed, but a radical change is impossible, they maintain. In the fourth stage, the radical change becomes possible but horribly costly. And in the fifth stage, no real change having been tried, it proves eventually even more costly to maintain the existing system than to opt for a radical break with the past.

The third stage has been dominating the debate for about three years since the American economist Eichengreen claimed that he had found the definitive argument against a break-up of the Euro: it would unleash the “mother of all financial crises” since it would lead to bank runs that would destroy the banking systems in Europe and possibly elsewhere.

Now, interestingly, The Economist is proceeding to stage four in its December 2 edition, with a paper titled “Don’t do it: The euro is proving horribly costly to some. A break-up would be even worse”, here and also here.

But the analysis is seriously flawed. Here are some excerpts from the paper, and a different and critical point of view in favor of an exit.

“A break-up might happen in one of two ways. One or more weak members (Greece, Ireland, Portugal, perhaps Spain) might leave, presumably to devalue their new currency. Or a fed-up Germany, possibly joined by the Netherlands and Austria, could decide to junk the euro and restore the D-mark, which would then appreciate.

In either case, the costs would be enormous. For a start, the technical difficulties of reintroducing a national currency, reprogramming computers and vending machines, minting coins and printing notes are huge (three years’ preparation was needed for the euro).”

But remember that at the time of the launch of the euro, the official claim in the deluge of publicity aimed at the public opinion of future member countries, was that these costs were small, or even negligible. And keep in mind that the national central banks are still in place and working today so that no new institutions are needed to recreate national currencies.

“Any hint that a weak country was about to leave would lead to runs on deposits, further weakening troubled banks.”

As I explained previously, the “Eichengreen impossibility” does not hold if there is a large euro depreciation prior to the exit of new national currencies. In that case no further depreciation would be needed for these new currencies, or in some cases a minor depreciation would be enough.

“That would result in capital controls and perhaps limits on bank withdrawals, which in turn would strangle commerce. Leavers would be cut off from foreign finance, perhaps for years, further starving their economies of funds.”

Really? Are currency union exits always leading to durable economic and financial catastrophe? Is that what happened to the following countries that chose to exit from a currency union: Bahrain (1973), Bangladesh (1965), Barbados (1975), Botswana (1977), Cape Verde (1977), Cyprus (1972), Dominican Republic (1985), Ghana (1965), Guatemala (1986), Ireland (1979), Israel (1954), Jamaica (1954), Kenya (1978), Kuwait (1967), Malta (1971), Mauritania (1973), Mauritius (1967), Morocco (1959), New Zealand (1967), Nigeria (1967), Pakistan (1949), Reunion (1976), Singapore (1967), South Africa (1961), Tanzania (1978), Tunisia (1958), Vanuatu (1981), among many others, including the countries that regained their independence from the Soviet Union since 1991 in Eastern Europe and Central Asia, and, last but not least, Argentina.

“The calculation would be only slightly better if the euro escapee were Germany.”

Not true. In that case, if the euro becomes the currency of the southern European countries, it will depreciate substantially, thus alleviating the cost of exiting from it, as explained above. While a “euro-south” would not be viable since it would present the member countries with the same “one size fits none” than the present euro, it would be a useful transition for the euro countries that today need a depreciation most, to exit in an orderly manner, and without an unbearable increase in the external debt due to a large depreciation of the national currency vis-à-vis the surviving euro.

“Again, there would be bank runs in Europe as depositors fled weaker countries, leading to the reintroduction of capital controls. Even if German banks gained deposits, their large euro-zone assets would be marked down: Germany, remember, is the system’s biggest creditor. Lastly, German exporters, having been big beneficiaries of a more stable single currency, would howl at being landed once again with a sharply rising D-mark.”

Not true if the euro, whether still including Germany, or without Germany, is sufficiently weakened in foreign exchange markets before the exit of national currencies.

The punch line: Stage five may be closer than we think.

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