Well, it’s finally come to this. You are one of the most troubled member states of the European Monetary Union. Your financial institutions are in shambles.
Your economy is depressed, too many of your people unemployed. The costs for your government to borrow are unsustainable.
Officially, you are trying to get things working or at least to the muddle through stage. Germans insist that you can have growth plus austerity — somehow everyone will earn more by spending less. It’s not happening. Every cut in spending just slows the economy down further, raising deficits and sending your borrowing costs soaring.
So you’re going to have to leave the euro.
In a four part series, we’ll explain how to get out of the monetary union, how to launch your own currency, and what obstacles you’re likely to encounter along the way.
For the purposes of this piece, we’re going to follow the lead of Roger Bootle of London’s Capital Economics, whose paper “Leaving the euro: A Practical Guide” informs nearly every step of my analysis here.
Bootle’s paper, which was written as a submission for the Wolfson Economics Prize, refers the the exiting country as “Greece” and the new currency as the “Drachma.” But, really, Greece is just a stand in for any of the so-called peripheral countries that might leave the euro zone because of
Step 1: Understand That You Have A Problem
If denial were a river, it would be the most traveled waterway in europe. Almost every political leader in power in europe still insists the monetary union can be maintained. Even the radical in Greece claim that they can engineer a way around austerity and out of debt without breaking up the currency.
We’re assuming here that you’ve finally decided to pull ashore and admit that there’s a problem — and that problem is deeply rooted in the single currency.
Perhaps your country has too much public debt. Perhaps the cost of labor in your country has made your products and services uncompetitive in global markets. Perhaps your banking system is carrying too many bad loans. Maybe household debt is at unsustainable levels.
Here’s how Bootle puts it:
"As a result of poor competitiveness and/or the burden of excessive debt, several members of the euro-zone suffer from a chronic shortage of aggregate demand, which results in high levels of unemployment. This worsens the debt position of both the private and public sectors, thereby weakening the position of the banks."
In short, under the current system, you are spiraling downward. Your economy needs a dramatic readjustment. You need to find a way to both reduce the burden of debt — by making it easier for both private and public debtors to pay their debts — and restore competitiveness to your economy. Defaulting on debts plus issuing a new, devalued currency may be your only practical choice.
Step 2: Plan for Redenomination and Devaluation
Leaving the euro will not just mean replacing domestic euros with Drachmas. While “going local” at parity with the euro would create some room for central bank quantitative easing , that almost certainly will not be enough.
Almost all domestic wages, prices and contracts will need to be redenominated into the new currency as a matter of law. That new currency will have to have its exchange value with the euro dramatically depreciated.
“It has to be both of these,” Bootle explains. “There can‘t be devaluation alone because the euro can‘t be devalued against itself, and a mere redenomination into a new currency would achieve nothing. It would be like measuring the distance from Paris to Berlin in miles rather than kilometers. The numbers would be different but there would be no change in the spatial relationship between the two places.”
A Secret Plan?
Step 3: A Secret Plan?
You are going to want to keep your plan secret for as long as possible. At least in theory, it would be best to have your plans to leave the euro shared with as few individuals as practically possible.
“Almost all emerging market devaluations were 'surprise' devaluations, and there is no reason to believe that any exit from the euro would not be a surprise as well,” writes Jonathan Tepper, the author of the bestseller “Endgame: The End of the Debt Supercycle,” whose own Wolfson prize entryruns through a number of historical examples currency conversions and devaluations.
If your plans to exit the monetary union become known early, you risk triggering a massive capital flight by both foreign and domestic investors. Bank runs, threatening what’s left of financial stability, will likely occur. Asset prices will fall; bonds yields may soar.
The problem is that europe is awash in rumors and leaks. Coalition parliamentary governments require information sharing at a much broader scale than a country with a unitary party or strong executive can get away with. There are just too many people who must be consulted and cajoled to go along with the plan to keep anything this important secret for very long.
South Sudan managed to secretly print currency for six months before declaring its independence in July 2011. This probably is not an option for any European country considering exiting the European Monetary Union. Once the printing presses are fired up, you have to assume that word will leak out.
Step 4: Act quickly.
Because secrecy probably isn’t an option, several measures will have to be taken relatively swiftly. First, you’ll have to implement capital controls to stem the flow of money out of the country. Second, you’ll have to prepare the banking system to stem a run on the banks. Third, be prepared for unanticipated chaos the will accompany the sudden repricing of assets and wages.
Many of those who have looked at a possible exit agree that you may have to move over a weekend. The takeaway: get it done over a weekend.
“Convene a special session of Parliament on a Saturday, passing a law governing all the particular details of exit: currency stamping, demonetization of old notes, capital controls, redenomination of debts, etc. These new provisions would all take effect over the weekend,” Tepper writes.
Capital controls almost certainly violate your EU treaty obligations. After all, the free movement of people, goods and capital is at the heart of the idea of the union. Fortunately, there is an emergency provision that may allow you to legally impose controls.
“There is a provision (Article 59) which might allow the temporary imposition of capital controls for a period not exceeding six months, if approved by the Commission and the ECBand agreed by a qualified majority of states,” Bootle explains.
Bootle argues that getting approval might not be as impossible as you might think. Your fellow EU countries are worried about their own exposure to your financial system. They don’t want a disorderly collapse of the banks that would accompany a bank run in your country. What’s more, the capital in-flight could be destabilizing to their financial system and national economies.
The best path may be to implement controls first, ask for permission later. Once you’ve put on the controls, it will become harder to deny plans to change the currency. Everyone will know what this means. So you cannot afford to drawn-out negotiation with other euro-members before you close off the avenue of capital exit.
It’s also important that you are prepared to immediately announce which contractual arrangements will be redenominated into the new currency. For contracts governed by local law, this should be relatively straight-forward. You simply announce that amounts once payable in euros are now payable in Drachmas at the appropriate conversion rate.
Contracts payable outside of Greece and to foreigners are more complex. It will be impossible for the country to unilaterally declare that these are now payable in the new currency at the new conversion rate without triggering a default on many of the obligations. Courts may attempt to enforce EU treaty obligations, which would mean that a country seeking to unilaterally change the terms of contracts would face the possibility of being forced out of the European Union altogether.
But don’t rule out EU cooperation here either. Even if a country is going to leave the currency union, other EU member-states may have incentives to agree to measures that could keep the broader union together. Avoiding a disruption in international trade is no doubt important to exporter states such as Germany, who don’t want to see their businesses shut out of markets. So it’s always possible that the currency exit includes a global agreement about what happens to foreign law contracts, including which ones will be redenominated and what the exchange rate will be.
Bootle recommends that an exiting country work closely with other countries prior to the exit, honor its official-sector debt commitments, attempt to avoid violating relevant international law and EU treaty obligations, and maintain a “friendly” public stance toward other nations.
It’s not clear, however, that this will be possible. There is a lot of animus in Greece about the Germans and vice-versa. If Greek leftists, in particular, triumph in the upcoming elections, it may not be possible for the leadership of the countries to agree to exchange rates and contractual currency conversions.
These are not just problems faced by the official sector. Private businesses engaged in international trade will face serious challenges. Let’s say an exporter of olives has a contract to ship 1000 cases of olives for 100,000 euros to an Italian merchant. After a currency conversation, does the Italian pay in euros or Drachma? Clearly, the Italian business would prefer to pay in devalued Drachma while the Greek olive-grower would want euros. There will be a lot of litigation surrounding these kinds of disputes.
In short, expect lots of confusion and disruption when the currency change is announced.
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