Thursday, 10 November 2011

How To Dismantle the Euro Without Blowing Up Europe

Yesterday I promised to sketch a way in which the Eurozone could be dismantled in a way which would deal with the immediate problems whilst preserving as many as possible of the benefits of the Eurozone.

And the first thing I want to stress is that, though the potential benefits are currently dwarfed by the imminence of its catastrophic failure, the Euro project wasn't begotten purely to cause financial mayhem, or to further the sinister Europa-building fantasies of the EU's visionaries. There is much to be said not just for a single market, but also for stable and predictable currencies within that single market. More, there's a great deal to be said for a conservatively German view of banking and central banking (though, in extremis, as we shall see in my next post, even some quite eminent German economists plainly don't understand the day-to-day back-office mechanics of what a central bank does). And there is also plainly merit in ensuring democratically elected governments are not cocooned from the discipline of the markets.

What little work to have been done on a breakup of the Eurozone assumes that all these benefits must be lost or foregone throughout the whole of Europe if the Eurozone breaks up. The locus classicus so far is a research paper by published in September by UBS, which warned that the consequences of a weak country leaving the Euro would include sovereign default, corporate default, collapse of the banking system and collapse of international trade. The paper estimated a weak Euro country leaving the Euro would incur a cost of around Eu 9,500 to Eu11,500 per person during the first year, with a further Ee3,000 to Eu4,000 per person per year over subsequent years.

Mind you, it would be no picnic for the Germans, either, if they left the Eurozone: Eu 6,000 to 8,000 for every German adult and child in the first year, and a range of Eu 3,500 to 4,500 per person per year thereafter. That's the equivalent of 20% to 25% GDP loss in the first year!

I have three comments to make on this. First, we're in 'spurious accuracy,' or 'magical realism' territory as far as the forecasts are concerned. Second, since the paper was unable to envisage how – short of a sort of confetti-producing monetary free-for-all – an exit might be achieved, the authors were free to colour in their favourite shade of lurid in all possible ways, economic, financial and political. Third, and notwithstanding these shortcomings, UBS is at least to be congratulated on having the balls to broach the subject at all – even if in the end it did little more than scaremonger.

The key to finding a solution is to understand very clearly what the underlying problem is. And Italy's case makes this absolutely crystal clear: Mr Berlusconi may not be your cup of espresso, but it is simply not true that he ran a regime of exceptional fiscal indulgence. During 2001-2007, Italy's fiscal deficit averaged 3.2% of GDP, which is hardly deeply differentiated from France's 2.9% average, or even Germany's 2.7%. Since 2008, Italy's deficit has averaged 4.9% of GDP, which is frankly conservative compared to France's 7.3% (though Germany confined itself to 3.8%). If moralizing of all sorts can be temporarily adjourned, it's plainly not Italy's current fiscal policies the market cannot stomach. Nor is it the debt burden, which, at around 120%, is only slightly higher than the average since 1995 of 111%. What really kills is the absolutely correct perception that whilst it has the Euro as a currency, Italy will never be able to grow sufficiently fast to contain its debt-burden.

So what we are looking for is an way to ensure that when a country exits the Eurozone,  it will both be in a position to grow, whilst at the same time retaining the financial and fiscal disciplines encouraged membership of the Eurozone. And, quite obviously, whatever exit route is achieved, it must also be built to re-win financial stability and confidence at the earliest possible opportunity.

Put in these terms, the solution is obvious. Currencies can and should exit the Euro by first redenominating all domestic assets and liabilities of the banking system in the new currency, and also redenominating all external government debt in the new currency, whilst at the same time committing to fully servicing the debt in the new currency. But second, and crucially, it should at the same time announce a currency-board arrangement which pegs the new currency to the Euro, and dissolve the national central bank at the same time.

For those who've spent time in Hong Kong, this solution will seem obvious. But, strangely, I've never heard it mentioned as a possibility.

A currency board is simplicity itself: its founding principal is that for every unit of the new currency to be issued (let's call it the New Lira), the note issuing institution must deposit the full stated amount of the currency to which it is pegged, with the currency board. If the New Lira currency board is declared at 60 Eurocents, if the note-issuing body is a private bank (and why not?), it is obliged to lodge 60 Eurocents with the currency board. The currency board accumulates the interest on that deposit, whilst the bank makes its money from the New Lira financial asset it subsequently creates/sells. Crucially, there is no central bank to intervene in money markets, which means that banks must carefully monitor the daily net clearing balance of the banking system. If that net clearing balance is negative, the rise in interest rates will persuade a bank somehow to scrape together the Euros needed to print more money in order to rectify the imbalance. Conversely, if the net clearing balance is positive, one would expect interest rates to shrink, at which point banks may (or may not) find it profitable to redeem the New Lira for Euros.

Clearly a currency board subcontracts the monetary policy of the country to the monetary policy of the Eurozone, and so also patrols the fiscal possibilities of that country to the underlying cashflows (and eventually capital flows) of the private economy operating within that monetary policy. Sometimes, such as in Hong Kong, this is seen as introducing a degree of monetary arbitrariness: at the fringes of the Eurozone, however, such linkage is entirely justifiable, and desirable on both sides of the monetary border.

In other words, establishing a currency board allows the absolutely necessary currency re-set as a precondition for renewed growth,  whilst reinforcing the medium and long-term financial disciplines which the Eurozone's architects and current members profess to value.

And what of those left holding suddenly devalued New Lira government bonds? Well, here the news is actually rather good: assuming that at the time of the declaration of the currency board, the Euro-denominated government bonds are trading at a deep discount to face value, the instantaneous re-establishment not only of monetary discipline but also the new prospect of renewed growth in the medium to longer term will surely result in the yields on those bonds falling in the short-to-medium term. (Since, after all, lack of growth was the problem, and constant monetary indiscipline the fear.) In those circumstances, one might expect to find buyers even of Greek debt at 25%+. In short, what a bank lost immediately on the currency could be expected to be made up in the short-to-medium term on capital gains as bond yields return to 'normal'.

Even French banks might survive.

At what level should the currency boards be declared? I haven't done the detailed work, but plainly, the depreciation needs to be sufficient to give an assurance that growth is possible. In the end, one should avoid spurious accuracy. I am reminded of a story told of the blessed John Greenwood, who when devising the (highly successful) Hong Kong currency board in 1983, carefully worked out that the correct value should be eight HK$ to one 1 US$. His calculations were rejected out of hand by Sir Edward Youde, the governor, as quite implausibly lucky (or so I am told). The Cantonese would simple never believe it. So he altered the valuation to 7.8 where it has stayed.

I understand Lord Woolfson has offered a prize of £250,000 for anyone explaining how to dismantle the Eurozone painlessly. Feel free to forward him this piece: the task is significantly easier than either he has been encouraged to believe. 


  1. this does not address the issue of flight...

  2. Yes, this is a valid criticism. But where does one start? Take a look at the next piece (Target 2, Keinen Sinn, and the New Lira), which strongly suggests we've already had loads of capital flight to German banks from other Eurozone banks, reflected in the bloated Target2 Germany surplus. It seems absolutely reasonable to believe/expect that under a currency board arrangement, those Target2 imbalances would gradually be eroded. What happens on the first day, though, is anyone's guess - not least because a lot would depend on presentation and coordination. Just as the development of any bank run depends on how you play it. . .

  3. You never heard of this "currency board" solution because it breaks any previously set record of idiocy.

  4. A bit harsh? I'd have thought the bar for idiocy on this matter has been set fantastically high already by our lords and masters. One way or another, the end-game cannot avoid dealing with the mismatches in competitiveness. The only question is whether you attempt to help this or frustrate it.

    It also sounds as if the whole idea of 'currency boards' are new to you. They work pretty well (in their own way) in other parts of the world.