Five ways the eurozone could break up
- 4 June 2012
- From the section Magazine
The Wolfson Prize offers £250,000 to the economist who comes up with the best plan to manage a potential break-up of the eurozone. The five ideas in the running are summarised here.
The conundrum posed is this: "If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?"
Lord Wolfson, whose family charity puts up the prize money, has said there is a serious need for a solution to any euro break-up. Here are the short-listed entries:
1. Greece - or another country - could go
The most realistic scenario for euro break-up is that Greece, or one or more of the weaker peripheral countries, will leave the eurozone, introduce a new currency which then falls sharply, and default on a large part of their government debt.
Preparations for exit must be made in secret and acted on straightaway. Just before departure, some form of capital controls will be essential, including temporary closure of banks and ATMs. With no time to print new notes, euro notes and coins should continue to be used for small transactions. The new currency should be introduced at a one-for-one rate with the euro. But it will soon depreciate by something like 30-50% giving a boost to Greece's international competitiveness.
The government should redenominate its debt in the new national currency and make clear its intention to renegotiate the terms of this debt. They must announce robust measures to keep inflation in check but, with them, markets may well lend to the exiting country again the medium term. Importantly, the exiting country has an opportunity to break free from a crippling debt strait jacket.
Mark Pragnell, Capital Economics
2. Pain sharp but short-lived
Many economists expect catastrophic consequences if any country exits the euro.
However, during the past century, 69 countries have departed from currencies with little downward economic volatility.
The mechanics of currency breakups are complicated but feasible, and historical examples provide a roadmap for exit. The real underlying problem in Europe is that peripheral countries have external debt levels that are higher than most previous emerging market crises, and they face severe misalignments in wages and prices with their neighbours in the core. Europe has the characteristics of a classic emerging markets balance of payments crisis writ large. As such, the problem is not the mechanics of exit, but of managing a severe and necessary adjustment.
The adjustment can come quickly via exiting the euro and devaluing, or slowly via a fall in real wages and prices.
Exiting from the euro and devaluing would be very painful, but the pain would be short and sharp.
Departing would accelerate insolvencies, but would provide a powerful policy tool to restore competitiveness via flexible exchange rates. Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable.
The European periphery could then grow again quickly with lower debt levels and more competitive exchange rates, much like countries that left the Gold Standard in the 1930s (Britain and Japan 1931, US 1934, France 1936) and many emerging markets after recent defaults and devaluations (Asia 1997, Russia 1998, Argentina 2002, Iceland 2008).
3. All return to national currencies
Germany should commission a top-secret task force, to prepare a plan for use only should one country be imminently leaving the eurozone. The plan would call for an emergency meeting of the leaders of the 17 eurozone states, and the German chancellor put to them the proposition that they collectively, and immediately, abandon the euro, reverting to their national currencies at euro entry rates.
The ECB would be abolished and its functions returned to the national central banks. All bank accounts, assets, liabilities and obligations in each member state would be immediately redenominated into national currencies. Assets, liabilities and derivative contracts that are not identifiable as domiciled in a specific state would be redenominated into a run-off ECU - a basket of the new currencies weighted by ECB shareholding.
All member states would agree to extend unlimited liquidity to the banks domiciled in their states, and most would require re-capitalisation. Euro notes and coins would all be redenominated into the currency of their issuing national central bank (euro notes have serial number prefix letters identifying the issuer). National notes would be printed as soon as possible. Markets would re-open after enforced bank holidays, and the new drachma would fall, say, 60% below its official euro conversion rate; the new deutschmark would rise, say, 20% above its official conversion rate.
This would allow the southern states to get back to work, and curb Germany's chronic trade surplus with the eurozone. This route would be cataclysmic, but would finally end the crisis, and lay foundations for a new Europe. The German chancellor would explain that should they not all agree to Germany's request, then Germany would implement a separate plan to leave the euro itself.
4. How to redenominate currencies
A break-up of the eurozone implies a need to redenominate contracts from euro into new currencies. This is relevant for bonds, loans, deposits and other financial instruments.
This process is complicated by various legal constraints. Different financial instruments are governed by different laws, and many euro denominated instruments are governed by foreign laws, especially English laws.
Eurozone governments cannot change laws of foreign countries and they cannot easily redenominate foreign law assets. Since there are tens of trillions of euro-denominated contracts in existence under foreign law this is a very large potential problem.
Our plan stresses the importance of facilitating an orderly currency redenomination process in all break-up scenarios. This includes the need for an ECU-2 currency basket to settle euro claims in a full-blown break-up, where the euro ceases to exist. The ECU-2 would constitute a bridge between the euro (which no longer exists in a full blown break-up) and the new national currencies. The ECU-2 concept would thereby help avoid arbitrary currency conversions and prolonged legal battles about redenomination. In the absence of an efficient process for redenomination, a full-blown break-up of the eurozone is likely to be devastatingly disruptive and could see a complete freeze of the global financial system.
5. Split the eurozone in two to stop currency flight
My approach is designed to allow an orderly transition of the eurozone to two or more regions, and prevent the speculative capital flow, that could force a country out of the eurozone.
These new regions would have their own central bank, monetary policy, and currency unit. All euros would get treated equally and get exchanged for a basket of the new currencies at an agreed and fixed exchange ratio - the paper describes how this ratio gets set. So everyone would receive a basket of the new currencies, and it would be up to them to decide what currencies to exchange them to. The settlement value of existing euro-denominated contracts and debt could be determined by the exchange ratio and the relative value of the new currencies.
Post-separation, competitiveness could be restored by the exiting country or countries managing a gradual devaluation, using higher nominal interest rates and inflation. Higher interest rates prevent a sudden currency collapse and stops currency flight. In addition, any renegotiation of, or default on, debt could be managed quite separately. And, unlike with a crash exit, savers in the exiting countries are not penalised and speculators are not rewarded and the process can allow time for migration to the new currency regimes. Because it reduces the risk of speculative capital flows, the "Newney" approach - New Euro-White (New and New Euro-Yolk (Ney) - could also support the eurozone remaining together.