Unwinding the euro

IMG_1563-1” The euro is dead: long live the German euro, the French euro, the Greek euro…..”
Without a fiscal accord the euro was always doomed. When the euro was first established there was a request that each country should observe certain fiscal rules under “The Stability and Growth Pact”. These rules required each country to ensure that a yearly budget deficit was never more than 3% of that year’s gross domestic product (GDP) and that its accumulated yearly debts were never more than 60% of GDP. At the same time the UK, who is not a member of the eurozone, chose the same limit for the budget deficit, but a lower limit of 40% for its accumulated national debt.

In the situation described above are the seeds of destruction. Given an international fixed currency in the eurozone and national fiscal setting mandates, we have the necessary conditions for what is known in game theory as the “Prisoners Dilemma”. Each member country has the incentive to encourage all other member countries to observe the rules and as long as this happens each individual country can see advantages in breaking the rules. In the early days of the euro, it may be surprising to note that the first countries to break out and seize this advantage were Germany and France, claiming that higher than expected unemployment made them a special case and therefore their budget deficits would exceed the limit. Of course, more recently, Greece has shown how the game can be played to its advantage and to the anticipated destruction of the eurozone. Is this the ultimate end game as each member claims they are a special case? Now if only one or two countries break the rules at any one time then the situation can be contained, but in 2009 the G20 meeting gave the go ahead for all countries to break their self imposed rules with the explanation that the “Credit Crisis” would be best overcome if all countries pursued their own fiscal stimulus package.

Across the eurozone almost all countries found themselves exceeding the limits of the stability and growth pact with large budget deficits into double figures and larger national debts into treble figures as proportions of GDP. At the same time the expected economic growth did not materialise so that they could not grow themselves out of their debt crisis. The UK found a partial solution by quantitatively easing (QE) and inflating its way to a smaller real debt, while blaming international factors for the inflation that QE arguably caused. And as long as the Bank of England can maintain its credibility, they may get away with a further round of QE and the inflation it will cause. In contrast, it is not possible to do this across the eurozone as the European Central Bank is more committed to keeping inflation on target at 2% or less per annum.

This means that in the eurozone there may be monetary harmony, but it is the fiscal disharmony that will cause the euro to die or at least only have a slim chance of being revived after a long stay in intensive care. So it is time to stop burying heads in the sand and start thinking the unthinkable just in case it happens; and if these thoughts do nothing more than promote further thoughts on such a forthcoming event then the world economy will be better equipped to deal with the problem ahead.

Without discounting a possible resurrection in a different form, this is how the euro can be laid to rest.

On an undisclosed date in the not to distant future the following things will need to be in place. Each Central Bank of a eurozone country will once again be empowered with control over its own monetary policy and have its own printing presses. On a Friday evening after all financial markets in the eurozone have closed, the euro will cease to be legal tender and each member of the eurozone will have sufficient printed euros in place and be ready to exchange all the euros and euro denominated contracts into its own currency i.e. the French euro, the Spanish euro, the Irish euro and so on. This now means that all sovereign debt will be valued in a domestic euro.

Unfortunately the preparation required before the process described above can start must have been completed in the strictest secrecy. The European Bank and all official policy statements prior to this weekend must have given their full support to the euro while the survival plan was in the preparatory stage. It has been said before and applies here that being economical with the truth is the only way that this transition can take place in an orderly way and, of course, the euro will not be lost totally as the process unfolds over the following few days.

The next step is that, over the weekend, banks will reopen for 24 or 48 hours to exchange euros still in circulation, which are not now legal tender, into the new domestic euro at a 1 to 1 rate of exchange. Here proof of residence and a relatively short time period will minimise the import and export of currency. On Monday morning each member country will have its own domestic euro currency and each currency will now be tradeable on foreign exchange markets. The relative value of domestic euros will now rise and fall against each other and all other currencies under market conditions. It is not anticipated that domestic currencies will become immediately very volatile as the ECB has maintained a fairly strict control of euro circulation. However over the longer term there may be significant changes in value dependent upon the strategies adopted by the newly empowered Central Banks. Also for a further short period of time old euros can be exchanged for new euros at the market rate and similar arrangements will have to be made for exchanging euros held outside the eurozone.
After the chosen weekend, domestic currencies within the old eurozone will be moving against each other and there will be winners and losers, particularly among the holders of sovereign debt, but under this system no one will lose everything.

At this point in time it would seem that the euro is dead. However, it was suggested earlier that a union of sorts may be revived and the following points are suggested. If we assume that by the end of the weekend there are some countries who really want to remain members of a eurozone then, having done what is described above, they can now also make an agreement with each other for their euros to be legal tender in each other’s country with a view to fixing the rate of exchange at an appropriate time. For example, suppose Germany and France want to enter into this arrangement along with other countries that have maintained a relatively strong fiscal stance e.g. Estonia, Bulgaria and Luxembourg, then their euros will remain legal tender in all chosen countries. Outside this other countries may want to join but this time it will be essential to have a binding fiscal agreement over the maximum size of a budget deficit and national debt as a percentage of GDP.

Also this same approach could apply if only one, two, three or four countries wanted, or were asked, to leave the euro. Those leaving could be persuaded that they have not completely broken from the euro and that they now have the added advantage of being able to manage their own monetary policy. Arguably they could see themselves in a much stronger position as they are now able to choose an inflationary solution to their internal problems. The process of rebalancing their economies may then avoid the damaging effects brought about by unemployment, strikes and violence as the government can use the breathing space caused by the little understood inflation that takes place. There is a brief moment in time when even the weakest government may be able to get its house in order by blaming the inflation it has caused on external factors such as commodity prices, and the fall in the rate of exchange against the stronger euros and other currencies. After all the UK has adopted this approach through it quantitative easing programme and is currently succeeding in persuading us that the inflation, caused by the Bank of England, is actually being caused by these same external factors.

Obviously there are many adjustments and additions to this approach to make it function efficiently, but it would be outside the scope of this paper to cross every t and dot every i. Suffice it say that if a collapse is imminent, it may provide a framework for a more orderly transition, or if it does nothing, then just thinking about this may be sufficient to frighten member countries of the eurozone into getting their fiscal policies aligned with a binding fiscal contract.

John Hearn 12/11/2011
University lecturer and economist at ifs University College, School of Finance.

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