Options for Europe – Part 78

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe

Chapter 23 Abandon the Euro ­ Costs, threats and opportunities

[PREVIOUS MATERIAL HERE]

[BY WAY OF EXPLANATION – I AM WRITING SECTIONS OF THIS CHAPTER AS I GET INFORMATION SORTED IN A COHERENT WAY – IN THE FINAL DRAFT – THE SECTIONS MIGHT BE ARRANGED IN A DIFFERENT ORDER TO WHAT WILL APPEAR HERE OVER THE NEXT FEW DAYS. I WROTE MUCH MORE TODAY THAN APPEARS BELOW – BUT THE TEXT BELONGS IN SEVERAL SUB-SECTIONS AND SO I THOUGHT IT WOULD BE LESS DISJOINTED FOR THOSE THAT ENJOY FOLLOWING THE UNFOLDING STORY IF I JUST KEPT WHOLE SUB-SECTIONS TOGETHER.]

[NEW MATERIAL TODAY]

The exit process

There are many different considerations for a nation choosing to exit a monetary union. There are historical precedents, which help us to understand the pitfalls and desired strategies. The following points summarise the process that a nation might undertake to exit the euro-zone. We will then discuss each issue in more detail.

• Secrecy – All decision-making and planning has to done in secrecy to minimise the costs of the resulting exit. All announcements to be made on a Sunday, when all banks are closed.
• Reintroduction of national currency to be used within national borders. All levels of government would require tax obligations to be met in this currency. Major improvements in tax law enforcement would be require to reduce the increased participation in ‘black market’ activities.
• Float the currency on international foreign exchange markets after negotiating re-denomination at a stated parity (perhaps 1 to 1 or the parity that ruled on December 31, 2001).
• Negotiate the transfer of monetary policy and prudential functions of the ECB to the national central bank, with the nation’s contribution to the ECB capital reserves, bank notes and foreign currency reserve equivalents (and share of accrued profits) returned.
• Imposition of capital and foreign exchange controls for some indeterminate period.
• Re-denomination of all bank account balances and all debts incurred under national law into the national currency. Bank would be closed for a day or so following the announcement. Current public sector debt is issued under national law and so-called ‘place of payment’ rules support a nation’s capacity to offer legal payments in the national currency.
• Euro payments for transactions permitted for a limited period as in the dual system between 1999 and 2002 but euros would exchange at the parity determined on foreign exchange markets. New currency notes and coins would progressively eliminate the need to transact in euros.
• Reduce the danger of social unrest and provide an immediate stimulus to growth by announcing a national Job Guarantee, which would offer anyone wanting a job a position at a socially-acceptable minimum wage.

Transaction costs

Chapter 3 of the European Commission’s One market, one money report released in 1990, estimated the ‘transaction costs’ of moving from the 12 national currencies to the euro to be equivalent to “about 4% of Community GDP” (European Commission, 1990: 63). The major part of these savings would result from the “disappearance of the exchange margin and commission fees paid to banks”. The analysis recognised that the savings would vary across the Member States such the gains for a nation “whose currency is extensively used as a means of international payments and belongs to the ERM may be of the order of between 0.1% and 0.2% of national GDP” and for “small open and less developed economies of the Community may stand to gain around 1% of their GDP” (p.63). The European Commission published a follow-up report in 1998, which estimated “that transaction costs of about 0.8% of EU GDP may be saved through EMU” (IFO Institute, 1998: 46). The study provided no estimates for the individual nations. A later study, using a different methodology, found the estimates to be higher at both the Community and national levels but noted they were upper bounds (Mendizábal, 2002). The estimates of these studies would be lower if they had have been conducted in 2014 given the increased sophistication of banking and other financial institutions and the increased emphasis on electronic transactions via credit cards and the like.

As an aside, the financial market cost savings conjectured in the 1990s by these studies failed to foresee the massive and irrational explosion of financial market transactions that led to the GFC. Far from reducing the claim on GDP, the financial markets (banks and related institutions), aided and abetted by financial market deregulation, a lack of oversight from the regulators of the remaining rules, and, plainly, illegal business practices, rapidly increased its share of world income. The mess that this frenzy created has cost multiples of GDP relative to the shift into one currency was alleged to have saved. Further, the imposition of austerity, which has blighted growth for years in the Eurozone has also forced nations to incur massive losses, which dwarf the estimated savings in these Commission Reports. While not denying the existence of transactions costs when nations trade with different currencies, the retention of a nation’s own currency and the capacity to manage fluctuations in private spending, would have delivered huge net gains relative to the austerity route with one currency.

The other point about these earlier estimates, however much we downgrade them to reflect 2014 reality, are not applicable to the situation where one nation exits the EMU. The estimates were arrived at by assuming that the multitude of currencies would collapse into the euro. If, for example, Italy was to re-introduce the lira, then the transaction costs associated with lira-euro exchanges would be minimal. Further, for any nation contemplating exit, the increased transaction costs would be influenced by how open their economies are and how much of their trade is intra-EMU rather than beyond it. A less open economy with a higher proportion of trade outside the EMU will experience smaller increases in transaction costs as a result of abandoning the euro. Table 23.Z shows the Trade-to-GDP ratios for a selection of European nations and other nations, and, where possible, the proportion of exports in GDP. The United Nations Conference on Trade and Development (UNCTAD) propose an Index of Openness based on the Trade-to-GDP ratio, whereby the sum of the current value of exports and imports of goods and services are expressed as a percentage of GDP. The higher the ratio, the more open the economy is. Care is needed when making cross-country comparisons because a nation such as Belgium has much less opportunity to trade within its own borders than say China or the United States.

Table 23.X Trade openness and Exports to GDP, per cent

Source: UNCTAD Stat, Goods and Services Trade Openness, Annual; Eurostat. 2000 openness values for Luxembourg are for 2002. Values for Exports as a % of GDP for Ireland and Malta are for 2012.

Nations such as Greece, Italy, Spain, and Portugal are relatively closed when compared to the average EU nation. According to Eurostat, 53 per cent of Italian exports go are bought within the EU while around 40 per cent are absorbed by EMU nations. For Greece, around 53 per cent of its exports go to the EU with about 37 per cent being sold to EMU nations. Nations such as Belgium, Spain, France, Netherlands, Portugal are more heavily dependent on intra-EMU exports. The dramatic increase in German openness since 2000 is notable and reflects the deliberate suppression of domestic demand (Hartz) and the reliance on net exports for growth, which has been part of the euro-zone problem.

Why re-denomination rather than default?

On June 6, 2011, German Finance Minister Wolfgang Schäuble wrote a letter to the ECB, the IMF and his Ecofin finance ministers, which expressed doubt that Greece could meet the terms of the bailout conditions in place and return “to the capital markets within 2012” (Reuters, 2011). He knew the IMF would not oppose further funding in these circumstances but predicted that without “another disbursement of funds before mid-July, we face the real risk fo the first unorderly default within the euro zone”. He then judged that “any additional financial support for Greece has to involve a fair burden sharing between taxpayers and private investors”, which introduced the idea of the PSI (private sector involvement) at the highest levels. He called for a “substantial contribution of bondholders to the support effort”, which should be achieved ” through a bond swap leading to a prolongation of the outstanding Greek sovereign bonds by seven years” (Reuters, 2011). This set in place what would become a major default by the Greek government on its privately-held debt liabilities all managed by the Troika. The Greek government bond debt held by the ECB (its largest creditor), the national central banks (also large creditors) and the European Investment Bank (a smaller creditor) were excluded from the haircut. Various tricky legal mechanisms were put in place to ensure the default was not subject to further legal challenges (for example, to cope with debt issued under English law). The details of the PSI need not concern us here but suffice to say, the “present value of the haircut of the Greek debt exchange was in the range of 59-65 percent” (Zettelmeyer, 2013: 19).

The question is why is a forced restructuring of public debt to the detriment of the private investor preferable to a negotiated withdrawal? The PSI was a Troika-managed and imposed loss for private investors who had presumably acted in good faith. In fact, the preferred exit strategy is to re-denominate all government liabilities in the new national currency. In the case of the withdrawal the losses would come via the re-denomination of the debt and the likely depreciation of the new currency. Scott (201z: 3) argues, however, that “redenomination of debt has distinct advantages over restructuring as a technique to reduce debt burden”.

[CONTINUE TOMORROW – OUTLINING ALL THE STEPS AND ISSUES INVOLVED IN A UNILATERAL EXIT]

Additional references

This list will be progressively compiled.

Athanassiou, P. (2009) ‘Withdrawal and Expulsion from the EU and EMU: Some Reflections’, Legal Working Paper Series, European Central Bank, No 10, December. www.ecb.int/pub/pdf/scplps/ecblwp10.pdf

Banco Central de la Republica Argentina (2007) ‘Single Free Exchange Market (MULC) Transactions and the Foreign Exchange Balance in the First Quarter of 2007’. www.bcra.gov.ar/pdfs/estadistica/MULC1trim07i.pdf

Bundesverfassungsgericht (2009) ‘Entscheidungen: Lissabon-Urteil’, 2 BvE 2/08 vom 30.6.2009. http://www.bverfg.de/entscheidungen/es20090630_2bve000208.html

ECB (2014) ‘Capital Subscription’, https://www.ecb.europa.eu/ecb/orga/capital/html/index.en.html, Accessed May 1, 2014.

European Commission (2010) ‘Consolidated versions of the Treaty on European Union and the Treaty on the Functioning of
the European Union ‘, Official Journal of the European Union, C83, 30.3.10.

IFO Institute (1998) ‘Currency management costs’, The Single Market Review, Subseries III, Volume 6, Commission of the European Communities.

MacCormick, N. (1999) Questioning Sovereignty, Oxford, Oxford University Press.

Mendizábal, H.R. (2002) ‘Monetary Union and the transaction cost savings of a single currency’, Review of International Economics, 10(2), 263-77.

Policy Exchange (2012) ‘Wolfson Economics Prize 2012’. http://www.policyexchange.org.uk/component/zoo/item/wolfson-economics-prize-2012

Reuters (2005) ‘Italy minister says should study leaving euro-paper’, June 3, 2005.

Reuters (2011) ‘TEXT-German Schaeuble’s letter on Greece to IMF, ECB, euro peers’, June 8, 2011. Thttp://www.reuters.com/article/2011/06/08/greece-germany-letter-idUSB4E7G900O20110608

Scheller, H.K. (2004) ‘The European Central Bank – History, Role and Functions’, European Central Bank, Franfurt. https://www.ecb.europa.eu/pub/pdf/other/ecbhistoryrolefunctions2004en.pdf

Scott, H. (1998) ‘When the Euro Falls Apart’, 1-2 International Finance, 1, 207-228.

Scott, H.S. (2012) ‘When the Euro Falls Apart – A Sequel’, Working Paper, Harvard Law School, January.

Sukkar, E. and Smith, H. (2013) ‘Panic in Greek pharmacies as hundreds of medicines run short’, The Guardian, February 28, 2013. http://www.theguardian.com/world/2013/feb/27/greece-blames-drug-companies-shortages

Thieffry, G. (2005) ‘The not so unthinkable – the break-up of the European Monetary Union’, International Financial Law Review, July. http://www.iflr.com/Article/1978253/Not-so-unthinkablethe-break-up-of-European-monetary-union.html

Varoufakis, Y. (2014) ‘Europe’s latest policy on Irish and Greek banking losses: A tale of two swindles too similar for comfort’, April 1, 2014. http://yanisvaroufakis.eu/2014/04/01/europe-and-the-stressed-banks-of-ireland-and-greece-a-tale-of-two-swindles-too-similar-for-comfort/

Voßkuhle, A. (2012) ‘Über die Demokratie in Europa’, Speech to Rhur Political Forum, Dortmund Concerthall, February 6, 2012 published in Aus Politik und Zeitgeschichte (APuZ), 13/2012, Bundeszentrale für politische Bildung, 3-9.

Wetzel, D. (2001) A Duel of Giants: Bismarck, Napoleon III, and the Origins of the Franco-Prussian War, Madison, The University of Wisconsin Press.

Wolf, M. (2013) ‘Why the euro crisis is not yet over’, Financial Times, February 19, 2013. http://www.ft.com/intl/cms/s/0/74acaf5c-79f2-11e2-9dad-00144feabdc0.html#axzz30L8DwwS0

Wolf, M. (2014) ‘Managing a Bad Monetary Marriage’, paper presented to iNET Conference, Toronto, Canada, April 2014.

Zettelmeyer, J., Trebesch, C. and Gulati, M. (2013) ‘The Greek Debt Restructuring: An Autopsy’, Working Paper Series, WP13-8, Peterson Institute for International Economics.

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.