Professor Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs.
Lord Wolfson recently announced a prize for academic economists who came up with a plan for an orderly exit of one or more countries from the euro with a closing date of 31st January 2012.
I am convinced that the problem is more urgent than is implied by Lord Wolfson’s deadline so, at the risk of giving up the opportunity to win a handsome cash prize, I am revealing my plan today.
So, what are the options?
The obvious approach is for eurozone leaders to meet and decide to break up the euro. This is extremely tricky. Before the meeting, blanket capital controls would have to be put tightly round all countries which might leave. These would have to be rigidly policed, yet there would be no time to prepare – there could not be a single second’s notice given. A plan for reintroducing national currencies across a number of countries would have to be hatched rapidly and the EU constitution would have to be changed. Laws in member states requiring ratification by referendum would have to be over-ridden. This is only the start of the technical problems that would arise from this approach. An orderly transition would probably require something akin to a police state being imposed in the relevant countries and would be followed by large-scale political unrest. This short-term series of events would then be followed by years of legal wrangling about the status of euro debts (both sovereign and private).
The second approach would be for the northern European states to leave the euro and set up their own currency union. This approach has merit in that we would be less likely to see capital flight from the states that would remain in the euro (possibly to be renamed the sudo-euro). It would still require a constitutional change and the creation of a new central bank for the north. There would be enormous complexities in the reform of the management of the ECB (which would look after the sudo-euro). In addition, there are some tricky questions. What happens to France? What happens to Ireland (for which the best options would be to join sterling or resurrect the punt – neither of which are likely to be politically acceptable). The advantage of this approach is that legal challenges to the status of euro debts in southern countries are unlikely to succeed and the northern countries can move at a pace of their own choosing to create the new currency – as long as both are freely floating and can be exchanged at market exchange rates.
In my view there is a better alternative. We should have a simple constitutional change to remove the clause in the EU constitution that requires the euro to be the sole legal tender currency in eurozone countries. The euro would remain legal tender in all eurozone countries but they would be allowed to issue new sovereign currencies if they wished or could allow any other currency to be legal tender (for example, private currencies, gold-backed currencies or the dollar). The rapid practical effect is that Greece would reintroduce the drachma but the euro would remain legal tender.
There are huge advantages to this. To take the example of Greece, Greeks would have a hard(ish) currency in which they could save and make long-term contracts. There would be no doubt about the legal status of private debts and credits denominated in euro and little doubt about the legal status of Greek government debt (any doubts would revolve around whether it was denominated in euros or the “sovereign currency of the Greek government” – most likely the former). There would be no capital flight – all euro deposits in Greek banks would remain euro deposits.
What problems does this solve? What problems does it not solve? And what new problems might it create?
This approach would allow the Greek government and employers to write labour market contracts in drachma. It would ensure that this rigid, illiberal economy would have a bit more flexibility in the wake of economic shocks.
It does not, though, wipe out Greek euro debts. They are euro debts and would remain euro debts. However, default is really no different in principle from re-denominating debts in drachma and allowing the drachma to depreciate so this is not a huge problem. It is better to have an orderly default on debt that is unambiguously euro denominated as legal uncertainty about the status of those debts.
It should be added that this reform will not – and cannot – deal with the underlying weaknesses of the Greek economy: if the new drachma depreciates, living standards will fall. These weaknesses cannot be dealt with simply by currency reform.
Some argue that Gresham’s law would prevail and that the bad currency (drachma) would drive out the good currency (euro). This is not true.Gresham’s law only holds at disequilibrium exchange rates. A more likely problem is that people may not wish to write contracts in drachma. This is a risk worth taking – at least there will be the option of writing such contracts.
The real problem with this proposal revolves around the transactions costs of having two currencies in the same jurisdiction. In my view, that is a minor inconvenience compared with the chaos that would ensue from breaking up the euro. In any case, the transactions costs would not be nearly as great as those from re-establishing a new currency in each member state and abolishing the euro. Indeed, parallel currencies have existed elsewhere in the world. The other essential complementary measure is that the ECB should be radically reformed so that it does not take on euro sovereign debt issued by all member states as if it is risk free – that way, sovereign debt remains a matter for the member states and not for the eurozone as a whole.
If this plan reminds you of the hard ECU plan of the UK government when the euro was first designed, you would be right. How much better if the euro had originally been made a parallel legal tender currency throughout the EU with member countries simply retiring their sovereign currencies as and when they wished.
Twenty years on it seems to me that, unless the eurozone wishes to impose a police state and either ride roughshod over contracts or face years of legal wrangling over the status of trillions of euro worth of debt, the creation of parallel – or competing – currencies is the only credible solution to the problems created by the imposition of EU monopoly money in the eurozone. There is no credible alternative.