Monday, March 1, 2010

Leaving The Euro

The economic situation in some of the peripheral EURO economies like Greece, Italy and Spain is pretty grim - with a prolonged recession, prospect of deflation, uncompetitive exports, rising unemployment, and current account deficits. In the case of Greece it is compounded by record levels of government debt.

A textbook solution to the above problems, is to allow a devaluation of the exchange rate and pursue a more expansionary monetary policy.

But, being in the Euro, it would be very problematic to do it. Exchange Rates are permanently fixed, and the ECB show no signs of deviating from its religious devotion to low inflation whatever the costs.

One question is can an economy actually leave the Euro and go back to it's original currency? Could Greece leave the Euro and readopt their own currency?

Problems of Leaving the Euro

Firstly, there are grave political problems, the fallout could affect the economies reputation and lead to less confidence and less investment e.t.c in the long term.

Transaction Costs. Switching from one currency to another is a significant cost. Not only do you have to re-introduce a currency, but, also change over bank machines, and any coin operated machine. This is not insurmountable. After all, it was achieved in switching over to the Euro. But, the difference is that in 1999 there was an enthusiasm and willingness to pay for the transaction costs - it was sold as a one off. The cost and inconvenience of making the transition in an economic crisis is much harder to gain public support - let alone enthusiasm.

Euro Savings and Mortgages Need to be Converted. A more significant problem is that Greeks would need to not just convert currency but also all financial contracts currently in Euros. Savings in banks, mortgages all would need converting at a pre-arranged level.

The difficulty is agreeing an exchange rate to make the conversion to.
If markets thought the level was too high, and the currency likely to depreciate there would be an outflow of savings from Greece to other Euro countries where savers can guarantee the level of their savings. If people expected the Greek currency to devalue significantly against the Euro (quite a likelihood, they would want to deposit abroad.) It could lead to a run on Greek bank deposits.

It would be even more difficult to get people to buy Greek bonds because no one would want to hold a bond with likelihood of devaluing currency.

Wage Contracts. In a country like Greece, it would be difficult to re-negotiate wage contracts. Powerful trades unions, may demand a large nominal wage increase to compensate for the devaluation in the Greek currency. If unions were successful in gaining large wage increases, this may offset the gains in competitiveness due to devaluation.

Leaving the Euro

If the ECB decided to tackle deflation and print money (about as likely as the US forming a single currency with Cuba and Mexico). A country like Germany may get fed up with the devaluation of the Euro and general decline in competitiveness. They could leave the Euro, without the risk of a run on bank deposits. In fact the opposite could happen, The new D Mark would be very strong compared to the Euro, and it would be much easier for Germany or a strong economy to leave the Euro. Interestingly, I see David Blanchflower raising the theoretical possibility of Germany leaving Euro to re-form the D-Mark (Germany jettison Euro). The D-Mark would appreciate helping struggling Euro members to regain competitiveness.

Obviously, I can't see this happening, but, theoretically it would be much easier for Germany to leave than Greece.

No comments: