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The eurozone crisis prompts talk of loan defaults and currency withdrawal, but there is a third way...

The events of the past four years have cruelly exposed the weaknesses in the design of the euro. But they have also revealed how difficult it is to construct a strategic response that balances the interests of growth and solidarity with the maintenance of appropriate incentives for nation states.

Although viewed from Brussels or Frankfurt it may appear that there is no viable alternative to the current policy prescription for countries such as Greece, Portugal and Spain, the economic pain in these countries seems to be pushing them to breaking point and shows no sign of abating.

The remedy of internal devaluation to restore competitiveness, austerity to restore sound public finances, and bank deleveraging to restore the financial system to health, constitutes the most complete deflationary economic policy seen in western Europe since the war.

Although the euro has taken surprisingly little of the blame, it seems just a matter of time before the electorates of southern Europe demand expansionary polices that are at odds with membership of the euro. But to date, exit has only really been discussed as the product of a breakdown in relations between eurozone countries.

A soft consensus has developed that if a country were to leave the euro it would have to exit unilaterally and float its new currency. Its government would redenominate contracts and bank deposits into devalued local currency, in what would represent a kind of “confiscation by redenomination”.

Who knows how far the exchange rate would fall. This hardly sounds like a compelling alternative. But what if the various actors in this drama came to understand that an agreed exit plan for weak eurozone countries was in everyone’s interests?

Could Europe find a blueprint for exit that worked for the periphery and for core Europe? In “How to manage a euro exit”, using Greece as an example, I propose a blueprint that could, I believe, be seen as a more rational answer than the current binary alternatives of euro irreversibility or the chaos of a unilateral exit.

Under this proposal all euro-denominated contracts governed by Greek law (loans, wages, rents etc) would convert from the euro to a new drachma on a one-for-one basis.

The external value of the drachma would be fixed at two drachma to the euro, supported by the ECB and the Bank of Greece, giving rise to a 50 per cent depreciation (although a smaller depreciation could be selected).

Most significantly, deposits in Greek banks would be converted to drachma at a rate of one euro to two drachma, preserving their full value. Maintaining the value of deposits on redenomination is a crucial feature of this proposal.

Since bank deposits are instantly movable at face value, an exit that depreciated deposits would require exchange controls and a surprise announcement (implemented over a weekend) to avoid massive capital flight.

The risk of contagion to other peripheral countries would also be huge – deposits would flood out of any other country thought to be at risk of a similar fate on an uncontrollable scale. Preserving the value of bank deposits would make an exit a practical option by negating the need for a surprise announcement or the introduction of capital controls.

Greece could take six months to ready itself for “conversion day”, giving it time to print bank notes. The proposal would also remove the risk of capital (deposit) flight from other weak eurozone countries. Indeed, this blueprint would encourage depositors in other peripheral countries to repatriate funds already moved abroad.

Preserving the value of bank deposits is also a recognition that while an exiting government can legitimately redenominate domestic contracts, euro bank deposits are ultimately a claim on the ECB, not on national governments.

Devaluation by exiting member states would have a corrosive effect on confidence in the whole euro project. The risks of a floating exchange rate are also clear.

The Greek government has a large fiscal deficit and no credibility within financial markets. Without access to international capital markets, foreign exchange traders will assume that Greece will finance its deficit by printing money. The drachma would fall precipitously and then be blown around by subsequent political and economic developments.

A wage price spiral could easily develop, pushing inflation up to dangerous levels. A fixed exchange rate offers several clear advantages.

First, it would give Greece’s post-exit monetary policy credibility, ensuring that the rise in the price level is a one-off process. Second, it would provide stability for the traded goods sector, encouraging investment. And third, Greek interest rates would continue to be tied to those of the euro, protecting the Greek economy from the risk of a spike in interest rates that might be expected to accompany a floating exchange rate.

If exit was inevitable, the ECB would surely accept the need to support a fixed exchange rate to the euro because a hyper-volatile drachma and an unstable Greece are in no-one’s interest.

The Greek banks would need to be compensated for a conversion on these terms. The Greek government would meet this cost, providing each bank with a “balancing credit” to cover any gap between the value of its assets and liabilities on conversion.

The funds would be raised by the Bank of Greece, which would create new drachma, in a similar fashion to the Bank of England’s quantitative easing programme. Based on Bank of Greece figures, I estimate that the cost of applying this enhanced conversion rate for deposits would be 190bn drachma or 95bn with another 70bn drachma (35bn) to cover the mismatch of banks’ assets and liabilities that remained in euros because they are governed by foreign law.

The creation of money to fund the balancing credit should not be inflationary as banks would be required to repay ECB debts with the proceeds (i.e. Greece’s TARGET2 liabilities should be repaid in full) and because in a fixed-exchange rate regime the quantity of money in circulation will be determined by demand, not supply (i.e. central bank currency reserves will adjust to meet money demand).

How far-fetched is the idea of an agreed exit blueprint? If a Greek government was elected on a euro exit platform, would it make sense for the rest of the currency block to insist that it goes it alone in a unilateral exit that could have devastating consequences, not just for Greece, but for the eurozone economy as a whole? Or would they agree to work with Greece to successfully manage the transition?

The rational answer seems obvious. Since the euro crisis first hit the front pages three years ago, the eurozone seems to have been confronted with a stark choice of bailouts and austerity for the periphery stretching into the future, or the calamity of a member exit triggering an uncontrollable financial panic.

An agreed blueprint for exit to a fixed exchange rate with the value of deposits protected offers an alternative that is worth serious consideration.

Rob Thomas is an advisory board member of the Centre for Asset Management Research at Cass Business School.

Photo: Getty Images


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