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ww.variantperception.com January2 A Primer on the Euro Breakup: Depart, Default, and Devalue as the Optimal Solution If member states leave the euro, what is the best way for the economic process to be
ww.variantperception.com January2 A Primer on the Euro Breakup: Depart, Default, and Devalue as the Optimal Solution If member states leave the euro, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership? A submission for the Wolfson Economics Prize SUMMARY Many economists expect catastrophic consequences if any country exits the euro. However, during the past century 69 countries have departed from currencies without experiencing major problems. The mechanics of currency breakups are complicated but feasible. The entire process of moving from one currency to another has typically been accomplished in a few months. This paper will examine historical examples and provide specific, actionable recommendations for the exit of the eurozone based on previous currency breakups. The real underlying problem in Europe is that peripheral countries have external debt levels that are higher than most previous emerging market crises and they face severe misalignments in wages and prices with their neighbors in the core. Europe has the characteristics of a classic emerging markets balance of payments crisis writ large. In fact, levels of net external debt exceed those seen in previous crises. As such, the problem in Europe is not the mechanics of exit, but how to manage a severe and necessary adjustment. This paper provides steps that can be taken to mitigate the negative consequences. The correction can come quickly via exiting the euro and devaluing or slowly via a fall in real wages and prices. Exiting from the euro and devaluing would be very painful and would likely lead towards panic and contagion in financial markets. Departing would accelerate insolvencies, but would provide a powerful policy tool to restore competitiveness via flexible exchange rates. Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable. By defaulting and devaluing, the European periphery will escape the debt deflationary straitjacket of the euro. These countries would have lower debt levels and more competitive exchange rates, much like countries that left the gold standard in the 1930s (Britain and Japan 1931, US 1934, France 1936) and many emerging markets after recent defaults and devaluations (Asia 1997, Russia 1998, Argentina 2002, Iceland 2008). KEY CONCLUSIONS Peripheral European countries are suffering from solvency and liquidity problems making defaults inevitable and exits from the euro likely Greece, Portugal, Ireland, Italy and Spain have built up very large unsustainable net external debts in a currency they cannot print or devalue. Peripheral levels of net external debt exceed almost all cases of past emerging market debt crises that led to default and devaluation. This was fuelled by large debt bubbles due to increased capital flows after the introduction of the euro and an inappropriate one-size-fits-all monetary policy. Each peripheral country is different, but they all have too much debt. Greece and Italy have high government debt. Spain and Ireland have high private sector debt. Portugal has high public and private debt. Greece and Portugal are arguably insolvent, while Spain and Italy may be solvent in the long run but are facing severe liquidity risks. Defaults are a partial solution. Even if the countries default, their real effective exchange rates will still be overvalued if they do not exit the euro. The euro is not a good currency area and is like a modern day gold standard where the burden of adjustment falls on weaker countries Like the gold standard, the euro forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionary bias, where the burden of adjustment is always placed on the weakcurrency country, not on the strong countries. Peripheral countries can only adjust via internal devaluations where wages and prices fall. The solution from European politicians has been to call for more austerity, but public and private sectors can only deleverage through large current account surpluses, which is not feasible given high external debt and low exports in the periphery. So long as periphery countries stay in the euro, they will bear the burdens of adjustment and be condemned to contraction or low growth. Countries that left the gold standard returned to growth, and countries that leave the euro will grow again. 02 Withdrawing from the euro would merely unwind existing imbalances and crystallize losses that are already present The cash flows of households, corporations and governments in the periphery are simply not high enough to properly service private sector debt. Exiting the euro would speed the recognition of inevitable eventual losses given the inability of the periphery to grow its way out of its debt problems or successfully devalue. Policymakers then should focus as much on the mechanics of cross-border bankruptcies and sovereign debt restructuring as on the mechanics of a euro exit. Defaults and debt restructuring should be achieved by departing the euro, redenominating sovereign debt in local currencies and forcing a haircut on bondholders Almost all sovereign borrowing in Europe is done under local law. This would allow for a redenomination of debt into local currency, which would not legally be a default, but would be considered a technical default by ratings agencies and international bodies such as ISDA. Devaluing and paying debt back in drachmas, liras or pesetas would reduce the real debt burden by allowing peripheral countries to earn euros via exports, while allowing local inflation to reduce the real value of the debt. All local private debts could be re-denominated in local currency, but foreign private debts would be subject to whatever jurisdiction governed bonds or bank loans Most local mortgage and credit card borrowing was taken from local banks, so a re-denomination of local debt would help cure domestic private balance sheets by reducing the real burden of debt. The main problem is for firms, particularly banks, which operate locally but have borrowed abroad. Exiting the euro would likely lead towards a high level of insolvencies of firms and people who have borrowed abroad in another currency. This would not be new or unique. The Asian crisis in 1997 in particular was marked by very high levels of domestic private defaults. However, households and companies started with clean balance sheets not weighed down by debts. The breakup of the euro would be an historic event, but it would not be the first currency breakup Within the past one hundred years, there have been 69 currency breakups. Almost all of the exits from a currency union have been associated with low macroeconomic volatility and most were accomplished quickly. Previous examples include the Austro-Hungarian Empire in 1919, India and Pakistan 1947, Pakistan and Bangladesh 1971, Czechoslovakia in , and many USSR satellite states from 1992 to Some countries experienced hyperinflations, but the primary reason was not the mechanics of exit but the soundness of monetary and fiscal policies following the departure. Countries with independent central banks experienced low inflation and economic growth, while central banks that printed money to finance government deficits experienced high inflation or hyperinflation. Previous currency breakups and currency exits provide important lessons and a roadmap for exiting the euro While the euro is historically unique, the problems presented by a currency exit are not. There is no need for theorizing about how the euro breakup would happen. Previous historical examples provide crucial answers to: the timing and announcement of exits, the introduction of new coins and notes, the denomination or re-denomination of private and public liabilities, and the division of central bank assets and liabilities. The entire process of moving from one currency to another has typically been accomplished in a few months. The mechanics of a currency breakup are surprisingly straightforward; the real problems for Europe are overvalued real effective exchange rates and extremely high debt Historically, moving from one currency to another has not led to severe economic or legal problems. In almost all cases, the transition was smooth and relatively straightforward. The difference with a euro breakup is that people would not want to hold new deeply devalued national currencies. This strengthens the view that Europe s problems are not the mechanics of introducing a new currency, but the existing real effective exchange rate and external debt imbalances. European countries could default without leaving the euro, but only exiting the euro can realistically restore competitiveness. The key danger for countries departing the euro is hyperinflation due to poor fiscal and monetary policies The problem of hyperinflation arose in some countries that departed previous currency unions. However, this was not due to exiting a currency but rather to the 03 monetary policy post exit, where central banks printed money to finance government spending. Countries that monetize fiscal deficits experience high inflation and even hyperinflations. Creating a currency board or mandating an inflation target can prevent hyperinflations. All peripheral countries are running substantial fiscal deficits. If they leave the euro and default, they'll be temporarily shut out of international bond markets and forced to close those deficits on their own. That will mean more austerity, which will be easier to handle thanks to the depreciation. However, in a country as politically troubled as Greece (and with serious problems with tax evasion) it may be difficult to avoid monetizing the debt, potentially generating hyperinflation. The experience of emerging market countries shows that the pain of devaluation would be sharp but brief and rapid growth and recovery would follow Countries that have defaulted and devalued have experienced short, sharp contractions followed by very steep, protracted periods of growth. Orderly defaults and debt rescheduling, coupled with devaluations are inevitable and should be embraced. The European periphery would emerge with de-levered balance sheets. The European periphery could then grow again quickly, much like many emerging markets after defaults and devaluations (Asia 1997, Russia 1998, Argentina 2002, etc). In almost all cases, real GDP rebounded sharply and quickly exceeded previous levels. Leaving the euro might well be one of the best things that happened to them. IMPORTANT NOTE TO THE READER Did you ever think that making a speech on economics is a lot like pissing down your leg? It seems hot to you, but it never does to anyone else. President Lyndon B. Johnson The author decided to write this paper in plain English for the layperson to reach the widest audience possible. The paper is, however, based on a broad review of the most recent academic and professional literature from the worlds of economics, finance and law. ABOUT THE WRITER Jonathan Tepper is the co-author of the NY Times bestseller Endgame: The End of the Debt Supercycle, a book on the sovereign debt crisis. Jonathan is the Chief Editor of Variant Perception, a macroeconomic research group that caters to asset managers. He is also the portfolio manager of an equity long/short hedge fund at Hinde Capital. Jonathan is an American Rhodes Scholar. Since leaving Oxford, Jonathan has worked as an equity analyst at SAC Capital and as a Vice President in proprietary trading at Bank of America. He earned a BA with Highest Honors in Economics (his honors thesis was on optimal currency area theory and the symmetry of economic shocks to the labor market in Europe) and History from the University of North Carolina at Chapel Hill, and a M.Litt in Modern History from Oxford University. 04 CONVENTIONAL THINKING ABOUT A EURO BREAKUP: CATASTROPHE AHEAD It would be like a Lehman-times five event. Megan Greene, director of European economics at Roubini Global Economics A euro break-up would cause a global bust worse even than the one in The world s most financially integrated region would be ripped apart by defaults, bank failures and the imposition of capital controls. The Economist, 26 November 2011 If the euro implodes, [the UK s] biggest trading partner will go into a deep recession. Banks may well go under, so will currencies both new and old. Investment will freeze up. Unemployment will soar. There is no way the UK is going to escape from that unscathed. Matthew Lynn, MoneyWeek A euro area breakup, even a partial one involving the exit of one or more fiscally and competitively weak countries, would be chaotic. A disorderly sovereign default and Eurozone exit by Greece alone would be manageable However, a disorderly sovereign default and Eurozone exit by Italy would bring down much of the European banking sector. Disorderly sovereign defaults and Eurozone exits by all five periphery states would drag down not just the European banking system but also the north Atlantic financial system and the internationally exposed parts of the rest of the global banking system. Willem Buiter in the Financial Times Given such uniform pessimism on the part of analysts and the unanimous expectation of financial Armageddon if the euro breaks up, it is worth remembering the words of John Kenneth Galbraith, one of the great economic historians of the 20 th century, The enemy of the conventional wisdom is not ideas but the march of events. 05 PAPER OVERVIEW SECTION ONE: A SUB-OPTIMAL CURRENCY LED TO BALANCE OF PAYMENTS CRISIS First, this submission will examine the problems within the euro area and show that exiting the euro is the best option for peripheral countries and the most likely path towards a return to growth. The section will show that the euro is not an optimal currency area, and this has led to credit booms that are now turning to bust in the periphery as well as a lack of competitiveness. The European periphery is experiencing a classic balance of payments crisis but within a single currency where devaluation and defaults are much more difficult. This submission will show that periphery growth is unlikely if not impossible within the euro straitjacket. SECTION TWO: CURRENCY BREAKUPS HAPPEN OFTEN WITHOUT MAJOR TRAUMA Second, the paper will provide a brief overview of studies of currency exits. During the past century 69 countries have exited currency areas with little downward economic volatility. The mechanics of currency breakups are complicated but feasible. The conclusion - that most exits from a currency union have been associated with low macroeconomic volatility and that currency breakups are common and can be achieved quickly - flies in the face of conventional wisdom. The section will summarize the lessons that can be learned from previous exits. We will briefly examine the specific cases of the Austro-Hungarian Empire in 1919, Czechoslovakia in , and the USSR s ruble zone in All of these cases show that currency exits are rarely associated with macroeconomic volatility. The paper will also look at the cases of Soviet republics that exited and faced hyperinflation, due the extremely loose central bank policies following the departure. SECTION THREE: PRACTICAL RECOMMENDATIONS FOR DEPARTING FROM THE EURO Using previous currency breakups as a model, as well as emerging market devaluations, we will then suggest a series of practical steps that will be necessary to achieve the cleanest, most efficient departure from the euro. The paper will also address the best way to default, restructure debt and devalue. SECTION FOUR: DEFAULTS AND DEVALAUTIONS ARE RARELY AS BAD AS FEARED Finally, we will look at previous emerging market crisis analogues, and why this leads us to end on an optimistic note regarding currency devaluations. Almost all economic analysts argued that dire consequences would follow previous defaults and devaluations (Asia 1997, Russia 1998, Argentina 2002, and Iceland 2008). Invariably economic consensus was too pessimistic and wrong about previous emerging market crises. History shows that following defaults and devaluations, countries experienced two to four quarters of economic contraction, but then real GDP grew at a high, sustained pace for years. The clear implication from our analysis is that conventional economic thinking was wrong at the time about most emerging market defaults and currency devaluations, and almost all the dire predictions about the breakup of the euro will likely prove to be wrong as well. It will certainly be very painful, but it is unlikely to be the outright catastrophe many economic commentators assume. Policymakers should then plan ahead meticulously for exits and implement them as quickly and cleanly as possible. The paper concludes that the best way to promote sustained growth in the European periphery is to depart the euro, default on debt that cannot be repaid, and devalue the currency to restore competitiveness. 06 Section One A Sub-Optimal Currency Area Led to a Balance of Payments Crisis Writ Large THE NEED TO EXIT A ONE-SIZE-FITS-ALL MONETARY POLICY Europe exemplifies a situation unfavourable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe. Professor Milton Friedman, The Times, November 19, 1997 The introduction of the euro in 2000 was a milestone in a very long political process of deeper integration of the European Union. While there were economic arguments for and against creating the euro, the pure economic costs and benefits were not the main consideration. The main reasons countries joined the euro was to bind the European project further politically and symbolically. It is ironic that a project that was meant to tie European countries closer together may well be what tears Europe apart. Politicians may not have carefully analyzed the economic landscape of a monetary union, but economists had. In the 1960s, long before the euro was created, Robert Mundell wrote about what made an optimal currency area. This ground-breaking work won him a Nobel Prize, and other economists built on his framework. As he explained, a currency area is optimal when it has: 1. Similar business cycles Countries should experience expansions and recessions at the same time (technically this is referred to as symmetry of economic shocks). 2. Mobility of capital and labor Money and people have to be willing and able to move from one part of the currency area to another. 3. Flexibility of wages and prices Prices need to be able to move downwards, not just upwards. 4. Fiscal transfers to cushion the blows of recession to any region If one part of the currency area is doing poorly, the central government can step in and transfer money from other regions. Europe is not an optimal currency area because it has almost none of these characteristics. Despite hopes that eurozone countries would become further integrated, countries within the euro area became less aligned over time. The United States, unlike Europe, is a good currency union. It has the same coins and money in Alaska as it does in Florida and the same in California as it does in Maine. If you look at economic shocks, the United States absorbs them pretty well. Generally business cycles are coordinated, but if they are not, mobility of capital and labor help ease the adjustment. If someone was unemployed in southern California in the early 1990s after the end of the Cold War defense cutbacks, or in Texas in the early 1980s after the oil boom turned to bust, they could pack their bags and go to a state that was growing. That is exactly what happened. This doesn t happen in Europe.
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