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Sovereign Debt and Eurozone Exit

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So my previous post ignored the 800-lb gorilla in the room, namely sovereign debt. The goal of exiting the eurozone would be to make your economy more successful and allow monetary policy that is appropriate for your national economy. If successful, this will lead to reduced unemployment and higher tax revenue. It will not solve chronic deficits.

So I believe that sovereign debt should be converted from euros to the new national currency at the shadow exchange rate. This would avoid a European-wide banking crisis as investors should be indifferent between the old debt in euros and the new debt in lira (or pesetas or drachmas). But it wouldn’t solve the Greek problem of continuous deficits due to overspending and poor tax collection. I don’t believe there is any monetary solution to that issue. It should, however, greatly help countries like Spain and Italy which have not been financially profligate.


Written by Liam C Malloy

May 11, 2012 at 9:06 am

Posted in Eurozone

How to Break Up the Euro

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Let me start by saying that this is completely outside of my area of expertise (assuming I have one). But sometimes an outsider’s perspective can be useful. And because a breakup of the eurozone seems increasingly likely, here is my suggestion on the best way to accomplish that.

The problem, as I understand it, is that euros are completely mobile within the eurozone so that if Greece (or Spain or Portugal or Italy or Ireland) looks like it’s about to leave the currency in favor of the drachma, everyone will take their euros out of Greece and put them in Germany. Then as the drachma depreciates against the euro, they can exchange their euros for drachmas without losing their real purchasing power (and even increasing it within Greece). This will cause a banking crisis making the exit extremely painful.

So we have two related problems with which we have to deal. First, how do we keep the euros from flying out of the countries that are most likely to leave the eurozone and adopt a new national currency. And second, how do we price those new currencies against the euro. The problem is that we’ve been assuming that we can’t do the second until the countries have left the euro, making a solution to the first problem seem impossible.

The solution requires that we price the potential new currencies (against the euro) before any countries actually leave. If the new drachma (or peseta or lira or Irish pound) is priced appropriately, there will be no desire to move euros around. For example, let’s say that in order to get Greek prices back in line with the rest of Europe, the new drachma would have to depreciate 100% so that the exchange rate would be two drachmas per euro. If that’s the “correct” real exchange rate, so that the purchasing power of two drachmas in Athens is the same as one euro in Frankfurt, then people will be indifferent between having two drachmas and one euro. If Greek depositors know that they will get two drachmas for each euro in their account, then they will have no incentive to move those deposits to Frankfurt before conversion.

The goal of this plan is to create a shadow exchange rate for each country within the eurozone (although it’s especially important for those most likely to leave). This way you know that you’ll get two drachmas for every euro or 1.3 pesetas or 1.5 Irish pounds. This would keep the capital in the troubled countries because depositors and investors would know that their value was safe.

How do we do this? We need to create a market for these nonexistent currencies. While I’m not 100% sure about the best way to do this, I do have a suggestion. I suggest that we create dual-track eurobonds. The first track would be straightforward bonds of varying durations. The interest rates would be determined by auction as in most bond issues (again, this isn’t my field, but this is my understanding of how things work). The second track would take the interest rates from the first track, but would introduce the possibility of being paid in euros or a new national currency. The exchange rate would be determined by auction in the same way that the interest rates were determined for the standard bonds.

For example, let’s say the regular 1-year eurobond is paying 2% interest. If you buy a €1,000 Greek 1-year eurobond at an exchange of 2 drachmas to the euro, there are two payout options. First, if Greece stays with the euro you will get your €1,000 plus 2%, or €1,020. It will behave just like the standard bond. However, if during that year Greece exits the eurozone, you would get paid in drachmas. In this case your principal would be ₯2,000 and with 2% interest you would receive ₯2,040 (is that the right symbol for the drachma?).

These shadow exchange rates would be public information so that every depositor and investor would know how many drachmas she would receive for every euro in a Greek bank or in exchange for euro currency in Greece. So how would an exit from the eurozone work? First these bonds would be set up, ideally for each country in the eurozone, but certainly for those countries most likely to leave (Greece, Spain, Portugal, Ireland, Italy). The bonds will then tell us how much depreciation each currency would need in order to keep investors indifferent between holding euros and drachmas. It would then be up to each national government to decide whether or not to stay in the eurozone or adopt a national currency.

If the country decides to leave the euro and adopt the national currency, this is what I assume would happen: The exchange rate is determined by the national eurobonds. On the day of the conversion, bank deposits and other financial investments (including the national eurobonds) within the country are switched automatically from euros to the new currency. If the exchange rate is 2 drachmas per euro and you had €5,000 in your account, you now have ₯10,000. All prices within the country (including wages) are switched one-to-one to the new currency. That is, if you were earning €30,000 in Greece as a school teacher, you are now earning ₯30,000. If a bottle of Greek retsina cost €10, it now costs ₯10. So the real wage for domestically produced goods stays exactly the same. But of course the cost of imports will rise and the cost of exports will fall (remember, that’s why we’re doing this in the first place). A BMW that used to cost €20,000, or 2/3 your annual salary will now cost ₯40,000, or 4/3 your annual salary. On the other hand, that €10 bottle of retsina will now only cost €5 in Frankfurt. And Germans will find a vacation in Greece to be much cheaper than before. This should boost Greek exports and employment.

The whole key to this plan is that we don’t know what the exchange rate should be. We know it isn’t 1:1. That’s why we’re having this problem in the first place. But we won’t be able to figure it out. We need to use the market, investors with real money on the line, to figure out the appropriate rate. Maybe it’s 1.2 drachmas per euro, maybe it’s 1.5. I have no idea. But if investors are willing to buy the national eurobonds, this means they are indifferent between euros and the new currency at that rate.

Will people be able to game the system? I’m not sure. Let me know. I’m sure that international finance people will be able to improve this plan, but we need a plan to minimize the chaos that a breakup of the euro will otherwise entail. I think this would help.


Written by Liam C Malloy

May 10, 2012 at 9:47 am

Posted in Eurozone