Thursday, June 28, 2018

How to Leave the Euro: A Practical Roadmap for Italy

The leaders of Italy’s new populist government say they do not want to leave the euro. Except, no one believes them.

They are on record as saying the euro was a bad idea. Until they were stopped by the President of the Italian Republic, they tried to appoint Paulo Savona, a well-known euroskeptic, as finance minister. Instead, they appointed him European Affairs Minister. In a recent book, Savona called the euro a “German cage” and wrote that “we need to prepare a plan B to get out of the euro if necessary ... the other alternative is to end up like Greece.” In short, it is not surprising that the new government’s commitment to the euro is in doubt.

When whenever the possibility that some country might leave the euro arises. Leaving abandoning one currency and introducing a new one just too difficult, they say. They point to the years of planning that went into launching the euro in the first place. They warn that a country facing currencies would face a host of problems, ranging from panicked runs on banks to the need to reprogram vending machines.

Ultimately, though, such technical difficulties are surmountable. If Italy decides to leave the euro, the key to success will be to learn from the experience of the many countries that have changed currencies in the past. Here is a practical roadmap, drawing on the imaginative, pragmatic, devices that other countries have used to ease the introduction of a new currency.

Lesson 1: Use a Temporary Currency
Those who worry about technical barriers to changing currencies often point to the time it would take to print notes, mint coins, and put them into circulation. That time can be greatly shortened by using a temporary currency during a transition period.

Latvia’s exit from the ruble area in the early 1990s is a case in point. First, in May 1992, authorities introduced a Latvian ruble as a temporary replacement for the old Soviet ruble. Only months later, after due preparation, did they put the new permanent currency, the lats, into circulation. Distinguished by some of the most handsome coins in Europe, the lats served for more than 20 years, until Latvia switched again, joining the euro.

A temporary currency solves several problems. For one thing, it can be run off quickly and cheaply without all the elaborate counterfeiting safeguards of a modern currency. It won’t be around long enough to be worth counterfeiting.

The speed record for introducing a temporary currency seems to have been set by the Soviet occupiers of eastern Germany after World War II. When the Americans, British, and French replaced the old reichsmark with the deutschmark in 1948, the Soviets were caught flat-footed. As now-worthless Nazi-era currency flooded into the Soviet zone, occupation authorities hastily printed paper stickers, which they stuck on a limited number of reichsmark notes to serve as a temporary currency. Those were then replaced with a permanent currency, which became known as the ostmark and lasted until reunification.

To make things easy, there is no real need to issue coins in the temporary currency. For example, when Kazakhstan switched from the ruble to the tenge in the early 1990s, there was a period in which there were no coins in circulation. Their place was taken by grimy little fractional banknotes, which were a nuisance, but got the job done. Nicely minted tenge coins came later.

A temporary currency can also serve the useful purpose of absorbing public disrespect. If the new currency is expected to depreciate, as would probably happen to any new currency, were Italy to leave the euro under current conditions, people are going to think up some derisive name for it and treat it with contempt. For example, a temporary Belarus ruble issued in 1992 was popularly called the zaichik or “bunny” after a whimsical picture on the one ruble note. The name fueled many jokes until a new, somewhat more respectable Belarus ruble (without the bunny) was issued later.

Giving the temporary currency the same name and denomination as the old one, as was done in Latvia and Belarus, simplifies accounting, signage, and other technical matters. Following that  example, Italy might begin with a temporary Greek euro. A permanent new lira could come later, after the government established credible monetary management.

Lesson 2: Do not Fear Parallel Currencies

Introducing a new currency would be harder if it had to replace the old one all at once, but there is no reason it would have to do so. Many countries have eased the transition from one currency to another by allowing parallel circulation during a transitional period.

Sometime,s the old currency can be left in circulation for a while at a fixed exchange rate. That is how the euro was first introduced, and the same practice has been followed as new members later joined the Euro Area. Temporary parallel circulation makes sure that everyone doesn’t have to spend January 1 standing in line at their bank, and it gives technicians time to update parking lot gates so that no one is trapped in an underground garage with the wrong coin in their pocket.

Parallel currencies with a floating exchange rate are also possible. Floating-rate parallel currencies often develop spontaneously in countries experiencing hyperinflation. While the ruble or peso or whatever remains the legal tender, people start using a hard currency such as the dollar or euro alongside it. Typically, the rapidly depreciating local currency continues to be used as a means of exchange (at least for small transactions) while the more stable foreign currency serves as a means of account and a store of value.

In the hyperinflation case, parallel circulation often ends with the introduction of a new local currency having a fixed value relative to the unofficial parallel currency. For example, in the early 1980s, the value of Argentina’s peso was undermined by hyperinflation. As the peso became less and less dependable, people began to use U.S. dollars as a unit of account and store of value. In 1985, the Argentine government temporarily stopped hyperinflation by replacing the peso with a new currency, the austral, which it declared to have a fixed value of one dollar. When resurgent hyperinflation destroyed the austral in the early 1990s, it was ditched, in turn, in favor of a new peso, again declared to be worth one dollar. Estonia in 1992 and Bulgaria in 1997 are other examples in which parallel currency circulation preceded the introduction of a new, stable national currency.

If a country like Italy decided to exit the euro now, the situation would be different. Instead of moving from a less to a more stable currency, it would intentionally be abandoning the too rigidly stable euro in order to achieve desired inflation and depreciation.  That would make it a little like running the Argentine movie in reverse. Instead of the euro gradually coming into broader circulation as the national currency became less stable, a temporary floating currency could be introduced gradually alongside the euro, to be replaced only when the economy began to stabilize.

What would motivate people to use the new currency? One way to bring it into circulation would be to introduce it first where people have no choice. For example, if Italy were to leave the euro area, it could begin by printing a new, temporary, Italian euro, which at first would be used only to pay government salaries, pensions, and interest on the national debt, and also be accepted for payment of taxes. Gradually, its use could be extended, pushed along by administrative means as needed.

Lesson 3: Default Early, but Not Often

As a further barrier to exit from the euro, skeptics often point out that devaluation would very likely force default on any obligations that could not be redenominated to the new currency. True enough. But then, if a country could service its obligations, it wouldn’t be thinking about exit and devaluation in the first place, would it? The fact is, if a country is insolvent, it is going to have to default in one way or another. The only question is whether default with a change in currency is preferable to default within the old currency.

In general, the best strategy for anyone who can’t meet financial obligations is to default early, but not often. That means stopping payments on obligations as soon as it is clear that they cannot be met in full. The time to sort out any partial payments is after default, not before. A prolonged period in which default appears increasingly certain, but has not yet occurred, only encourages bank runs and capital flight.

One form of “defaulting often” is to ask for evergreening.  Evergreening occurs when creditors make additional loans to debtors they know to be insolvent, with the intent that the proceeds of the new loans be used to keep payments current on the old ones for a little while longer. The trouble is, that is rolling a snowball down the hill. The problem gets bigger and bigger the more you put off facing up to it.

Another mistake is to try to negotiate terms of default in advance. Negotiating a new “haircut” with your lenders every few months, as Greece did in the aftermath of the global financial crisis, is another form of defaulting often. There are three problems with this strategy. First, the debtor’s bargaining power is likely to be weaker if nonpayment is only a threat, not a fact. Second, the debtor is subject to pressure to accept terms like mandatory austerity measures that reduce its actual ability to repay. Third, there may simply be no way to know what kind of partial payment is realistic until some time has passed and the dust has settled.

Not all exit problems are mere technicalities

Not all barriers to switching currencies are mere technicalities. The combination of default and devaluation will cause real pain to foreign creditors, and the defaulting country is likely to suffer as a result. Fortunately, in today’s world, creditors are unlikely to use force, as France and Belgium did when they occupied the Ruhr in 1923 in an attempt to collect defaulted German reparation payments. The invasion helped set the stage for World War II, and no one has tried the tactic since. Still, that does not mean defaulters can expect to get off unscathed.

For one thing, defaulters may end up with limited access to international credit markets, as Argentina found following its 2001 default. Default by a member of the euro area, followed by an attempt to redenominate debts into a devalued currency, would create thorny legal problems in view of the many financial and nonfinancial firms that operate across national borders. National courts of creditor countries might attach any extraterritorial assets of the defaulting government, or of its citizens, that they could get their hands on. They might even make it hard for government officials or private citizens to travel. No one really knows.

Furthermore, devaluation and exit from the euro would not solve all macroeconomic problems, or perhaps we should say, it would solve one set of problems but would raise others. If the operation were carried out by a new populist government that abandoned structural reforms and budget discipline, it could be hard to achieve lasting stability. Again, Argentina is a cautionary tale. Despite a quick return of economic growth following its default, the government found it hard to control inflation and was eventually voted out of office.

In short, there are many reasons why no euro member has yet left the currency area. The pros and cons of doing so remain open to debate. However, as the debate goes on, let’s hear more about the real issues. Technicalities like printing banknotes and reprogramming vending machines. If Italy, or anyone else, really wanted to introduce a new currency, it could do so.

A version of this post previously appeared at Milken Institute Review

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