What Does It Look Like to Leave the Euro?

The Economist has an excellent piece this week outlining just how difficult it would be to leave the euro.  Bank runs, capital controls, angry voters, and where, exactly do you get currency for people to use?

How could this be done? Introducing a new currency would be difficult but not impossible. A government could simply pass a law saying that the wages of public workers, welfare cheques and government debts would henceforth be paid in a new currency, converted at an official fixed rate. Such legislation would also require all other financial dealings--private-sector pay, mortgages, stock prices, bank loans and so on--to be switched to the new currency.

The changeover would have to be swift and complete to limit financial chaos. Bank deposits would have to be converted at the same time, and the same rate, as overdrafts and mortgages to keep the value of banks' debts in line with their assets. When Argentina broke its peg with the dollar in 2001, it decreed that bank deposits should be switched at a more favourable exchange rate than loans, in an effort to appease savers. This imposed losses on an already crippled banking system, and led to a sharp contraction in domestic credit.

The central bank would have to distribute new notes and coins fast. It would also have to set interest rates, and would need a lodestar, probably an inflation target, to guide it. Whatever the official exchange rate at a changeover, the new currency would quickly find a market level against the euro and other currencies. A new D-mark would be expected to rise against the now-abandoned euro; a new drachma or punt would trade at a big discount to its official changeover rate--a devaluation, in effect.

The switch to the euro was smooth, but it was planned for years in great detail and in co-operation among countries. The reverse operation would be far messier. The mere prospect of euro break-up could cause bank runs in weak economies as depositors scrambled to move savings abroad to avoid forced conversion. If Germany were the leaver, it would face an inward flood.

To prevent such a drain, a weak country thinking of leaving the euro would have to impose caps on bank withdrawals, other forms of capital controls, and perhaps even restrictions on foreign travel. That might not work in a region as integrated as Europe--and if it did it would depress the economy by limiting the circulation of cash for commerce. It would also cut the country off from foreign credit, because foreign firms and banks would fear that their money would be trapped. Trade would suffer badly, at least for a while.

A departing country would also have to prepare for legal challenges. A change in the currency in both weak and strong countries would impose devastating losses on businesses and depositors at home and abroad. Savers who could not get their money out of banks before its forced conversion would not be happy to be paid in a devalued currency. Many would sue, as happened in Argentina. The legal uncertainty would further hamper the banks, which would be loth to extend credit for fear they might yet be forced to make depositors whole.

Foreign banks and pension funds holding weak economies' euro-denominated government bonds would suffer an effective default. They might sue, too. A sovereign might expect to win its legal battles if it drafted its conversion laws well and if it could assert the primacy of its law over European law. But the European dimension would at the very least mean that costly legal battles would drag on.

All the while a government seeking to replace the euro with a devalued currency could scarcely rely on bond sales to finance its operations.

Of course, as the article notes, by the time a government becomes likely to pull out of the euro, many of these things will have happened already.  Indeed, in the case of Greece and Ireland they have happened already--it's just that the Germans have intervened to offer lower-cost funds.  If it hadn't been for the bailouts, Greece would almost certainly have already defaulted, and I'd guess Ireland wouldn't be too far off.

To a large extent, how long the euro can hold together depends on German domestic politics. If they're willing to keep offering bailouts on sufficiently attractive terms, they can probably keep it together.

It's probably in Germany's best interest to do so, given this list:

Bank assets as a percentage of GDP

Luxembourg 2,461
Ireland 872
Switzerland 723
Denmark 477
Iceland 458
Netherlands 432
United Kingdom 389
Belgium 380
Sweden 340
France 338
Austria 299
Spain 251
Germany 246
Finland 205
Australia 205
Portugal 188
Canada 157
Italy 151
Greece 141

(For comparison, total banking assets in the U.S. are equal to approximately 82 percent of GDP.)

Those in the know seem to be relying on this simple self-interest: by this logic, no matter who gets elected, no matter what they promise the voters, when they get into office, they will realize that if they let contagion spread, they risk impairing the capital of banks that are Too Big to Save.  Meanwhile, in the PIIGS, opposition parties may talk a good game, but will ultimately be restrained by the fact that their governments need to keep going back to the debt markets, either to borrow new funds, or to roll over existing debt.  They aren't going to risk a financial crisis that might shut off their access to funds (from markets, or stronger governments).  If you've been complaining that Irish austerity is too draconian, contemplate what Irish austerity would be like if they suddenly had to chop their roughly 7% primary deficit to zero.

I hear all the reasons that this has to muddle through.  But I remain worried. Already, I am not hearing great things about the German economic team; the economists are having a harder and harder time persuading the politicians that this is a good idea and the voters are getting madder and madder.  Angela Merkel is fiercely resisting expanding Europe's emergency fund.   Meanwhile, so are voters in Ireland who don't see why they should have to pay through the nose to bail out foreign banks.

As Herb Stein said, if something can't go on forever, it won't.  And this can't go on forever.