This article was first published in the October 2012 International edition of Accounting and Business magazine.
One of the cardinal rules of firefighting is always identify your exit before entering a blaze. Several eurozone nations must wish they had followed this advice when joining the continent’s bold experiment in currency union. Since the euro was intended to be a club that none could leave, no emergency escape plans were ever made.
Lord Wolfson, a eurosceptic, wants to change that. He issued a challenge to economists to draw up a blueprint on how best to dismantle the currency. The £250,000 prize attracted 400 entries and was won by veteran commentator Roger Bootle, founder of the consultancy
Capital Economics and former chief economic adviser to Deloitte. His winning submission is a meticulous instruction manual on how failing states can extract themselves from the zone in an orderly manner.
The first merit of Bootle’s 156-page handbook is that it doesn’t sugarcoat the risks. Any nation wishing to exit the crumbling structure will confront a huge range of dangers. For a start, all hell would break loose if news of an imminent departure were to leak to the press. Citizens would make a beeline for the bank and immediately withdraw their savings, provoking an instant financial crisis. The replacement currency would plunge on the foreign exchange markets – in the case of Greece possibly by up to 50%.
Of course, currency devaluation is the ultimate goal of leaving the zone as it would eventually boost exports and promote economic growth. In the short term, however, it would raise the risk of hyperinflation. Rampant price rises would undo any gains in competitiveness and leave the hapless state back where it started.
Then there are the practical issues of printing a new currency. A country could be left without cash in circulation for up to six months.
One ironic effect of leaving the zone would also be to boost the real value of the nation’s foreign debts. So far from solving a debt crisis, leaving the euro would actually make matters worse – at least in the short term.
‘Our goal in the euro paper was to find a way around some of these perils,’ says Jonathan Loynes, chief European analyst at Capital Economics and one of the co-authors of the plan. ‘We looked to the history of currency break-ups – such as the collapse of the Soviet Union and Czechoslovakia – for clues about how this adjustment could be made with the least possible trauma.’
Keep it under your hat
The first challenge is to keep secession plans secret for as long as possible. Ideally, a momentous decision like leaving the euro should be democratic, taking the pulse of all political parties as well as the public.
Sadly, such an inclusive approach is not practical, Bootle warns. Advanced notice of such plans could precipitate ‘large capital outflows as international investors and domestic residents withdraw their funds’. Bond yields would surge and banks quickly run out of cash. So Bootle’s first tip is to keep the exit plan hush-hush until the last possible moment.
The Czech government, for example, decided to break up its currency union with Slovakia on 19 January 1993, following the dissolution of Czechoslovakia in 1992. It concealed this decision from citizens until 2 February, just six days before the two new states adopted separate national currencies.
In his plan Bootle says the key to making a success of the clandestine approach ‘would be to keep the number of people who knew as small as possible and the delay between the decision and implementation fairly short’. Printing a whole new currency ahead of time is probably out of the question, given the lengthy period that such an operation would require.
Closing the hole in the wall
Once the cat is out of the bag, capital and banking controls would be needed to prevent money fleeing the country. ‘Cash machines… would need to be shut down,’ advises Bootle’s plan. ‘Otherwise, realising that the euro would become more valuable than the drachma, most Greek residents [for example] would attempt to withdraw as many euros as possible from their bank accounts.’
Currency controls could be supplemented by forbidding residents from buying foreign assets overseas or setting up bank accounts outside the country. Foreign businesses in the country might also be barred from repatriating profits back to the home office. Capital Economics argues that such radical steps could be avoided if plans are kept hidden – especially if the transition takes place over a weekend when banks are closed.
The most obvious practical issue in leaving the euro is that of minting new notes and coins. Since this might take months, the departing country would be left in limbo. One stopgap solution would be to stamp existing euro notes with a drachma symbol. This is not an option favoured by Bootle. Instead, the Capital Economics plan argues that a country like Greece could largely do without cash for a while.
A recent survey by the European Central Bank showed that cash accounted for just 5% of total transactions for the majority of businesses. For the small amounts of cash that are needed, the euro could continue to be used until a new currency was ready, Bootle argues.
Another question is the potentially inflationary threats posed by a new currency. Retailers might take advantage of the changeover to raise prices. Many shoppers suspected this happened when the British shifted to a decimal system in 1971. To avoid such covert hikes, Bootle recommends introducing the new currency at parity to the euro, so an item that used to sell for 1.5 euros would sell for 1.5 drachma, although the new currency’s real value could soon fall sharply.
Most crucially, however, the public would have to be quickly convinced that price rises were not going to get out of hand. A new inflation target would need to be set, to kick in after an initial adjustment phase. The nation could also consider issuing indexed bonds, whose interest payments would rise along with prices. This would reduce a government’s incentive to let inflation rip, Bootle says, and so reassure investors and the public.
Return to growth
Politicians could offer another guarantee of good behaviour by setting up an independent auditor to monitor public borrowing. A departing sovereign should also organise an orderly default on foreign debt, writing down debts to a sustainable level so the nation could resume economic growth.
The Wolfson Economics Prize ended up underlining many of the dangers of a euro split. But thanks to the Tory peer, discussing the practicalities of a breakup is no longer a taboo.
Christopher Alkan, journalist