The Euro area needs economies which have converged sufficiently to be managed together with sustainable budget deficits and debt refinancing requirements.
The Euro founders set out sensible tests to ensure only countries equipped to deal with Euro discipline joined. In the initial enthusiasm it was decided to allow a number of countries to join which were far from converging. In some cases the discipline of the zone has brought convergence, in other cases countries have needed IMF programmes.
The task is to carry out the least number of changes necessary to create a sustainable remaining Euro area capable of growth and greater prosperity, whilst freeing the exit countries sufficiently so they too can grow again. There are four main economic strains: big balance of payments imbalances between countries, high unemployment in some uncompetitive countries , banking weakness, and state debt financing problems.
Some countries will over time become more competitive through zone discipline. They have to raise productivity, and set real wages at appropriate levels. Some of these adjustments can prove painful, if wages have to fall. Others with more urgent problems may need to leave the Euro to adjust their economies more fundamentally. Devaluation is part of the answer for an extreme case like Greece, providing an immediate adjustment to competitiveness. It cheapens exports and makes imports dearer, adjusting the trade deficit.
Some countries with debt problems will over time be able to cut their deficits by cutting spending, or by growing their tax revenue more rapidly. Countries with large inherited debts will need to repay some debt when possible. Others simply have too large a debt and deficit to make longer term adjustment a sufficient answer. Greece again is the extreme case. Greece is seeking a voluntary arrangement with private sector creditors to cut the debts. Devaluation following exit from the Euro could help.
The optimum monetary reconfiguration
The early exit of Greece from the Euro zone is recommended, as the least change needed.
Portugal and possibly Ireland should also be invited to leave the zone. Neither can finance themselves in the markets in the usual way, despite austerity packages and substantial new borrowings from the EU and IMF. Early exit, devaluation, and domestic growth policies including monetary accommodation to foster the private sector would help, and would reduce the strains on the zone.
Italy’s main problem is the overhang of past debt. This may be manageable. Italy can meet the deficit and inflation requirements. The country is rightly putting in place more productivity and cost reduction policies to improve competitiveness.
Spain has serious problems with banks and the past property bubble. She would probably recover more quickly with devaluation. However, there is considerable support in Spain and the EU to keep Spain in the system. She can still borrow in the normal way in the markets to pay the bills, and is keen to pursue fiscal orthodoxy .
Italy and Spain will be supported in the zone. There is no power to force their exit. The question of a country leaving the Euro should automatically arise if and when the country needs to seek financial assistance, when the EU does have negotiating power to request an exit. These proposals do not require Treaty revision, avoiding the delays and political difficulties that poses.
Implications for sovereign debt, private savings and domestic mortgages.
It is recommended that an exit country changes all contracts, assets and liabilities into its new currency for domestic users under its jurisdiction.
Devaluation helps the borrower and harms the lender. As the exit countries are too heavily in debt, this natural bias helps recreate equilibrium.
Implications for international contracts denominated in Euros.
It is further proposed that the EU legislates for compulsory conversion of all assets, liabilities, and contracts for all EU citizens and resident companies to the new currencies.
Foreign owners and contracting parties outside the EU should have the right to negotiate their future currency between Euro and any new currency, avoiding jurisdictional clashes.
Effects on the stability of the banking system
The current banking system is unstable. In peripheral countries like Ireland and Greece the banks have too much debt. Banks throughout the zone have lost money on holding bonds in the weaker countries, and may also have lost money in the property crashes in peripheral countries. The system is currently heavily dependent on ECB support through its large loan facilities
The exit countries should establish their own Central banking regime immediately. They should reassure during the transitional period, promising to stand behind their commercial banks, and making plenty of liquidity available.
The ECB would need to continue its generous policy towards the remaining banks in the system, and to the exit countries whilst they establish their own arrangements.
Overall stability would be improved. Markets would have a clearer idea of true values and losses, which could help confidence . Responsibility for the worst cases would pass to new national institutions in the exit countries, enabling the ECB to concentrate on the large cases of Italy and Spain.
Approaches to transition
The paper sets out a timetable, and provides advice on the legal, economic and political steps for a successful early exit of some countries from the zone. Much has to be done right at the beginning. Preparations need to be fast, thorough and secret , so when the news is announced all the key matters are in place for a smooth transition. Fortunately there are many precedents for this work. The author has traced 87 successful cases of exits from single currencies or zones since 1945.
It is recommended that the exit countries become EU countries with an Article 139 derogation from immediate membership of the Euro. They will revert to candidate status. This reduces the legal and institutional complexities. They need to provide nationally for full powers for their enhanced Central Banks to resume their old roles. The rest of the Eurozone continues under its current legal framework, using the present institutions.
Distinguished fellow of All Souls College Oxford .
Lectured on the Euro at Oxford, Cambridge, Middlesex Business School and other universities.
He wrote one of the two Penguin books on the Euro. His “Third Way Which way?” set out a new way of analysing public and private sector activities. His “After the Credit Crunch “ and “Surviving the Credit Crunch” provide commentary on the recent economic and banking crises.
He has chaired international industrial businesses, and been a Director of a bank and of various financial sector companies.