The question how best to manage process of a country’s leaving the euro has an answer. Most approaches have started from the wrong premise, however. The task is not realistically to effect the quickest and most decisive break with the institutions of the eurozone. The “nuclear option” of an extended bank holiday in Greece (to take the most pressing case), in which deposits of euros would be replaced with drachmas, is the simplest answer to the question, but is in fact no answer at all. It would require not only a cessation of commerce but a clampdown on people leaving the country.
Long before this point had been reached, there would have been a run on the banks. Greece, Portugal and Spain all have experience in the past 40 years of dictatorial government. An economic programme that, to have any chance of working, would have to curtail liberties that citizens take for granted would stand little chance of even ameliorating the situation.
In fact, there are many historical cases of countries leaving currency unions, but none of them is applicable to today’s events. This paper explains the reasons why this is so. Moreover, the competitive boost of a new drachma would be economically marginal and overwhelmed by the increase in debt servicing costs, leading to wholesale default and the country’s being locked out of the capital markets.
Every proposal for Greece and the other indebted economies to leave the eurozone starts from the premise of this type of “Big Bang” approach, modelled on Argentina in 2001-02, yet it speedily runs into the problems of political turmoil and financial collapse. A dash for the drachma (or escudo or peseta) will hugely aggravate the problems of the eurozone if, as Greece and possibly other eurozone economies disengage, there is no floor under the new (or restored) currency.
This submission proposes instead a way of providing such a floor and thereby enabling countries safely to leave the euro. The proposal is to introduce a new currency (the “New Drachma”) as part of a currency board. A currency board is like a gold standard except that the currency is pegged to another currency and not to a commodity price. The central bank is thus committed to exchanging its monetary liabilities at a fixed exchange rate. It can issue only as much domestic currency as it has holdings of foreign currency given the exchange rate. The New Drachma would be pegged to the euro and that would be the floor.
A peg to the euro would not on its own untie the straitjacket that Greece is in owing to euro membership. The currency board should, therefore, be a dual currency board in which the New Drachma is pegged to two reserve currencies – the dollar as well as the euro. It would be at the discretion of the central bank which reserve currency it gave in return for New Drachmas – but the workings of the market, and the search for dollar-euro arbitrage by market participants in Greece would mean automatically that the New Drachma would be pegged to whichever of the dollar or the euro was the more depreciated currency in each case. This would provide an economic lubricant - a little bit of inflation and depreciation, but with the retention of the monetary credibility needed to make the structural reforms to welfare spending and labour markets that Greece in particular has avoided for decades.
A dual currency board has been seriously proposed in the case of the emerging economies from the former Soviet bloc, but more usually the peg was to a weighted basket of currencies. This has the disadvantage of not being so readily understandable and transparent when the very purpose of a currency peg, for countries leaving the euro, would be to reassure consumers, businesses and investors. For that reason, a peg to the two reserve currencies is preferable. It is a practical course by which Greece and economies with similar problems can leave the euro without sparking a banking collapse, and while keeping open also their access to capital markets and the prospects for structural reforms. The success of the scheme would depend on the willingness of international lending institutions to provide sufficient foreign currency reserves and act as international lenders of last resort to the banking system, but this is a more likely way of securing a successful international rescue than persisting with the current round of negotiations over emergency funding mechanisms.
The proposal does not resolve the problems of the heavily indebted economies; but it does provide a breathing space in which to tackle these countries’ economic difficulties and insulate the risk of contagion. Currency boards are usually interim steps on the way to either a currency union or a fully flexible rate. That would be the choice of Greek and other policymakers and voters once the board had done its work.
There remain huge complications, not least legal challenges from companies investing in Greece. But legal cases take time, whereas this step would be quick and without sacrificing monetary credibility of having a reserve currency. When the euro was launched, its supporters who recognised the design flaws assumed that the necessary institutions would be built as the currency gained credibility. That never happened. But it might happen with the proposed scheme for Greece and the other indebted economies. Exit from the euro with a dual currency board would cause an immediate shift in perception but with market credibility retained and enhanced. Thus could be established a virtuous circle in which debt servicing costs come down, the opportunity to cut costs and improve productivity is presented, without an atmosphere of constant crisis - and sustainable growth returns to southern Europe.