Right & Wrong From Eichengreen About Euro Area Breakup
Barry Eichengreen writes in a good way about the procedural problems associated with Greece or anyone else exiting the euro area. There have been many cases of currency areas’ breaking up in the past, but in those days capital was less mobile and/or the motive for doing so wasn't to lower the value of money.
"The insurmountable obstacle to exit is neither economic nor political, then, but procedural. Reintroducing the national currency would require essentially all contracts – including those governing wages, bank deposits, bonds, mortgages, taxes, and most everything else – to be redenominated in the domestic currency. The legislature could pass a law requiring banks, firms, households and governments to redenominate their contracts in this manner. But in a democracy this decision would have to be preceded by very extensive discussion....
...One need only recall the extensive planning that preceded the introduction of the physical euro.
Back then, however, there was little reason to expect changes in exchange rates during the run-up and hence little incentive for currency speculation. In 1998, the founding members of the euro-area agreed to lock their exchange rates at the then-prevailing levels. This effectively ruled out depressing national currencies in order to steal a competitive advantage in the interval prior to the move to full monetary union in 1999. In contrast, if a participating member state now decided to leave the euro area, no such precommitment would be possible.The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.
Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises."
It could be argues that one way of getting around the massive capital flight would be to outlaw capital outflows during the discussion about exiting. But apart from the many practical problems associated with that, including the possibility of bank runs of people wanting to switch to euro notes, that would likely simply ensure that capital flight would happen during the discussion to introduce the controls.
Another way of getting around this problem would be to say that bank deposits and bonds would still denominated in euros. But that would create the problem of debt traps. If say the Greek debt burden is 105% of GDP, and a new drachma falls 30% in value, then the debt burden would immediately increase to 150% of GDP. If the drachma falls 50% the debt burden rises to 210% of GDP. It should be clear that with this solution, the debt problem of Greece wouldn't be solved. It would in fact likely get worse, just as the big devaluations of Ukraine and Iceland only worsened their debt problems. Trying to inflate your way out of debt doesn't work if the debt is denominated in a foreign currency.
While Eichengreen is basically right that the practical or procedural problems makes a euro area break up extremely unlikely (notwithstanding the wishful thinking from certain British and American pundits to the contrary), he is wrong about the economic pros and cons about an exit:
"the country would be forced to pay higher interest rates on its public debt. Those old enough to recall the high costs of servicing the Italian debt in the 1980s will appreciate that this can be a serious problem.
But for each such argument about economic costs, there is a counterargument. If reintroduction of the national currency is accompanied by labour market reform, real wages will adjust. If exit from the euro area is accompanied by the reform of fiscal institutions so that investors can look forward to smaller future deficits, there is no reason for interest rates to go up. Empirical studies show that joining the euro-area does result in a modest reduction in debt service costs; by implication, leaving would raise them. But this increase could be offset by a modest institutional reform, say, by increasing the finance minister’s fiscal powers from Portuguese to Austrian levels. Even populist politicians know that abandoning the euro will not solve all problems. They will want to combine it with structural reforms."
Assuming that the transition problems discussed earlier could somehow be solved (or assume that Greece had never entered the euro area), would exiting (or not entering) the euro area really make debt service more costly? Quite to the contrary under the current circumstances if the government issues debt in its own currency. The reason for that is that with your own central bank, you can have the central bank hold down interest rates by monetizing or threatening to monetize the debt. A comparison of Greece, which pays a real interest rate of 5% on long term securities, and the U.K which pays a real interest rate of 0.5% on its long term securities, despite the fact that the Greek and British deficits are equally large, illustrates this.
And Eichengreen is also wrong on structural reform. There is no reason at all to assume that Greek politicians would have been more willing to for example cut government spending if they could devalue and have a central bank partly monetize its debt. Quite to the contrary they would be a lot less likely to institute reforms resisted by government sector employee unions and others benefiting from the status quo. If there was little cost of borrowing more money then it would have little incentive to take the heavy political price of fighting government sector employee unions and others. It is only because of the current pressure from the bond markets that the Greek government has the political will to do so.
"The insurmountable obstacle to exit is neither economic nor political, then, but procedural. Reintroducing the national currency would require essentially all contracts – including those governing wages, bank deposits, bonds, mortgages, taxes, and most everything else – to be redenominated in the domestic currency. The legislature could pass a law requiring banks, firms, households and governments to redenominate their contracts in this manner. But in a democracy this decision would have to be preceded by very extensive discussion....
...One need only recall the extensive planning that preceded the introduction of the physical euro.
Back then, however, there was little reason to expect changes in exchange rates during the run-up and hence little incentive for currency speculation. In 1998, the founding members of the euro-area agreed to lock their exchange rates at the then-prevailing levels. This effectively ruled out depressing national currencies in order to steal a competitive advantage in the interval prior to the move to full monetary union in 1999. In contrast, if a participating member state now decided to leave the euro area, no such precommitment would be possible.The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.
Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises."
It could be argues that one way of getting around the massive capital flight would be to outlaw capital outflows during the discussion about exiting. But apart from the many practical problems associated with that, including the possibility of bank runs of people wanting to switch to euro notes, that would likely simply ensure that capital flight would happen during the discussion to introduce the controls.
Another way of getting around this problem would be to say that bank deposits and bonds would still denominated in euros. But that would create the problem of debt traps. If say the Greek debt burden is 105% of GDP, and a new drachma falls 30% in value, then the debt burden would immediately increase to 150% of GDP. If the drachma falls 50% the debt burden rises to 210% of GDP. It should be clear that with this solution, the debt problem of Greece wouldn't be solved. It would in fact likely get worse, just as the big devaluations of Ukraine and Iceland only worsened their debt problems. Trying to inflate your way out of debt doesn't work if the debt is denominated in a foreign currency.
While Eichengreen is basically right that the practical or procedural problems makes a euro area break up extremely unlikely (notwithstanding the wishful thinking from certain British and American pundits to the contrary), he is wrong about the economic pros and cons about an exit:
"the country would be forced to pay higher interest rates on its public debt. Those old enough to recall the high costs of servicing the Italian debt in the 1980s will appreciate that this can be a serious problem.
But for each such argument about economic costs, there is a counterargument. If reintroduction of the national currency is accompanied by labour market reform, real wages will adjust. If exit from the euro area is accompanied by the reform of fiscal institutions so that investors can look forward to smaller future deficits, there is no reason for interest rates to go up. Empirical studies show that joining the euro-area does result in a modest reduction in debt service costs; by implication, leaving would raise them. But this increase could be offset by a modest institutional reform, say, by increasing the finance minister’s fiscal powers from Portuguese to Austrian levels. Even populist politicians know that abandoning the euro will not solve all problems. They will want to combine it with structural reforms."
Assuming that the transition problems discussed earlier could somehow be solved (or assume that Greece had never entered the euro area), would exiting (or not entering) the euro area really make debt service more costly? Quite to the contrary under the current circumstances if the government issues debt in its own currency. The reason for that is that with your own central bank, you can have the central bank hold down interest rates by monetizing or threatening to monetize the debt. A comparison of Greece, which pays a real interest rate of 5% on long term securities, and the U.K which pays a real interest rate of 0.5% on its long term securities, despite the fact that the Greek and British deficits are equally large, illustrates this.
And Eichengreen is also wrong on structural reform. There is no reason at all to assume that Greek politicians would have been more willing to for example cut government spending if they could devalue and have a central bank partly monetize its debt. Quite to the contrary they would be a lot less likely to institute reforms resisted by government sector employee unions and others benefiting from the status quo. If there was little cost of borrowing more money then it would have little incentive to take the heavy political price of fighting government sector employee unions and others. It is only because of the current pressure from the bond markets that the Greek government has the political will to do so.
posted by stefankarlsson at 4:49 PM
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