The Euro crisis – causes & cures

27 Feb

Is abandoning the Euro the way out for the southern states?

For countries retaining their own currency, the classic way out of this situation is a one-off devaluation, imposing a one-time capital loss on the holders of (say) lira debt, and imposing a one-off adjustment in the living standards of the country devaluing. Of course in practice the situation is much more complex than this, as the UK experience in 1967 showed, and there is a particular problem in ensuring that the entire adjustment remains a one-off and does not trigger an inflationary spiral. But such a mechanism is at least a possibility.

The southern states have no such option. Each would have to introduce their own currency, and declare a conversion rate to the euro. We can safely assume that, if each country reverted to its pre-euro currency, the offered conversion rate would represent a significant mark-down to its going-in rate. The governments concerned would then have to offer a conversion programme to holders of Euro-denominated government debt to induce them to switch to a domestically-denominated substitute. “Offer” may of course be putting it politely – a more likely scenario would be a forced conversion or default. And the resulting domestic debt would no doubt need to offer a higher yield than equivalent Euro area debt.

But by this time the banking sector in the country concerned would be in meltdown. It would be facing losses of 50% or more on its government bond portfolio and CDS payments would probably have been triggered. On the liabilities side of its balance sheet – as the Euro area has no capital controls- it would probably have seen a massive flight of deposits to non-domestic Euro area banks, which it would be financing by discounting any bill out loan on its books with its central bank. But even with this, a significant contraction of credit would be likely by the domestic banking sector, while the Euro area recipients of the “hot money” would often lack the distribution capacity to recycle the funds.

It is less clear what would happen to the Euro as a medium of exchange in the country concerned.The government would presumably declare the “lira”  the legal currency, pay state benefits & salaries in lira, & request tax payments in lira. But a dual currency solution is surely more likely, with corporates & the entire tradeables sector continuing to use the euro. The status of contracts would also be interesting -would the government pass a law requiring all “domestic” contracts to be redenominated to lira? And how would you determine the difference between domestic and non-domestic contracts?

Other solutions

So faced with these difficulties it is not surprising that even socialist countries like Greece have sought more or less any alternative to leaving the euro. But adjustment will still be required – and if that is not to come via devaluation, then similar changes will be needed by other means. The fundamental needs are to make the economies competitive and the debt burden serviceable.

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