Thinking the Unthinkable: How to Break Up the Euro Area
The unthinkable is becoming possible. Until recently, the breakup of the euro area seemed nothing but an illusion, but suddenly this possibility is a clear and evident danger. If the euro area is to be broken up, it should be done as amicably, cleanly, symmetrically —and as fast as possible.
A collapse of the euro only a dozen years after its introduction would be a great folly. But as Wolfgang Munchau of the Financial Times has pointed out, such a risk is steadily rising and policymakers need to consider how to minimize the damage of such an economic disaster.
Collapses of currency zones are usually very painful, and a dissolution of the euro area will be no exception. Three historic examples are the collapse of the Soviet Union, Yugoslavia, and the Habsburg Empire. All ended in hyperinflation along with massive declines in output.
Two contrarian reassuring examples are the collapse of the Latin Monetary Union (1865–1927) and the Scandinavian Monetary Union (1873–1914). But they were both based on the gold standard, which provided financial discipline and a standard exchange rate. A third example is Czechoslovakia, where the long-lasting koruna was divided between the Czech Republic and Slovakia in February 1993, and where the two new currencies initially stayed pegged.
There are strong reasons to assume that a breakup of the euro area will pertain to the difficult category. First and most important, it is comparatively easy to break up a currency union, if there is an external norm, such as the gold standard, which the euro lacks. Second, the more countries that are involved, the worse the disruptive mess is likely to be. With its 17 members, the Economic and Monetary Union (EMU) offers a most complex picture.
Third, when things fall apart, clearly defined policymaking institutions are vital, but the absence of such institutions lies at the heart of the very problem of the euro area. Fourth, the absence of any thinking or legislation about a breakup of the euro area is bound to make the mess all the greater. Finally, the proven incompetence of the European policymakers will likely discredit them not only for their failures in economic and monetary policy but also for the leadership of the European Union as a whole.
Fortunately, all the euro countries still have fully equipped central banks, which should greatly facilitate the process of recovering their old functions—distribution of bank notes, monetary policy, maintenance of international currency reserves, exchange-rate policy, foreign currency exchange, and payment routines.
A first question is how many currencies there will be and what their names will be. Time is short. Therefore solutions must be as simple as possible. The only realistic option is a wholesale breakup, in which each country adopts its own currency, reverting to its old currency. New combinations may make sense, but any such solution must be decided later, after a major discussion. A currency is useless if it does not imbue the holder with confidence.
In three hyperinflationary currency union collapses, the most fortuitous counties were those that left first: Czechoslovakia from the Habsburg Empire, Slovenia from Yugoslavia, and the Baltic states from the former Soviet Union. When the game is over, there is no benefit in delay or in remaining loyal to nothing, waiting for a collective accord. The last countries in these currency areas have been flooded with an abundance of the old currency, which has unleashed hyperinflation.
The most important insight is that when the euro area is evidently over, all countries will benefit from leaving it quickly. It is better for all of them to exit together. But if any nation is hesitant, the others had better leave as fast as they can for their own sake. Any delay would cause extra costs in terms of uncertainty and rent-seeking speculation.
The ideal model for a dissolution of a monetary union is the partition of Czechoslovakia in 1993. It was amicable and orderly. And it was fast and simple. The euro members should opt for these properties. When the need for dissolution of the euro area appears inevitable, all countries should agree on an early exit date.
It is not necessary to print bank notes in advance. Presumably some euro countries have stored their old bank notes and can circulate them again. Alternatively, it is enough to stamp bank notes in each nation as national for a month or two, as the Czechs and Slovaks did, because counterfeiting currencies usually takes time. Then new bank notes can be printed and delivered.
Currency exchanges are highly sensitive. Usually, they are undertaken in the course of one month so that everybody has a fair chance to exchange currency. But crooks should not be able to construct dubious schemes. All currency offered must be freely exchanged and a vigorous public information campaign must be pursued to show the new banknotes and explain that no confiscation is intended. Fortunately, the euro central banks have all the logistics ready from their recent exchange from the national currency to the euro, so this should be easier than in the past.
Everybody will pose the question: Why exchange euros for an uncertain new local currency and not for a known entity such as the US dollar? Initially, considerable demand for dollars is inevitable, but the post-communist lesson is that people surprisingly quickly accept using local currencies as long as the interest rates in the national currency are competitive.
Rather than regulated interest rates and restricted currency exchange, the renewed central banks need to regain credibility by pursuing a responsible monetary policy. Fortunately, the old national central banks have retained their currency reserves, which are substantial and form the base of any credibility. Monetary policy must be characterized by extraordinary transparency. To begin with, interest rates will have to be higher than in US dollars to attract funds, keep inflation down, and give the new currency credibility.
The new central banks will require swap lines in US dollars. It is vital for the US Fed to provide such swap lines, which should be fully in line with current Fed policy.
Exchange-rate policy is tricky. There are strong arguments for maintaining a rather strict peg in the short period of one or two months when the currencies are being exchanged, to avoid unnecessary disruptions, as was successfully done between the Czech Republic and Slovakia. Later on, a natural choice would be to adopt inflation targeting and allow the currencies to float freely, while the smallest countries might want to peg their currencies as some did in the 1980s and 1990s.
A major issue is what assets to denominate in what currency. The basic principle must be that all euro assets on the territory of one nation be denominated in the renewed national currency. All unnecessary currency mismatches must be avoided.
In earlier times, outside assets were no major concern, but today outsiders hold trillions of euro assets outside of the EMU, notably in central banks' foreign currency reserves. A first principle should be that assets clearly pertaining to one country, such as treasury bills or national corporate bonds, be denominated in that national currency. Cash, however, poses difficult political questions, which must be resolved quickly.
The devastation of the ruble zone, Yugoslavia and the Habsburg Empire was brought about by the uncoordinated issuing of currency by several central banks, which naturally led to hyperinflation. Thus, it is vital that the monetary emission authority of the ECB be maintained until the euro area actually breaks up. But it is equally important for the ECB to lose that authority if the euro area breaks up. Then the national central bank in each country should take over all monetary responsibilities of the ECB. No currency zone can persist without a unified monetary authority.
One of the most complex issues might be to maintain the payment system in all its complex details, for which a lot of technical work will be required.
It is time to think the unthinkable. Once again, former Estonian Prime Minister Mart Laar's words ring true: "To wait means to fail."