When I was running through Italian default scenarios earlier in the day, I asked “Could Italy unilaterally exit the euro zone and redominate euro debts at par into a new Lira currency to forestall the default? Perhaps. That is something to consider at a later date.”
Well that later date is now. I caught David McWilliams writing how he thought the end of the euro is nigh. In his discussion he outlines how a ‘two-speed’ Europe would function after an Irish exit from the euro zone. I imagine the same could work for Italy too. The part highlighted caught my eye:
Consider what the two-speed Europe might look like.
The first thing we know is that the peripheral countries can’t keep up with Germany. Take Ireland as an example. When we had the Punt linked to the Deutsche Mark we devalued six times in thirteen years just to try to keep up competitively with the Germans. Conversely, when we joined the Euro and could not devalue, we lost 30% competitiveness against Germany. It could not be clearer.
For the other peripheral countries the situation is worse.
So we all need a change in the value of the currencies we trade in to make our companies more competitive and thus, more likely to export. In tandem, we need to make imports more expensive so we don’t buy too many of them. The weaker exchange rate achieves this. Devaluations work. And to any one who doubts this, just point to the lasting competitive gains garnered by Finland and Sweden after their 1992 devaluations.
Without currency change, we can’t keep up with the Germans and this makes the EU’s promise of economic convergence hard to achieve without huge borrowing. Up till now, we borrowed to achieve a lifestyle and a level of economic activity. Now none of us can pay this money back.
So we need debt forgiveness or some debt deal. Accompanying the new euro would be mass debt write downs because if you reduce the value of the currency that the people get paid in but you don’t commensurately reduce the value of their outstanding debts, the people will simply not be able to pay and the country will default after the devaluation. This would not be clever. Everything must be done together.
So let’s think about the new euro. The new soft euro would trade at 70% of the old one (my figure plucked out of the air). This would mean that relative to Germans, our standard of living would be cut by one third overnight. We would achieve in one night what the present policy seeks to do in five years.
We would be extremely attractive place to investment in because our labour would be much cheaper. But don’t forget that this reduces our income by the same amount.
All our debts would be reduced by 30% because they would be in a new currency. Obviously, the banks that lent in hard euros and would now get paid in soft euros would carry a huge exchange rate loss. This would need to be dealt with. Possibly, the banks in each country could issue bonds backed by the EU and redeemable for new euros at the ECB. These bonds could be considered capital so that the banks didn’t go bust.
What about the savers who lost out on their stock of old euro saving which would be devalued by 30% when converted into the new euro? They could be given new inflation-linked euro bonds issued by the State and redeemable from the ECB but not straight away. There would be an incentive to keep them in the banks as savings. This is normal because if you think about it, most people don’t touch their savings. The State would have to make sure that the new bonds were credible enough so that people wouldn’t want to cash them straight away.
There is no easy way out of this mess. There is no way we can wave a magic wand and promise that no one will be affected, but it is clear that the euro is on its way out and will at best, mutate into something else.
The two-speed euro idea, at least prevents the chaos of a messy implosion and the rushed reintroduction of many currencies. It achieves the competitive devaluation, which for us with the majority of our trade and investment coming from and going to, America and Britain, it would give us a shot in the arm. The debt forgiveness element would also give the heavily indebted commuter generation – the Pope’s Children – a break.
There is never a best way to do things in a crisis, simply a least bad way. Maybe this is it.
One thing we do know for sure is that “when things can’t go on forever, they stop”.
The key part: “All our debts would be reduced by 30% because they would be in a new currency”. It sounds like he’s thinking about Ireland the way I was about Italy. If it works for them, why wouldn’t it work for Greece, Spain and Portugal too?