Michael G. Arghyrou and John Tsoukalas advocate The Option of Last Resort for the solution of the current euro-area crisis: A Two-Currency EMU, on Economonitor of 7 February.
“The plan we propose involves the temporary implementation of a two-currency EMU, with both currencies run by the Frankfurt-based ECB. The core-EMU countries will continue to use the present currency, the strong euro. The periphery countries on the other hand, will adopt, for a certain period of time, another currency, the weak euro. Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms. Upon its introduction, the ECB will devalue the weak euro by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade against their main trading partners, the core-EMU countries. This will give the periphery a competitiveness boost while it introduces extensive structural reforms. The ECB will implement monetary policy for the whole of the EMU with its primary objective being price stability for all its members, strong- and weak-euro countries. It will do so in much the same way it does now, the only difference being that the ECB will be setting two rather than one reference rates.”
A similar plan was advocated by Charles Goodhart and Dimitrios Tsomocos in the FT of 24 January: The Californian solution for the Club Med – except through the temporary introduction of a dual national currency, for Portugal by way of example, through an escudo IOU instead of a dual “weak-euro” throughout the euro-zone, just like the IOUs that California and Argentina’s districts used to cope with a fiscal crisis.
The Gresham-Copernicus-Oresme-Aristophanes Law
The trouble with any dual currency system – whether bi-metallic or bi-paper or mixed – is that either the rate of exchange between the two currencies is determined by the market, depending on what can or cannot be done with either currency and how, or their rate of exchange is managed by monetary authorities presumably at a rate other than would otherwise prevail in the market (or there would be no point in managing it). At a market-determined exchange rate, the introduction of a new currency simply increases the amount of liquidity in the system, without any other effect; nothing happens that could not have happened by expanding money supply in the old currency (as it can always be done with paper money). At any managed exchange rate different from the market rate, Sir Thomas Gresham (1519 – 1579), an English financier during the Tudor dynasty, rules: “Bad money [the currency overvalued with respect to the market rate] drives out good [the undervalued currency]”. The dual currency ceases to be dual. This law is one of the oldest economic discoveries: it was anticipated by Nicolaus Copernicus, even earlier by Nicole Oresme in the fourteenth century, and had been stated clearly by Aristophanes in his play The Frogs, around the end of the fifth century BC.
The chervonets precedent
In the past the introduction of an additional currency has been advocated, and at least once implemented, not to weaken a strong currency and restore competitiveness but to stabilize a rapidly depreciating currency suffering from hyper-inflation. Thus in 1922-24 Lenin introduced in the Soviet Union a new gold-backed convertible currency, called chervonets after Peter the Great‘s gold coinage, and circulating next to the overinflated rouble, or sovznak. Over time the sovznak was de-monetized and disappeared through hyperinflation, while the new currency and the government budget were stabilized.
In the case of the chervonetz-sovznak coexistence clearly the rate of conversion between the two currencies had to be floating and market-determined, for the new currency at an under-valued fixed rate would be displaced by Gresham‘s law, while an overvalued rate would be pointless and rouble-inflationary. But if the two currencies were exchanged freely in the market the old currency would gradually disappear through higher and accelerating rouble-inflation and hyperinflation, which is what I understand actually happened in 1922-24, leaving a single sound currency. The parallel currency implemented a slow motion currency-stabilisation through accelerating rouble inflation, instead of a single inflationary shock to reach immediate balance.
In 1988-89 George Soros, Wassily Leontief, Ed Hewett and Ivan Ivanov (Deputy Chairman of the State Foreign Economic Committee, GVK) launched their “Open Sector”project, with the participation of many Soviet, western and east-European economists (see Phil Hanson, "Foreign Advice", in M.Ellman and Kontorovich, The Destruction of the Soviet Economic System – An Insiders’ History, M.E. Sharpe, Armonk-New York, 1988, pp.238-255). It was a plan, initially surrounded by secrecy, for both wiping out monetary overhang and promoting foreign trade by introducing a new convertible currency inspired by the 1920s chervonets, paid to Soviet exporters and then circulating in parallel with domestic roubles. I took part in the project and went along for the ride, but never believed in it: what had happened with the chervonets would have happened with the parallel, convertible hard rouble: slow-motion stabilisation through rouble hyperinflation. Not a very effective or attractive measure, and it was shelved, like other radical plans, without being taken seriously into consideration.
No way to restore competitiveness
The introduction of the weak-euro or the IOU escudo would undoubtedly add liquidity that might reduce the danger of sovereign default, especially through the use of IOUs directly issued by sovereign debtors – at a price, i.e. the higher discount rate applicable to the IOUs. But seeing how the weaker new currency could restore competitiveness is rather nebulous.
The envisaged devaluation of the weak euro immediately after its introduction, “by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade” presumes that the weak euro becomes legal tender in place of the old at par, and that traded goods prices quoted in weak-euro remain unchanged with respect to old euro prices. True, this happens to some extent with every devaluation, but here Gresham’s Law would demonetize the strong euro for all uses not specifically reserved to the old currency; producers and traders would be forced to re-consider their price policy in terms of the new weak-euro.
One inconsistency of this plan is worth stressing: “Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms.” But the weak-euro countries in order to benefit from greater competitiveness would have to price and invoice their goods in weak-euros, so how would they acquire the strong-euro they need to service their debts?
Easier euro-area enlargement?
Another claim made by Arghyrou&Tsoukalas for their two-currency EMU is totally bogus: “… our proposal will be beneficial for EMU’s enlargement: In the present circumstances, the young democracies of Central and Eastern Europe cannot realistically expect to join the EMU in the foreseeable future. A two-currency EMU will provide them a chance of joining the EMU at a reasonably close date, initially as members of the weak euro, thus maintaining internal popular support and the momentum of enlargement.”
Both the central parity with the Euro at which EMU candidates join ERM-II, and the final rate of exchange at which they replace their domestic currency with the euro, are negotiated by candidates with the EU monetary authorities. Joining a “weak-euro” or a “strong-euro” would happen at different parities, which could be tailored to the relative strength of weak and strong euro, without any competitive advantage for one or the other. This particular claim is nonsense.
The Goodhart-Tsomokos plan has some advantages over the weak/strong-euro scheme. For a start, the devaluation of the national IOU would be geared to the specific conditions of the country involved, rather than being a single-size for all “periphery countries”. Being a national scheme, it would not necessarily involve the ECB: “If the central bank does not want to do this, and under the Maastricht Treaty it could refuse, the Treasury could do this on its own.” And there is a mechanism for the national management of national IOUs and the euro: “… the government, whose taxes remain paid in euro, would be long in euro, whereas the Portuguese private sector would be long escudo, short euro. So, the government transfers its net long to the central bank and asks the central bank to manage the escudo/euro exchange rate, so that it is stabilised, say at a level that represents a 25 per cent internal devaluation, (the choice of number would need careful calculation).” “While managed, the exchange rate should not be pegged.”
But there are also serious additional difficulties with respect to the Arghyrou&Tsoukalas plan. “… escudo IOUs would be acceptable for all internal payments, except tax payments, between Portuguese residents, but not for any external payments between Portuguese residents and foreign residents. All public sector and private sector wage payments shift on to an escudo basis as do interest payments by a Portuguese resident to another resident. Portuguese residents’ deposits and borrowing with Portuguese banks shift to an escudo basis; others remain in euros.” “The escudo would be inconvertible, and non-residents would not be allowed to borrow it. After all, this would be but a humble state IOU, though written rather large and not a ‘proper’ currency; indeed its success would be evident in its disappearance within a defined horizon, say 4 years.”
Back to the drawing board
“It would be messy, and an unattractive dual currency mechanism.” Spot on, Charles. “But it could work; it has done so before now in other countries and circumstances.” You should remind us where and when (the chervonets/sovznak rate was floating and is not comparable to the managed IOU/euro regime). And you should explain how on earth, if external payments between Portuguese and foreign residents take place in euros, is Portugal’s external competitiveness going to be enhanced by the introduction of an inconvertible IOU escudo?