Saturday, February 13, 2010

These Are Some I Printed Earlier

A hypothetical monetary dis-integration of the euro-area has been contemplated from time to time. Martin Feldstein (former economic adviser to Ronald Reagan and a president of the National Bureau of Economic Research) fore­cast “that the euro area will break up as member states voluntarily quit the euro area” even before the euro’s birth in 1999, and repeated such forecast recently. Wolfgang Münchau and Susanne Mundschenk discussed no less than eight such scenarios of Eurozone Meltdown in April 2009. Such conjectures have become common place with the rise of sovereign default risk for the so-called PIGS [Portugal Italy Greece Spain, the former Club Med, now with Italy replaced by Ireland - I wish economic commentators were politically correct], measured by interest spreads over German bonds, or CDS rates.

Just as monetary integration is expected to bring about net benefits, its mirror image monetary dis-integration is likely to involve net costs. A trade contraction among former fellow-partners of the euro-zone, due to higher transaction costs; an exchange rate risk; the expectation of higher inflation outside the euro-area; higher interest rates due to both such exchange rate risk and higher inflation; lower Foreign Direct Investment and lower portfolio investments – are a high price to pay for a sovereignty symbol and the ability to restore competitiveness (at the cost of higher inflation) through successive rounds of domestic currency devaluation. Neither weak nor strong eurozone members have an incentive, let alone an obligation, to dis-integrate.

But suppose a country like Greece decided that the inability to devalue while in the euroarea, and the gross political interference by euro monetary authorities in domestic economic matters like pensionable age and pension levels, nominal wages, fiscal budget and deficit and national debt, was intolerable and politically unacceptable to government and/or a rioting population. Exiting the euroarea - Münchau and Mundschenk argue - might be illegal, would take a long time because it would require democratic discussions in Parliaments and likely constitutional changes, and it could be frustrated by capital flight during the long period it would take. This is not the case. Any EMU member who wished to exit the euro-zone, let us say Greece, could do it de facto without saying or doing anything at all about the euro, simply by issuing nicely printed banknotes denominated in Greek Euro, initially valued at par with the old euro and subsequently floating against the euro, with a single decree stipulating that the new currency is legal tender in the payment of wages and taxes.

As long as the Greek euro can be used to pay taxes, parity can be kept at least for a while. The new Greek currency is issued through wage and salary payments to public employees and re-absorbed via tax receipts, the government getting a bit of a breathing space in between. Euro government receipts available for other government expenses are not affected. Having been decreed legal tender in the payment of wages (as well as taxes) shops and their suppliers will have an incentive to accept new Greek euro in payment instead of the old euro. The very existence of the new Greek euro will breed a lack of confidence in it; Gresham’s Law will raise the velocity of circulation of the new Greek euro with respect to the old euro, which sooner or later will exchange at a premium, in a market in which both can be traded freely. Workers would immediately claim higher wages in Greek Euro, and they would probably get them. Market prices for consumption goods and then production and investment goods would also soon be expressed in Greek euro; traders still pricing their goods and services in euro could be paid by converting the weaker Greek euro into stronger old euro, for both are convertible.

The euro would continue to be used in all extant inter-temporal transactions that had been stipulated in euro, both in the public and the private sector. All new transactions would be stipulated and settled in whatever currency is agreed by the transactors – except wages would normally be fixed and settled in the new currency, although indexation of Greek euro wage payments to the euro market exchange rate would be allowed. Imports and exports would be priced and settled in currencies agreed by traders.

The Greek euro monetary issues would give the government additional liquid resources, and to Greek producers the chance of devaluing labour costs thus acquiring additional competitiveness – as long as the price flexibility afforded by the new currency is exploited. In practice the euro would be at least partly de-monetised, thanks to Gresham’s Law, and used only in old intertemporal transactions, so that this could be argued to be a single currency system – though I would not press the point and, should this system be viewed as a dual currency system, I will stand by what I wrote in the previous post, that dual currencies are always a bad idea.

The only redeeming feature of the system envisaged here is that it could work. Unlike the dual currency system proposed by Michael G. Arghyrou and John Tsoukalas, and by Charles Goodhart and Dimitrios Tsomocos (see my earlier post). The Arghyrou&Tsoukalas new currency is not national but circulates in all countries of the euro-periphery, the exchange rate between the euro and the weak-euro is managed by the ECB (still mysteriously able to target price stability for both currencies despite weak-euro devaluation); price-fixing and wage-fixing are left indeterminate (nominally unchanged in terms of the weaker euro, considering that price stability is preserved in both currencies?) and so is the payment regime. And in the Californian Solution proposed by Goodhart&Tsomocos, the inability to use their new currency to pay taxes, and above all its inconvertibility, would make their IOUs as unattractive and useless as the old Transferable Rouble.

Another advantage is that there would be no need for parliamentary debates or constitutional changes, just a government decree whereby the Treasury – as Goodhart and Tsomocos envisage – issue their Greek euros in the form of their own IOUs. The time-lag involved between decision and implementation is that necessary to print the new banknotes. If these could be printed secretly beforehand, and stored safely, a country’s quasi-exit from the eurozone could take place at a stroke, from one day to the next. A quasi-exit, because there would remain the possibility, if and when the national IOUs should return to parity with the euro, of rejoining de facto the euro area, equally at a stroke. An amendment of the Growth and Stability Pact would be appropriate to cope with this unexpected development, and in the event of a final exit from the eurozone the country’s accounts with the ECB would have to be reckoned and settled, but all this could wait.

Still a bit messy and inelegant, though. Just a feasible scenario, explored so as to encourage finding better solutions. It is a good thing that these kinds of games, even as mental experiments, are strictly verboten in Frankfurt.


Roy said...

"A bit messy and inelegant". Why, what is neat and elegant about a brutally deflationary budget?

Guy said...

"The new Greek currency is issued through wage and salary payments to public employees and re-absorbed via tax receipts, the government getting a bit of a breathing space in between."

Not much of a breathing space, as you seem to recognize. But then how would the issuing government gain substantial additional liquidity?

D. Mario Nuti said...

Nothing, Roy, but perhaps we could improve on both brutal deflation and a national-soft-euro.

Simple, Guy: by issueing more national IOUs than tax revenues. Of course that would be inflationary, but then this is precisely the point of floating against the euro, in which you could not inflate without worsening your current account - if at all. Of course there are no miracles in economics.

Anonymous said...

Sorry I am not an expert in this at all. Could a country (like Ireland) choose to create a IrelandEuro that operated alongside the existing euro but only expanded the money supply slightly. So for example, the country could introduce mortgage repayment, and mortgage interest payment tax relied on house purchases between 2003 and 2007 to help the young generation pay off the debts they have built up and at the same time help the solvency of the banking system. The resulting drop in tax receipts could be funded by the government creating/printing a dual currency valid for tax payments, but only print enough to fill the loss in tax receipts due to the scheme. Once the deflationary spiral was halted and the country was back on its feet the new currency could be slowly decommissioned and removed from circulation. Is this possible, does it make sense to you?

D. Mario Nuti said...

Without the ECB cover and associated discipline and credibility, the IrelandEuro would soon cease to trade at par with the Euro - otherwise there would be no point in introducing it, and anyway the bad IrelandEuro would displace the Euro if treated at par (Gresham’s Law).

IrelandEuro devaluation with respect to the Euro could restore Irish trade competitiveness and boost the Irish trade balance - as long as IrelandEuro inflation did not erode this newly gained trade advantage, and as long as Irish exports and imports were sufficiently price elastic. But interest on and repayment of existing debt incurred in Euro will have to paid in Euro: this burden for the Irish economic subjects whose income accrues in IrelandEuro will be a non-negligible element of the gross cost of the operation. “De-commissioning” the parallel currency - after “the country was back on its feet” - would also be a cost. In theory the operation might work, but it could not achieve anything that would not also be achieved by abandoning the Euro and re-adopting it again later, without any parallel currencies in circulation.