What is truth?

 

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Many economists expect catastrophic consequences if any country exits the euro. However, during the past century sixty-nine countries have exited currency areas with little downward economic volatility. The mechanics of currency breakups are complicated but feasible, and historical examples provide a roadmap for exit. The real problem in Europe is that EU peripheral countries face severe, unsustainable imbalances in real effective exchange rates and external debt levels that are higher than most previous emerging market crises. Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable. Exiting from the euro and devaluation would accelerate insolvencies, but would provide a powerful policy tool via flexible exchange rates. The European periphery could then grow again quickly with deleveraged balance sheets and more competitive exchange rates, much like many emerging markets after recent defaults and devaluations (Asia 1997, Russia 1998, and Argentina 2002)

KEY CONCLUSIONS

> The breakup of the euro would be an historic event, but it would not be the first currency breakup ever – Within the past 100 years, there have been sixty-nine currency breakups. Almost all of the exits from a currency union have been associated with low macroeconomic volatility. Previous examples include the Austro-Hungarian Empire in 1919, India and Pakistan 1947, Pakistan and Bangladesh 1971, Czechoslovakia in 1992-93, and USSR in 1992.

> Previous currency breakups and currency exits provide a roadmap for exiting the euro – While the euro is historically unique, the problems presented by a currency exit are not. There is no need for theorizing about how the euro breakup would happen. Previous historical examples provide crucial answers to: the timing and announcement of exits, the introduction of new coins and notes, the denomination or re-denomination of private and public liabilities, and the division of central bank assets and liabilities. This paper will examine historical examples and provide recommendations for the exit of the Eurozone.

> The move from an old currency to a new one can be accomplished quickly and efficiently – While every exit from a currency area is unique, exits share a few elements in common. Typically, before old notes and coins can be withdrawn, they are stamped in ink or a physical stamp is placed on them, and old unstamped notes are no longer legal tender. In the meantime, new notes are quickly printed. Capital controls are imposed at borders in order to prevent unstamped notes from leaving the country. Despite capital controls, old notes will inevitably escape the country and be deposited elsewhere as citizens pursue an economic advantage. Once new notes are available, old stamped notes are de-monetized and are no longer legal tender. This entire process has typically been accomplished in a few months.

> The mechanics of a currency breakup are surprisingly straightforward; the real problem for Europe is overvalued real effective exchange rates and extremely high debt Historically, moving from one currency to another has not led to severe economic or legal problems. In almost all cases, the transition was smooth and relatively straightforward. This strengthens the view that Europe’s problems are not the mechanics of the breakup, but the existing real effective exchange rate and external debt imbalances. European countries could default without leaving the euro, but only exiting the euro can restore competitiveness. As such, exiting itself is the most powerful policy tool to re-balance Europe and create growth.

> Peripheral European countries are suffering from solvency and liquidity problems making defaults inevitable and exits likely – Greece, Portugal, Ireland, Italy and Spain have built up very large unsustainable net external debts in a currency they cannot print or devalue. Peripheral levels of net external debt exceed almost all cases of emerging market debt crises that led to default and devaluation. This was fuelled by large debt bubbles due to inappropriate monetary policy. Each peripheral country is different, but they all have too much debt. Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level. Greece and Portugal are arguably insolvent, while Spain and Italy are likely illiquid. Defaults are a partial solution. Even if the countries default, they’ll still have overvalued exchange rates if they do not exit the euro.

> The euro is like a modern day gold standard where the burden of adjustment falls on the weaker countries – Like the gold standard, the euro forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionary bias, where the burden of adjustment is always placed on the weak-currency country, not on the strong countries. The solution from European politicians has been to call for more austerity, but public and private sectors can only deleverage through large current account surpluses, which is not feasible given high external debt and low exports in the periphery. So long as periphery countries stay in the euro, they will bear the burdens of adjustment and be condemned to contraction or low gr

CONVENTIONAL THINKING ABOUT THE BREAKUP OF THE EURO: CATASTROPHE AHEAD

It would be like a Lehman-times five event.

– Megan Greene, director of European economics at Roubini Global Economics

A euro break-up would cause a global bust worse even than the one in 2008-09. The world’s most financially integrated region would be ripped apart by defaults, bank failures and the imposition of capital controls.

– The Economist, 26 November 2011

If the euro implodes, [the UK’s] biggest trading partner will go into a deep recession. Banks may well go under, so will currencies both new and old. Investment will freeze up. Unemployment will soar. There is no way the UK is going to escape from that unscathed.

– Matthew Lynn, MoneyWeek

A euro area breakup, even a partial one involving the exit of one or more fiscally and competitively weak countries, would be chaotic. A disorderly sovereign default and Eurozone exit by Greece alone would be manageable… However, a disorderly sovereign default and Eurozone exit by Italy would bring down much of the European banking sector. Disorderly sovereign defaults and Eurozone exits by all five periphery states… would drag down not just the European banking system but also the north Atlantic financial system and the internationally exposed parts of the rest of the global banking system. The resulting financial crisis would trigger a global depression that would last for years, with GDP likely falling by more than 10 per cent and unemployment in the West reaching 20 per cent or more.

– Willem Buiter in the Financial Times

Given such uniform pessimism on the part of analysts and the unanimous expectation of financial Armageddon if the euro breaks up, it is worth remembering the words of John Kenneth Galbraith, one of the great economic historians of the 20th century:

The enemy of the conventional wisdom is not ideas but the march of events.

– John Kenneth Galbraith

http://www.variantperception.com/February 2012

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