VIDEO
European Central Bank Monetary Policy
Procedural Barriers to Exit
A final set of barriers to exit are the technical and legal obstacles to reintroducing the national currency. Take the case where a country suffering from inadequate competitiveness and high unemployment reintroduces its national currency in order to depreciate it against the euro.
It would be straightforward for it to pass a law stating that the state and other employers will henceforth pay workers and pensioners, say, in lira. With wages and other incomes redenominated into the national currency, it would become politically necessary to redenominated the mortgages and credit card debts of residents into the national currency as well; otherwise, currency depreciation would have adverse balance-sheet effects for households, leading to financial distress and bankruptcies. But with mortgages and other bank assets redenominated, bank deposits and other bank balance- sheet items would also have to be redenominated in order to avoid destabilizing the financial sector.
With government revenues redenominated into the national currency, not just public- sector wages and pensions but also other government liabilities notably the public debt-would have to be redenominated to prevent balance- sheet effects from damaging the government’s financial position.The idea that redenomination has to be comprehensive to limit financial distress is a lesson of Argentina’s exit from convertibility in 2001.20 It is also an implication of the literature on dollarization, where it is argued that partial dollarization creates scope for destabilizing balance- sheet effects.
It is better either to be fully dollarized (or euroized, in the present example) or to dedollarize (or de-euroize) by redenominating claims in the national currency (see, for example, Levy Yeyati and Ize [2005] and Levy Yeyati [2006]).21Technically, nothing prevents the legislature from passing a law requiring banks, firms, households, and governments to redenominate their contracts in this manner. But in a democracy, this decision will require discussion. And for it to be executed smoothly, it will have to be accompanied by planning.
Computers will have to be reprogrammed. Vending machines will have to be modified. Payment machines will have to be serviced to prevent motorists from being trapped in subterranean parking garages. Notes and coins will have to be positioned around the country. One need only recall the planning that preceded the introduction of the physical euro in 2002.
The difference between the transition to the euro and the transition back to national currencies is that in the first instance, there was little reason to expect subsequent changes in exchange rates and thus little incentive for currency speculation, while in the second case, such changes would be viewed as virtually inevitable. In 1998, the founding members of the euro area agreed to lock their exchange rates at the then- prevailing levels at the beginning of 1999.
This precommitment effectively ruled out efforts to depress national currencies designed to steal a competitive advantage prior to the locking of parities in 1999. In contrast, if a participating member state now decided to leave the euro area, no such precommitment would be possible. Pressure from other member states would be ineffective, by definition. And the very motivation for leaving would presumably be to change the parity.
Market participants would be well aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into lira, which would then lose value against the euro, would shift their deposits to other euro area banks. In the worst case, a system- wide bank run could follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would presumably shift into claims on other euro area governments, leading to a bond market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last- resort support. And if the government was already in a tenuous fiscal position, it would not be able to borrow in order to bail out the banks and buy back its debt. This would be the mother of all financial crises.
Presumably, the government would respond with a “corralito,” Argentine style, limiting bank withdrawals. It would suspend the operation of the bond market, although this might be of limited effectiveness insofar as the same bonds and derivative instruments based on them are also traded on other national markets. But all this would almost certainly be costly in terms of output and employment. It would be hard to keep production going while the financial system was halted in its tracks; this is a clear lesson ofArgentina’s 2001/ 2002 crisis.
When the ruble zone broke up in the 1990s and new national currencies were introduced, the successor states of the former Soviet Union were able to limit the destabilizing financial consequences because their banking and financial systems were not well articulated, so limits on deposit withdrawals and other forms of arbitrage were relatively effective. They could limit the substitution of foreign for domestic assets by imposing or simply retaining exchange controls, an option that is not available to EU members with commitments to the single market. They could seal their borders to provide time to stamp old currencies or swap old currencies for new ones. Firms did not have computerized financial accounts and inventory- management systems.
Europetoday is a more complicated place. All this means that the technical obstacles to exit may be greater than in the past. While these technical obstacles may be surmountable, they pose greater challenges than in earlier instances where monetary unions broke up. The same lesson is evident in the breakup of the Czechoslovak monetary union in 1993.22 The Czechs and Slovaks agreed to political separation as of January 1, 1993, but initially kept their monetary union in place in order to minimize dislocations to trade and economic activity. It was clear from the start, however, that politicians in both countries were actively contemplating exit.
The monetary arrangement signed in October 1992 establishing the Czech-Slovak currency union in fact made provision for exit (unlike the Treaty on European Union). The union could be abandoned (equivalent to exit, given that there were only two participants) if a member ran an excessive budget deficit, if it suffered excessive reserve losses, if there were excessive capital flows from one republic to the other, or if the monetary policy committee was deadlocked.23 Although the Czech and Slovak Republics initially agreed to maintain a common currency for a minimum of six months, the markets did not find this agreement credible; they expected that the Slovak authorities would push for a much looser monetary policy and that their Czech counterparts would not accept the consequent high inflation.
The result was a flight of currency and deposits fromSlovakiato theCzechRepublic. Given their divergent preferences and the market’s lack of confidence in the monetary union, the authorities decided in favor of monetary separation. The demise of the monetary union was announced on February 2, just five weeks after it had commenced operation, and separate national currencies were quickly introduced. Czechoslovak banknotes were stamped and then replaced with new national banknotes. During this period, no currency was allowed to be transferred or exported abroad.24
This case suggests that monetary separation is technically feasible under some circumstances. Some of the technical problems of introducing a national currency were solved by stretching out this process over time. Old Czechoslovak banknotes were stamped during the second week of February, but the process of introducing the new Czech and Slovak banknotes was finally completed in August.
The problem of adjusting vending machines and parking garages was addressed by allowing old Czechoslovak coins to continue to circulate in both countries for up to six months. But the circumstances that made this possible were quite different from those in the euro area today. The commercial banking system was only just getting up and running in theCzechRepublicandSlovakia.
The authorities adopted elaborate clearing mechanisms to limit withdrawals from and strains on their respective banking systems. Trading of shares in then Czechoslovak companies acquired as a result of the voucher privatization got underway only in May 1993-that is, three months after exit from the monetary union. Thus, there was limited scope for arbitrage between national banking systems and securities markets. There were few institutional investors in a position to shift large financial balances from one successor state to the other.
Moreover, in the period leading up to the monetary separation, extensive capital controls were already in place. These slowed capital flight from theSlovakRepublic, in particular, where the new currency was expected to weaken, but they did not halt them. Payments between the two republics were halted completely at the beginning of February while the details of the separation were ironed out. This protected the banking system, especially in theSlovakRepublic, from capital flight.
Finally, the fact that the old Czechoslovak currency disappeared at the end of the six- month transition eased the process of dissolving the currency union. In the case of an individual member exiting from the euro area, in contrast, the euro would continue to circulate in the rump euro zone (whose size would presumably be considerable). WereItaly, for example, to exit the euro area, stamp the euro area banknotes of residents or replace them with new Italian banknotes, and impose restrictions on capital flows for the period of the currency exchange, Italian residents would be able to simply hold onto their euro cash and coins and then export them once the restrictions were lifted.
This would make operations designed to exchange Italian residents’ euro banknotes for the new national currency-as opposed to injecting new national currency notes in addition to existing euro banknotes-considerably more difficult. The need for extraordinary measures is also the clear lesson of the breakup of earlier monetary unions, such as that of the successor states to the Austro-Hungarian Empire.25 Austria,Hungary, and the other ethnic regions of the empire all successfully introduced national currencies following World War I. Previously, they had operated a formal monetary union, with control of the circulation vested in the Austro- Hungarian bank in Vienna.
The component parts of the empire constituted a free- trade zone, and both real and financial integration were extensive. At the same time, like EMU today, the constituent states (AustriaandHungary) decided on separate budgets while contributing to some of the expenditures of the union. Ethnic demands for autonomy boiled up during World War I. Vienna, occupied elsewhere, and lost the capacity to assert its control over non- Austrian parts of the empire. Other regions held back food supplies, disrupting the operation of the internal market. Czechs and other ethnic groups withdrew from the military alliance, siding with the Allies. With the armistice, the Czechs, Poles, and Hungarians declared their political independence and sought to establish and defend their national borders.
They also abandoned prior restraints on their fiscal policies, partly owing to postwar exigencies and partly in reflection of the value they now attached to political sovereignty.Importantly, however, the Austrian crown remained the basis for the monetary circulation throughout the former empire. This was awkward for separate sovereign nations that did not share in the seignorage and that experienced asymmetric shocks and suffered from chronic fiscal and financial imbalances.
Starting withCzechoslovakiaand theKingdomofSerbs, Croats, and Slovenes (Yugoslavia), one successor state after another left the monetary union and introduced a national currency. Typically, this involved first announcing that only stamped Austrian banknotes would be acceptable in transactions. Stamping (either overprinting with an ink stamp or adding a physical stamp) had to be conducted carefully, with a high level of uniformity, to discourage forgery. At the same time the currency was stamped, a portion was withheld as a capital levy (as a way of transferring desperately needed resources to the government). InHungary, for example, 50 percent of tendered notes were withheld as a forced loan. InCzechoslovakia, the 50 percent tax was applied to current accounts and treasury bills when these were redenominated in stamped crowns. In turn, this created an incentive to withhold currency from circulation if there were prospects of using it in other countries where stamping had not yet taken place.
Thus, there was an incentive for capital flight not unlike that which might afflict an inflation-prone country today that chose to opt out ofEurope’s monetary union. Stamping was therefore accompanied by the physical closing of the country’s borders and the imposition of comprehensive exchange controls. Individuals were prohibited from traveling abroad, and merchandise trade was halted.
The capital levy, equivalent to depreciation of the new currency against the old one, could also precipitate a run on the banks, as it did inCzechoslovakia. InAustria, which could observeCzechoslovakia’s earlier experience, bank securities and deposits were frozen at the outset of the transition. Again, avoiding serious financial dislocations required closing the borders, banning foreign travel, halting merchandise trade, and imposing draconian exchange controls while the conversion was underway. The feasibility of similar measures today is dubious.
Finally, what about a country, say,Germany, that might wish to leave the euro area because other governments had successfully pressured the ECB to run inflationary policies? The procedural difficulties in this case would be less. Here, the expectation would be that the deutschemark, once reintroduced, would appreciate against the euro. There would be no incentive to flee German banks and financial markets but rather an incentive to rush in, given this one- way bet on appreciation.
The challenge forGermanywould thus be massive capital inflows in the period when exit from the euro area was being discussed. The result would be inflation, a booming stock market, and soaring housing prices.26 Soaring asset valuations are less uncomfortable than collapsing ones, but the financial dislocations would still be considerable. These uncomfortable financial consequences would in turn constitute a disincentive to contemplate exiting.Germanyfaced similar problems in the 1960s, when it was widely anticipated that the deutschemark would be revalued against the dollar. But at that point in time, it was able to impose capital controls to limit inflows.
Germanyreimposed controls in 1960 to 1961, the period prior to the first revaluation of its currency. In mid- 1970, the country then imposed discriminatory minimum reserve requirements against nonresident bank deposits and from May 1971 required prior authorization for the sale of money- market paper and certain fixed-interest securities to foreigners. Similar responses would be difficult in the context of the single market (assuming, as seems plausible, thatGermanywould still wish to preserve its single market obligations).27
This case can, in fact, be argued both ways on procedural grounds. It can be argued that Germany could insulate its economy from the impact of the capital inflows loosed by its reintroduction of the deutschemark, because German interest rates would be lower than foreign interest rates, and the risk premia associated with investing in Germany would be lower as well.Thus, the Bundesbank would be able to sterilize the inflows associated with its reintroduction of the national currency. Goodhart (2008)-in a note written partly in response to the – questions of the relevance of this German exit scenario. He observes that the ECB enjoys statutory independence. It has a mandate to pursue price stability. Its board is made up of professional central bankers who have internalized arguments for the value of low inflation. Changing the status quo and exposing the ECB to effective political pressure would require amending the international treaty that established the ECB and the euro- something thatGermanycould veto.
European politicians can posture all they want. They can take whatever measures they wish to elevate the visibility of the Euro group of finance ministers. But their statements and actions are unlikely to weaken the ECB’s commitment to price stability. And if Goodhart is right, the German exit scenario has a vanishingly small probability.
20. Note that across- the- board redenomination, while insulating domestic banks from destabilizing balance- sheet effects, might create problems for foreign banks, which saw their euro- denominated investments, say, in Italian government bonds redenominated into lira and then saw this currency depreciate against the euro. This is another reason why other euro area countries would not welcome exit by an incumbent seeking to restore competitiveness by reintroducing and depreciating its national currency.
21.Argentina’s experience also sheds light on another approach to exiting the euro area that has occasionally been proposed-namely, reintroducing the national unit as a parallel currency.Italywould not have to leave the euro area or eliminate its euro circulation in order to reintroduce the lira, according to this scheme; it could simply reissue the lira and allow it to circulate side by side, along with the euro. The Argentine provinces did something similar in 2001 when they experienced serious difficulties in financing their current expenditures: they issued very short- term notes that circulated as quasi currency (“Patacones,” in the case of theprovinceofBuenos Aires). The problem with this approach is that absent trade restrictions, it will have no effect on the prices of goods and services on local markets; it will simply drive out a corresponding number of Euros via trade deficits. This is what happened inArgentina: the more Patacones were issued, the more peso- denominated bank deposits were liquidated. Similarly, the more lira are issued, the greater the extent to which they will dominate the domestic circulation, until the point comes where only lira circulate domestically, and the parallel currency approach dissolves into the simple substitution of the domestic unit for the euro, after which exchange rate depreciation presumably follows. And seeing this outcome coming, holders of euro-denominated claims will flee Italian banks and markets in advance, precipitating the same kind of financial crisis.
22. See Fidrmuc, Horvath, and Fidrmuc (1999).
23. Under the provisions of the agreement, the Czechoslovak central bank was dissolved and replaced by a Czech National Bank and a National Bank ofSlovakia. The common monetary policy was made by simple majority vote of a six- member committee made up of the governors and two senior officials from the two banks.
24. Although there was apparently some movement of unstamped banknotes fromSlovakiato theCzechRepublicduring the period when stamping took place, because borders were not sealed to individual foreign travel.
25. See also Dornbusch (1992) and Eichengreen (2007).
26. The symmetry between buying and selling attacks on currencies is the subject of Grilli (1986).
27. The closest precedent for exit by a strong- currency country of which I am aware was the possibility that Luxembourgmight exit from its monetary union with Belgiumin 1993. The European Monetary System (EMS) crisis of that year had led to currency devaluation by a number of participating countries, and in the summer, Germanyand the Netherlandsconsidered the possibility of unilaterally exiting from the ERM rather than facing pressure to inflate along with Belgium, France, and the others. At this point, the authorities in Luxembourgevidently contemplated following the deutschemark and the guilder rather than the two francs, which would have required them to break their monetary union with Belgium. In fact, Luxembourghad established a protocentral bank (the Luxembourg Monetary Institute) a decade earlier, in 1983, when the Belgians had unilaterally realigned without engaging in prior consultations with their monetary union partner. (Ironically, the prime minister of Luxembourgat the time was Pierre Werner, commonly regarded as one of the fathers of the euro.) From the early 1980s, Luxembourgalso evidently maintained a stock of coins and banknotes for the contingency that it might have to exit from its monetary union with Belgium. (See former Prime Minister Juncker’s interview with Agency France Press, summarized at: http://news.bbc.co.uk/2/hi/ business/1677037.stm.) The implications for the present argument are unclear, becauseBelgium ultimately did not devalue against the guilder and the deutschemark in 1993.
Whether Luxembourg, with its open- capital markets and highly developed financial system, in fact could have smoothly broken its monetary link with Belgiumis at a minimum an open question. What is revealing, however, is that Luxembourgchose to destroy its stock of national notes and coins in 2002 when the physical euro came into existence?
