The Eurozone might not survive in its current form. Buiter and Rahbari (2012) put a likelihood of 50% on Greek exit – an event that would be something between an historic event and a global economic catastrophe (depending on how it was handled).
Europe needs planning to reduce the disruption arising from possible EZ exits. To do the job right, the planners will need to be experts on:
- Open-economy macroeconomics;
- European banking;
- Contract law;
- European public law; and
- EU decision-making.
They’ll need IMF-like, inside knowledge of real-world currency breakups, devaluations, banking and exchange-rate crises, sovereign defaults, and the attendant national and international policy reactions.
What we know about EZ breakup
One of the few with the requisite knowledge and experience is Barry Eichengreen, a professor of economics and political science at Berkeley, an ex-IMF policy advisor, and one of the most influential economic historians of his generation. His 2007 Vox column on the EZ breakup problem is the classic – viewed over 133,000 times (Eichengreen 2007). Willem Buiter is another of the rare birds who’ve mastered macro, finance, banking, and history. In a series of essays written with Ebrahim Rahbari and others, Buiter has tackled all the key questions and made many recommendations on how the exit could be best handled (eg, Buiter 2012, Buiter and Rahbari, 2011a, 2011b, 2012).
If you want to know what an EZ breakup will look like and how to mitigate the damage, read Buiter and Eichengreen.1
The ‘Britain’s got talent’ approach to policy analysis
This was not sufficient for Simon Wolfson – the son of the former chairman of the British retailer ‘Next’ who is now the Next chief executive. Wolfson funded a £250,000 prize for the best EZ breakup plan.
The contest seems designed to be amateurish – even the question reflects ignorance. “If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?” What Lord Wolfson meant was “European Monetary Union” – a common term among amateurs and the wording actually used in the 2011 press release announcing the prize.
What’s ignorant? Every EU member is in the Economic and Monetary Union (EMU). including Britain.2 Leaving EMU is conceptually easy for the 10 of the EU27 who aren’t in the Eurozone (quit the EU); leaving the Eurozone is the problem. Presumably some well-meaning expert substituted the correct meaning of EMU to avoid a dilettante’s error but in the process introduced confusion.3
This fundamental amateurism – a mis-specification of a prize question worth £250k – tells us that the real aim of the ‘Wolfson Economics Prize’ is not policy research. The most charitable interpretation is that the real goal was to raise someone’s fame/wealth quotient; the least charitable was that it is an attempt to start in Europe a conservative assault – of the type that has worked so shockingly well in the US – on good economic analysis.
Is it rude to point that out? Take ignorance seriously
Paul Krugman – in an essay that is a must-read for policy-relevant economists – diagnoses why so much public economic discourse is written by economically-illiterate people and why journalists and editors persist in treating their views as newsworthy (the Economist’s Charlemagne column devoted a whole page to the finalist essays).
As Krugman (1996) wrote: “In scholarly discourse, it is a normal courtesy to give one's debating opponents the benefit of the doubt. If they say something that seems confused, one tries to find a charitable interpretation.”4 But Krugman urges economist to take such ignorance seriously. To engage in what Ludwig von Mises called “exploding the fallacies of vicious reasoning. In the pursuit of this task the economist incurs the deadly enmity of all mountebanks and charlatans whose shortcuts to an earthly paradise he debunks.”5
Economics without economics training
Economists with the necessary background do not work on spec – they are already oversubscribed. No surprise then that so few economists participated – at least judging from the posted essays.6 The finalists have degrees in:
- History (Jonathan Tepper);
- Psychology, Philosophy and Physiology (Neil Record); and
- Engineering (Catherine Dobbs).
Their common credential seems to be a job in the City. Only two finalists did their last degree in economics;
- Roger Bootle did PPE at Oxford and received an economics B.Phil;
- Jens Nordvig has a master’s in economics.
The essay by Roger Bootle, a City economist predicting EZ breakup for years, is the only essay worth reading in its entirety. While it doesn’t handle all the issues with equal authority, the thorniest issues require exactly his sort of expertise on banking, financial markets, European politics, and macroeconomic realities. Moreover, Bootle (2012) tackles the real-world problem – a possible Greek exit. The essay’s biggest drawback is a reliance on a macroeconomic model that must have been cutting-edge when Bootle’s Oxford tutor was at university (see Bootle 2012, page 9). Jens Nordvig’s essay contains some useful nuggets on the legal side, but falls down on the macroeconomics.
The key sources of difficulties
EZ breakup (Greece’s exit to be concrete) involves problems stemming from five sources:
- Anticipation of devaluation;
- Devaluation (macroeconomics, balance-sheet issues, etc);
- Debt default (public and private);
- Cash introduction issues; and
- Eurozone exit issues (Treaty provisions, ECB capital, etc).
Of the five, anticipated devaluation is the most intractable. The rest are tricky but nothing IMF staff couldn’t handle. The anticipation problem concatenates three facts (Eichengreen 2007):
1) Greece would leave to devalue;
2) EU capital markets and banks are extremely integrated;7 and
3) Leaving would take time.8
Fact 1) creates a one-way wager; 2) provides the means of placing huge bets, and 3) gives everyone the time to do so – leading to “the mother of all financial crises” (Eichengreen 2007).
Two classes of solutions
The essays recognise this as the linchpin problem; two classes of solutions are offered – secrecy, and making all the euros equally bad.
- Bootle relies on secrecy as far as possible, and capital controls and a prolonged bank holiday for the rest;
- Tepper’s essay, which is vague on most points, is straightforwardly confused on this one.9
The real problem with secrecy is that Europe is no North Korea – secrecy on this scale is impossible. And, as Record (2012) writes: “Failure to maintain secrecy would almost certainly lead to a complete freeze in the markets … ”.10
- Such considerations lead Dobbs, Record, and Nordvig to conclude that the only good way for any nation to leave the Eurozone is for all to leave.11
Make all euros equally bad to avoid speculation
Dobbs oversimplifies, so hers is the cleanest explanation. Her plan is to legally transform every euro into a basket of two currencies – what she calls a ‘new euro yolk’ and a ‘new euro white’. And then she writes: “The Yolk countries can achieve a gradual devaluation of their currency by running higher nominal interest rates.”
If you think this failing-grade-confusion of the uncovered-interest-parity condition12 is a case where one should try to find a charitable interpretation, think again. Reading her on money supply and demand proves beyond any doubt that she, to misquote Macbeth, “be innocent of the knowledge”.13
Leaving aside Dobbs’ annoying dilettantism, two critical flaws are not addressed:
- Maturity mismatch;
- Political realities.
Promising to make all euros equally unpalatable would surely dampen bank runs. But the basket-conversion is a one-off move; new contracts are to be in offspring currencies, so maturity mismatches can become currency mismatches.
- If I borrowed €10 million for ten years to invest in a ten-year Eurobond, Dobbs’ solution avoids all valuation issues.
- But if I used the loan to invest in a hotel whose income stream is in soon-to-depreciate yolk euros, I’ll be broke.
To avoid this, I’d rush to unload the soon-to-be-bankrupt assets (debtor) or call in the loan (creditor). The impact on new bank lending is worth some extra thought.
Politics is the second problem. The all-leave-solution recalls the aphorism illustrating the difference between a valid argument and a true argument: ‘If we had some eggs, we could have eggs and bacon, if we had some bacon (which we don’t)’.
A Greek EZ exit – with possible contagion involving Portugal, Ireland, Spain, Italy, etc – is a politically realistic possibility and a mortal threat to the euro. Convincing the core EZ nations to ruin their monetary union to make a Greek exit easier is as likely as the 2012 Mayan end-of-times prophecy.14 This matters since:
- Solving a conundrum by positing an impossible premise is not a solution; it is a dodge.
No good solution
Reading Eichengreen, Buiter, and the five finalists, one thing is clear. As Bootle puts it: “The notion of some clever, technical trick that offers an escape from the nasty choice of external devaluation or internal deflation is a chimera.” In fact:
- EZ exit will be enormously costly,
- The costs will be instantaneous and fall heavily on the exiting nation; but
- The macro benefits will be slow to appear.
As Eichengreen (2007) concludes: “The implication is that as soon as discussions of leaving the Eurozone become serious, it is those discussions, and not the Eurozone itself, that will end.”
Erasmus: Call a spade a spade
To paraphrase Krugman, most economists cannot believe that those who write about EZ breakup could be ignorant of basic economics. But many are. Most of their readers are equally innocent of economics, so we cannot rely on market selection to sort out the chaff.
The upside, Krugman notes, is that “it is remarkably easy to make fools of your opponents, catching them in elementary errors of logic and fact. This is playing dirty, and I advocate it strongly.”
In the US, the failure of most policy-relevant economists to take ignorance seriously – especially when it was spread by wealthy conservatives with agendas – allowed some truly odious economic ideas to gain respectability. Europe should avoid the same fate by calling ‘a shovel-full a shovel-full’ – and this right from the start. Let’s not let Gulliver’s Yahoos hijack the Eurozone debate.
One happy sign was that the most of the media seemed to have perfectly captured the spirit of the Wolfson Economics Prize by doting over an 11-year old’s crayon-based entry (see the diagram).
Baldwin, Richard and Charles Wyplosz (2010), The economics of European integration, 3rd edition. Maidenhead: McGraw-Hill .
Bootle, Roger (2012), “Leaving the euro: A practical guide”, Capital Economics.
Buiter, Willem (2012),“Greece and the Eurozone: Political leaders should get off their high horses”, Vox Talk, VoxEU.org, 20 February.
Buiter, Willem and Ebrahim Rahbari (2011a), "A Greek Exit from the Eurozone: A Disaster for Greece, a Crisis for the World", Citi Economics, Global Economics View, 13 September.
Buiter, Willem and Ebrahim Rahbari (2011b), "The future of the Eurozone: fiscal union, break-up or blundering towards a 'you break it you own it Europe'", Citi Economics, Global Economics View, 9 September.
Buiter, Willem and Ebrahim Rahbari (2012), "Rising Risks of Greek Eurozone Exit", Citi Economics, Global Economics View, 6 February.
Buiter, Willem, Ebrahim Rahbari, Juergen Michels and Guillaume Menuet (2012), "EMU Crisis Outlook: Lender of Last Resort on the Way", Citi Economics, Global Economics View, 28.
Eichengreen, Barry (2010), “The euro: Love it or leave it?” VoxEU.org, 17 November 2007; reposted 4 May 2010.
Krugman, Paul (1996), “Ricardo’s difficult idea”, available at http://web.mit.edu/krugman/www/ricardo.htm.
Policy Exchange (2011), “Launch of the £250,000 Wolfson Economics Prize”, Press release, 18 October.
Von Mises, Ludwig (1990), Economic Freedom and Interventionism: An Anthology of Articles and Essays, Bettina Bien Greaves (ed), New York: The Foundation for Economic Education.
1 See the references therein, especially on private and public law issues where expert opinion can only come from lawyers.
2 See, for example, my textbook with Charles Wyplosz, Chapter 2 (Baldwin and Wyplosz 2010),
3 There is no such thing as the European Monetary Union (with caps, i.e. a proper noun), although amateur analysts often use it. In the early days, the ECB consciously avoided the creation of a proper noun to describe the monetary union and even today persists with ‘euro area’ (no caps, thus not a proper noun), This was, presumably, a reference to the informal ‘sterling area’ or ‘dollar area’ of yesteryear. One can only conjecture on why they thought a monetary union covering 1/7th of the world economy didn’t deserve a proper noun.
4 And that’s what happened in this contest. On the page announcing the finalists, the organisation running the contest charitably interpreted the prize as being for “a contingency plan for a break-up of the Eurozone”.
5 Von Mises (1990 pp 51-52),
6 And the fact that no winner could be found by the pre-announced 31 March 2012 deadline. Finalists now have till 29 May 2012 to ‘develop and resubmit’ their entries. I would add that three of them should invest in a crash course on macroeconomics.
7 Unhindered capital movement has been protected by the Maastricht Treaty since the 1990s.
8 See Bootle Appendix 5 for a good discussion of the time needed to produce a new currency (answer: minimum 6 months) and many other practical issues involved in currency switchovers.
9 After quoting Eichengreen extensively, he mis-concludes that it doesn’t matter. He writes: “Sadly, the bank runs in the Euro area are already happening with or without a Euro breakup. … The bottom line is that European banks have problems with or without any exits from the eurozone.”
Tepper’s essay reads like an extended blog post; it seems to be the fruit of several days of cutting-and-pasting from the internet (a flatteringly high share from VoxEU.org) with some wry comments and judgements interspersed (and these from someone with an understanding of economics that one would expect from a fellow with an MA in modern history),
I recommend skipping Tepper’s essay – unless you need some colourful, before-and-after pictures of broken-up currencies.
10 The quote continues: “This could create a vicious circle of acceleration before a credible plan was available, which would plunge the Eurozone into an existential crisis, and possibly also overwhelm the ECB in the process.” Aside: despite being a currency expert he capitalises all currency names. That would be like penning an essay on Shakespeare and repeatedly writing the prince’s name as ‘hamlet’.
11 Dobbs and Record are quite explicit about this; Nordvig considers sole exits and big-bang breakup. Record stresses the benefits for contracting problems. “I recommend that the Task Force proposes the abandonment of the Euro because this would force the legal frustration of all outstanding Euro contracts, and this would allow all Euro contracts to be treated in a common way as far as is possible, rather than legal jurisdiction and disputes thereof dominating the redenomination question.” A legal expert should be consulted on this amateur’s opinion, but it makes sense to this non-specialist. Nordvig’s ECU-2 solution is like Dobbs’ without the amateurism.
12 The condition applies to the exchange rate’s rate-of-change, not its level; the yolk euros would surely plummet immediately in anticipation of higher inflation (inter alia),
13 “The demand for the currencies will come in two main types: classic monetary supply; and Euro denominated financial instruments that are not included in the monetary supply, but which will be redenominated into the new currency” Dobbs (2012 p.32). This is one of the numerous sentences in the essay that will give you an idea of why so few economic plans are written by engineers.
14 Or at least not possible before they suffered repeatedly and massively from piecemeal EZ exit.