How to leave EMU

Membership of the Economic and Monetary Union of the European Union (EMU) is ostensibly a one-way street. Once you join the euro area (commonly known as the eurozone), you cannot leave. Yet the 4th December issue of The Economist carries on the front-page the heartfelt plea “Don’t do it” over a picture of a man with a euro coin for his face, just about to commit suicide. This just confirms what anyone interested in the topic already knew – of course you can leave the euro. It may be messy, it may be expensive (and The Economist devotes an article to explain just how messy and expensive it would be), but it is perfectly feasible.

This was already obvious. History clearly shows that monetary unions only survive in the long run if they conform to one of two patterns. One is between a minnow and a whale – eg., Luxembourg and Belgium from the 1920s to the 1990s; Ireland and the UK from the 1920s to the 1970s; or Panama, Ecuador and El Salvador and the United States (different periods). In those cases, the whale sets monetary policy to suit itself and completely ignores the minnow. The other possibility is between (roughly) equal countries, which also form a fiscal union. Any other monetary union will ultimately break down. One does not have to go back in the past to the Latin or Scandinavian Monetary Unions of the late 19th/early 20th Centuries. Just look at the Czech and Slovak Republics. After Czechoslovakia broke up on 1st January 1993, the two countries were to keep the single Czechoslovak koruna; by 8th February (less than six weeks later) the monetary union had broken up. Moreover, history is full of examples of how monetary unions break up – eg., following the dissolution of the Austro-Hungarian Empire, of the Soviet Union or of Yugoslavia.

That there is no formal route to leaving EMU is therefore irrelevant. A sovereign country that wishes and decides to leave the eurozone can and will do so. No one is likely to go to war to stop it. The questions therefore become, why would a country leave and how can it be done? Need it really be as messy and painful as The Economist claims?

As to why a country would leave, the answer is – in theory – simple. A country will leave the euro when the pain or cost of membership exceeds the benefits. In the case of the southern European countries, this includes the pain of continued uncompetitiveness and the need for painful and protracted structural reform to regain competitiveness (eg., in the cases of Spain or Italy, some combination of 25% nominal wage cuts or between 25 and 50 years of no wage increases), as well as fiscal retrenchment. In the case of Germany, the pain is the continued need to bail out southern Europeans who refuse to reform (leaving aside the issue of whether Germany is in fact helping to create the problems of southern Europe through its insistence on export-led growth).

This being said, there are three important caveats. The first is that although over a period of time, the pain of remaining in the eurozone may exceed the pain of leaving, the pain of leaving is likely at any given time to exceed the pain of staying. Second, before a country leaves (as opposed to is expelled from) the eurozone, it will need at least one senior mainstream politician supporting the idea. And third, one should not underestimate the willingness of the continental European political elites to inflict pain on their peoples in pursuit of what they see as ‘the greater good’.

Perhaps the most important of these caveats is the second. Ideally, for a country to leave the eurozone, it should come as a surprise and happen rapidly. But with the entire relevant political elite in the eurozone countries still committed to the EMU project, this is unlikely to happen. This means that leaving the eurozone would be preceded by a possibly prolonged by certainly open debate. But, in turn, this creates further problems.

What are then the problems with leaving EMU? There is one set of problems connected with the pre-discussion leaving; there are three further main problems connected with and subsequent to the leaving. Whilst not underestimating any of them, they can all be dealt with.

With the exception of Germany, which would leave EMU in order to revalue its currency, any country leaving EMU does so in order to devalue. This means that if EMU exit does not come as a surprise (which is highly unlikely, partly because of the public debate issue referred to above) the pre-exit period will be characterised by attempts by all concerned to protect themselves from the devaluation effects. This will include foreign creditors postponing payment to domestic debtors; and by foreign debtors insisting on early payment from domestic creditors. Both households and companies will withdraw funds from their domestic banking system, either keeping cash in hand or transferring deposits from, eg., Greek banks in Greece to non-Greek banks outside Greece.

Keeping cash in hand does perhaps not sound like much of a devaluation defence. But all euro notes and coins have national characteristics. The coins all have a national side; the notes have a national registration letter in the serial number (Greece is Y, Italy is S, the UK, should it ever join, is J, and so on). Any country that leaves the eurozone will at least initially have to use its ‘national’ euros as a currency, while remaining eurozone members will continue to use ‘their’ euros. A Greek concerned about Greek eurozone exit and devaluation can therefore protect himself by withdrawing his savings and insisting on receiving banknotes with, eg., X (Germany) in the serial number.

At its extreme, this could mean a wholesale flight of all bank deposits in a country deemed at risk of eurozone exit. That would threaten to collapse the banking system and that country’s economy – if banks lose all their deposits they also have to shrink their assets, that is to say call in their loans. But no business sector could withstand having to repay all its loans in advance and in one go. One way of solving this would be for the government to pass an emergency decree allowing it to borrow in the central bank (technically, this is currently illegal, but in an emergency that could be overturned) and then replace all bank deposits lost by capital flight. However, this also means a large rise in the government debt, further undermining public finances.

EMU exit itself would be announced by proclaiming that of a certain date, all local assets and liabilities would be denominated in the new domestic currency at a pre-set exchange rate. Again, ideally this should be done at once (eg., announcing EMU exit on a Sunday morning with immediate effect), combined with the imposition of capital controls, but, again, that is unlikely to happen.

Following EMU exit, any country leaving would most likely be exposed to lawsuits from outside creditors who object to being repaid in the new, devalued currency. However, it could try to pre-empt this by promising to honour euro-denominated external liabilities until roll-over. This depends on the size of its liabilities and whether it wishes to try to preserve some goodwill by taking on the exchange rate risk instead of putting on the lenders.

A second issue concerns what currency to use in the future. The Economist highlights this as a key problem. That is going too far. As noted above, for at least an initial period, a devaluing country would use ‘national’ euro notes and coins. This is similar to the period following the break-up of the Austro-Hungarian Empire, when the existing banknotes were simply stamped with the symbol of the relevant successor state. Even later, when a true national currency is reintroduced, it could conform in size, shape and weight to current euro notes and coins, avoiding the need for new machines and a complicated switch.

A completely different post-exit issue is how a country would fare on international capital markets following devaluation. There has been some concern that a country that defaults (and devaluation is default by other means) would be shut off from capital markets in the future, with no one willing to lend to it. This is almost certainly wrong. History shows that if the only threat creditors hold over a country is a refusal to lend if it defaults, then it should default. Moreover, it can be assumed that a country that leaves EMU and devalues not only gains an immediate competitive advantage, but also gains the longer-term advantage of an independent monetary policy that can be set to suit the country. This should, all things being equal, provide a powerful boost to the exiting country’s output growth, certainly so in the near term. That should improve public finances, at least in the near term. Add to that the fact that it would initially have to pay higher interest rates, it is very unlikely that lenders would refuse to provide new funds. (Judging by the past behaviour of capital markets, they would in fact probably be knocking at the doors of the relevant Finance Ministry bearing funds.)

There is no question that to leave the eurozone and EMU would be a messy and complicated procedure, with substantial risks. But these are not insurmountable, nor should it be forgotten that there are some clear advantages – both for the country leaving and for those staying. To rule it out completely is to ignore not only the lessons of the past, but also the fact that ultimately, countries are ruled by their self-interest, not by the devotion to an abstract and badly-conceived idea.