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A divorce settlement for the eurozone

The Financial Times

By Arnab Das and Nouriel Roubini

The European Central Bank has averted disaster, sparking a powerful relief rally – but nothing fundamental has been resolved. Greece may need another debt restructuring; Portugal and Ireland may need restructuring too. Spain and Italy may yet come under the gun. Banking crises are hardly ever resolved without removing toxic assets or recapitalisation. The eurozone still lacks essential features of monetary unions that have stood the test of time; and planned reforms may exacerbate latent fiscal, banking and external imbalances, leaving it less, rather than more, resilient to regional shocks.

Splitting up may be hard to do, but it can be better than sticking to a bad marriage. The periphery debt crisis threatens to engulf the core in huge bank capital shortfalls and fiscal liabilities, trapping both in protracted stagnation. This reflects possibly intractable eurozone design flaws. So we propose the following amicable divorce settlement.

Countries leaving the eurozone must rebalance away from growth led by debt, towards export- and income-led growth. Members of a “rump” eurozone should rebalance toward domestic demand. The EU free trade arrangement is critical to this end. Ideally, five distressed peripherals – Portugal, Ireland, Italy, Greece and Spain – would exit, negotiating bridge financing.

Currency realignment would aid this adjustment. It is far better to restore competitiveness through devaluation than by changing relative prices with a fixed nominal exchange rate, which implies protracted debt deflation, potentially ending in disorderly defaults and exits in any case, or sustained inflation above target in surplus countries. There would of course be disruption even in a cooperative, partial dismantling of the currency union, but it would be in everyone’s interest to minimise the damage by adhering to the agreed exit strategy.

This strategy would ensure exiting countries’ viability and the euro’s credibility. It would maintain the EU customs union to the benefit of all member states; and set a monetary framework for the rump ECB and exiting national central banks.

A transitional monetary framework would effectively reverse the exchange rate mechanism that led to the euro: FX targeting by exiting national central banks, with ECB support to avert currency collapse, capital flight and a resultant surge in inflation. New FX trading corridors would be widened in steps as inflation and exchange rate risk premia returned to normal.

After the transition, independent national central banks and the ECB would implement congruent inflation targets, averting protectionism in the wider EU by restraining competitive devaluation. Exiting countries would be small, open economies relative to the rump eurozone, where FX movements would quickly pass into inflation, inducing them to avoid maxi-devaluations that could provoke wage price spirals.

Unlike other currency regime changes, FX corridors would not be threatened by the inadequate FX reserves of exiting countries. The ECB would buy the new currencies at the floor of the trading band, to mitigate losses from currency collapses and disorderly defaults. This element of the plan would put the burden of financing adjustment and exit on the ECB and remaining eurozone members. But transitional alimony or one-off settlements are often the key to amicable divorces; transitional official financing would mitigate losses and defaults, as in many currency regime changes, and facilitate EU survival and cohesion – helping to avoid the de-globalisation that often follows financial crises.

A clear, consistent legal framework for exit is crucial. We would redenominate all contracts made under domestic laws into the new currencies at the time of exit. We would retain euro denomination for contracts made under foreign law, subject to the territorial connection of the contract or obligor, in line with consensus legal opinion.

Exiting countries should accelerate the “domestication” of external debts before the transition to minimise balance sheet mismatches. Imbalances in the payments system would be redenominated by negotiation and netted between the ECB and national central banks. The widening of FX trading corridors as risk premia fell would lessen balance sheet effects. An eventual free float of currencies by inflation-targeting, independent central banks would restore macroeconomic shock absorbers and aid policy credibility.

Banks and financial markets pose the gravest immediate threats to the exit strategy. Pursuing domestication prior to exit would reduce credit losses and currency risk. The ECB’s currency support would allow time for hedging and repayment of euro-denominated obligations. These policies would mitigate damage to the banking system and support economic activity and investment. However, doubts about the strategy might spark capital flight, requiring temporary bank nationalisation, curbs on deposit withdrawals and greater use of non-cash payments, as well as temporary capital controls.

We have divorce laws because amicable divorce is better for all concerned than enduring the chronic depressions that accompany bad marriages. The eurozone should devise plans for orderly exit sooner rather than later, because delaying often makes break-up more costly.

Post-Crisis World Institute