A smooth exit

TH reckons can hear it from here – the sound of the Animals’ We Gotta Get Out of this Place — a blaring anthem for protestors in Greece growing increasingly discontent with the austerity imposed on them by Europe and the IMF, and little sign of a way out of their troubles. In other parts of Europe, discontent with the Euro is sure to take hold as the psychological flip-flop from believing that a euro exit would be seen as a failure of the country to fulfill great expectations is surpassed by the perception that the euro was the cause of their troubles and exit is the solution.

So can Greece and other periphery countries exit and how?
There is only a small literature on the conditions that are required for a country to successfully “graduate” from a fixed to a flexible exchange rate. Most papers show that there have been quite a few exits from fixed to flexible exchange rates in the last 30 years, some are successful, others not so. Some happen in good times others in the midst of, perhaps even causing, a crisis.

Interestingly, one thing that the literature finds is that it is unclear what role good policy plays in shaping the success of exits. For example, in “How to Exit from Fixed Exchange Rate Regimes” by Asici, Ianovoa, and Wyplosz , the authors find “that post-exits are better when de-pegging occur in good macroeconomic conditions – an unnatural move for most policy-makers – when world interest rates decline and in the presence of capital controls. Importantly, ‘good’ macroeconomic policies do not seem to help with post-exit performance.” (The paper is a quite technical, but check out their table 10 and the end of the paper for a summary of their results).

But as interesting as it is, the existing literature is not really that useful for considering a eurozone exit since the set of exits that it studies typically involves countries that have already have their own currency and move from a fixed to a flexible exchange rate. Eurozone exiters would be doing something completely different. They would be introducing a new currency that may or may not be fixed in value to another currency. This completely changes the way people should think about the problem. Moreover, the question is not what would happen if a country adopted a new currency under an arbitrary set of circumstances, but how you should introduce it to minimise any negative consequences.

Lots of analysis on this subject assumes that if Greece or Portugal, say, exit, they would use the opportunity to solve either its sovereign debt or banking system problems by redenominating debts or bank deposits into a new (devalued) currency. It doesn’t take much to realise that if markets expect that to happen they will dump any financial assets that are likely to be redenominated. Hence most of the analysis argues that exit would trigger a massive run.

It doesn’t have to be that way. Suppose for example, country X was planning to so it announced that as of today the central bank had started issuing a new currency (the worgl) to anyone that wanted to hold it, and that it would trade on par with the euro. In addition, while the worgl would be made legal tender, the authorities would allow the euro to remain legal tender in the country. Under such circumstances, there would be no run into euros, because the country is completely euroised the introduction of the new currency changes nothing.

Who would hold the new worgl? Not too many, but there would be a few money collectors for novelty reasons, a few in the union movement holding it for reasons of national pride.

Now, suppose that the government also required all taxes and wages to be paid in the worgl. That would create a demand for it, but it’s not going to help eliminate the country’s competitiveness problem. To do that the central bank would have to commit to a devaluation of the worgl over time. That commitment plus requiring that wages would be paid in worgl, would give firms the boost that they need. In particular, while falling wages (in euro terms, but not worgl) might lead to falling prices in the non-traded sector (restaurant meals, etc.) it would boost profits in export and import competing industries where prices are set on world markets.

Suppose that the announced devaluation was 10%. This would reduce demand for the currency because people would expect it to lose value so to counter that effect the central bank would have to raise the policy interest rate to say 15%. This should be high enough to cover the expected devaluation and a risk premium.

Clearly this would not be easy – the 15% interest rates would reduce investment demand, which is interest rate sensitive. But it would re-balance the economy, creating demand for exports and reducing demand for imports and reducing the current account deficit and dependence on foreign finance. And while the interest rate sounds high, it is not as bad as it seems – remember firms (especially in the export orientated industries) will earn higher profits from the depreciating worgl. Furthermore, long-term interest rates should rise nowhere nearly as much. The reason being that after one year, the economy will have a real exchange rate that is close to equilibrium, and the policy rate should normalise.

The key to a smooth exit is a credible central bank that is willing to introduce a new currency and forego the temptation to money finance the government’s budget, or bailout banks. It was the temptation to use the printing press to bail out the banks that ultimately did in Indonesia in 1997. The big question is whether the periphery governments could convince markets that the central bank is fully committed to the plan.

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