It is far from perfect but leaving the euro is not an option

 

ECONOMICS:The euro may have been an over-ambitious undertaking but moving to a new currency would be a bridge too far, writes DAN O'BRIEN

AUGUST IS a good time to take stock. Its slow pace provides the opportunity – whether one is holidaying or not – to take a step back, to ponder the big issues and to consider the challenges to come.

Among the biggest economic issues for the foreseeable future is the euro: whether it should continue to exist and whether the Republic should remain part of it.

From the vantage point of August 2010, the benefits and costs of European monetary union are more evenly balanced than they have ever been in the experiment’s decade- plus history. Even the euro’s most ardent advocates can provide evidence of only smallish economic benefits.

The economic costs of locking diverse economies into a single currency have become all too clear in recent months. They will continue to be felt for a long time to come. So, too, will the political costs. It is not overstatement to say that sovereign debt crisis amounts to the most profound challenge for the European integration project since its inception in the middle of the last century.

Despite all of this, there have been very few voices calling for any country to pull out of monetary union and fewer still for the entire project to be abandoned. But, given the enormity and enduring consequences of what has happened in recent months, these matters will be raised in the future more frequently. Discussion may well take place in less calm times than August 2010.

A recent short paper*, co-authored by the head of Argentina’s central bank at the time of that country’s currency crisis in 2002, gives a clear, succinct and largely jargon-free inventory of the issues. It focuses mainly on the most obvious and immediate threat to the project – the possibility that one of the peripheral members in its desperation could be tempted to ditch the euro and relaunch its own currency as a means of hastening the return to competitiveness.

What would happen if this were tried? “We know virtually nothing,” Blejer and his co-author, fellow Argentine Eduardo Levy- Yeyati, state from the outset. They do so in order to differentiate leaving the euro from their country’s experience almost a decade ago.

Then, Argentina did what Ireland had done in 1979 – it abandoned a “currency board”, which is a particularly rigid type of currency peg short of full-blown monetary union.

While Argentina suffered violent chaos when it abandoned its currency board in 2002, the change happened smoothly in the Republic in 1979 because the link with sterling was simultaneously replaced by (less rigid) peg to the deutschmark, the strongest European currency.

Now things are very different. If Ireland or any other euro-zone country were to elect to leave monetary union with the aim of launching a weaker currency, the challenges would be “almost unthinkable”, according to the Argentine authors.

There are four identifiable policy challenges, only some of which are illuminated by the abandonment of Argentina’s currency board.

First, the introduction of a new currency would require the banking system to be shut down for an indeterminable period as a new currency was printed and distributed.

Doing anything less would be to invite a systemic bank run as everyone tried to get their hands on euros. Access to deposits and funding would cease or be severely curtailed during that time.

This happened in Argentina in 2002, but as Ireland is a much more financialised economy than Argentina, the damage would certainly be greater. Although it is impossible to say how great the effect would be, it is certain that the absence of a payments system in a modern economy such as Ireland’s for any period more than a few days would be catastrophic.

Second, external payments would also be thrown into chaos. In order to control the transition, strict controls on capital and foreign currency movements would have to be introduced. Because Ireland is much more open an economy than Argentina in 2002, the negative effects would be much greater via the trade and investment channels.

Third, a new currency would require the redenomination of all contracts. Given that the stock of Ireland’s external liabilities is huge (and dwarfs that of Argentina in 2002), the balance sheet effects would be similarly huge. The holders of euro-denominated liabilities owed to foreigners – mostly the State and financial institutions – would see their balance sheets explode. They would both become instantly insolvent.

Fourth, insolvency would necessitate massive debt restructuring. Any euro-zone country moving to establish its own currency would have to seek equally massive bridging finance from an external source, such as the IMF. It would probably not be on offer.

In summary, the euro may have been an over-ambitious undertaking. It may have been a mistake for Ireland to join and it might now be desirable to have the pound back. But getting from the euro to a new pound is the real issue. Between here and there is a chasm whose bottom cannot be seen. Attempting to leap that unknown cannot be contemplated.

Mario Blejer and Eduardo Levy-Yeyati

Leaving the euro: what’s in the box? http://www.voxeu.org/index.php?q=node/5326

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