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How to Leave a Monetary Union

di - 21 febbraio 2012
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What happens when a country changes its currency, either by creating a new one to replace the existing one or when it leaves a monetary union? A good starting point is New Zealand’s switch from Sterling to the NZ dollar at the end of the 1960s. That was a simple matter of redenomination and printing new notes. There was no expectation of a parity change, so contracts were simply novated into the new currency. A country following that example could, say, choose to announce that one unit of the old currency would convert in all contracts to one unit of the new.
Scotland should it become independent of England would probably go down that same course. It is committed to monetary independence from England – but not at the moment at least to monetary independence, as the Scottish National Party is, or at least was, enthusiastic about Eurozone membership for Scotland. A likely initial course would be for Scotland to issue its own £1 notes and simply make them exchange for English notes at one for one.  This is what Ireland did following independence in the 1920s.  English notes continued to circulate alongside the new Irish notes and that would probably happen in Scotland. All the government then has to do is pursue policies that allow the exchange rate to hold. This replicates the work of a currency board and derives credibility in a similar way. A recent example of this can be found in Argentina in the 1990s where they pursued a one-for-one peso to the US dollar.
Novating contracts into the new currency could obviously apply to all internal contracts. That definition includes all old currency bank deposits in domestically based domestic banks. It also includes all debts issued domestically. Thus, for example, Greek government debt converts to the new currency. Conversion would, and this is essential, occur on both sides of the balance sheet.
There would need to be clear and consistent and legally defensible rules for assets and liabilities of foreign banks in Greece and of Greek banks outside Greece. It might turn on whether these banks were branches or subsidiaries.
Contracts written so that they are adjudicated in a non-Greek jurisdiction (e.g. London) would be exempt from this conversion; although it would of course be available should both parties consent.
New notes would not need to be printed. Old notes could be franked, and new ones issued only as the old wore out.
Any currency could be used internally, although as is usual the State would accept only the domestic currency in payment of debts to it (such as taxes, to the extent that they are paid in Greece).
So everything is easy.

Why the fuss?
The current fuss, and claims that change is impossible, arise either from ignorance of even recent history or a desire to believe that something one does not want is for that reason alone impossible.
But it can not be denied that the above description of what to do makes the process seem more straightforward than it is likely to be. It does so because it describes an equilibrium situation –in effect, where we would end up if we started from a disequilibrium one.
We initially assumed that no change in parity is expected because, as with the New Zealand (and hypothetical Scottish) examples, the change is taking place in a world of pegged (or stable in the Scottish case) rates. There are three other possible situations.
The first is when although the world has floating exchange rates, a par value for the new currency is announced which is roughly where people expect it to be relative to the old and is little different from the old. The second is a situation where there is no clear expectation, but little move is expected. And the third is the difficult one – no-one knows where the currency will lie, but it is expected to be weak.
The first two cases approximate to what we called the New Zealand model. It is the third we need to consider further.
That situation too is viable in the long run – the problems arise in the transition. There will be a flight from the currency and banks of the devaluing country. The banks will have to have liquidity restored or they will collapse, and they will lose capital as they are forced to sell assets.
All this could be prevented by surprise. We set that possibility aside.
It could be mitigated, and the move to the equilibrium solution effected more smoothly, by the sudden introduction of exchange controls within the currency zone, and also between the currency zone’s troublesome members and the outside world. This would of course be in effect an announcement that the currency zone was about to break up. Action to achieve that would have to be quick, as the controls would soon start to leak.
Another possibility is that one part of the zone (the “North”) would tolerate steadily increasing transfer of risk from the other part as individuals move investments from one part (the “South”) to the North as the zone inches towards collapse. This would be followed by transfer of wealth from North to South when the collapse (or breakup) occurs.
Any profits made by those who have transferred their deposits from Southern to Northern banks will have their offsetting losses. These losses are likely to fall primarily on the central banks and thus ultimately the tax payers of the Northern countries. This redistribution of losses from commercial to central banks will result because any other distribution would very likely lead to banking system collapse, or at the least such severe strain that the economies of the Northern countries would suffer badly.
But refusal to continue this intermediation would precipitate a disorderly break up unless it were accompanied by the above described exchange controls and a rapidly engineered orderly breakup of the zone. The Southern banks would be unable to meet depositors seeking to withdraw funds and their governments would be forced to declare redenomination.
Massive losses seem likely to arise from the transfers of deposits and so long as the redenomination of currencies is delayed the liability will mount. For moving a deposit from a Southern to a Northern bank provides insurance free of any charge except the cost of moving.

Effecting the Transition
Delay does not provide a solution. It simply increases the losses that will arise from debt default and redenomination. So the first recommendation is that if a monetary union is threatened with break up, either complete or partial, the sooner that reality is recognised the better. At the least it would minimise subsequent recriminations.
The second, and final, recommendation is as follows. Learn from history. Unions have broken up in the past. Supposedly fixed exchange rates have changed. A most useful precedent is when the USA left the gold standard in 1933 and resumed it in a modified form and at a new parity in 1934.
In 1933, Congress and the President passed a series of Acts and Executive Orders which suspended the gold standard except for foreign exchange transactions, revoked gold as legal tender for debts, and banned private ownership of significant amounts of gold coin.
The dollar initially floated freely, but was in 1934 re-pegged to gold at a different price ($35 per ounce instead of $20.67 per ounce); it was not restored to use for domestic transactions.
Much of the arrangements for all this were made during a special long bank holiday that the President (Roosevelt) had called.
We are approaching a long bank holiday – Christmas. There could scarcely be a better time than December than to plan discreetly for and then effect the break up of a monetary union.


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