Anders Åslund recently wrote a great deal of sense in RealTime (December 5) about a development that no longer looks impossible even if it is widely agreed that it would be unfortunate. I certainly agree that if a euro area breakup happens, it is better that it be done quickly, by all members simultaneously; that the national currencies should revert to their old names; that the old central banks that still exist should take responsibility for running monetary policy by a low-inflation rule in each of the successor monetary areas; and that all euro assets that were issued by a national authority should be redenominated into the new national currencies. Unfortunately this still leaves at least one critical issue to be resolved. And there is one issue for which Åslund’s recommendation may prove infeasible.
The critical unanswered issue is what to do about euro assets that are the liability of a pan-European authority, notably the European Central Bank (ECB). One possible way of resolving this issue would be to require that every euro holder present its claims to one of the successor central banks within the fixed time period for conversion, and acquire one or another of the successor currencies. It is not difficult to predict that most of the claims would be presented to Germany (or conceivably some other country like the Netherlands if its currency were expected to appreciate even more). The ECB would presumably transfer to the Bundesbank the claims it was holding against those liabilities, like Italian bonds. It is predictable that the Bundesbank would be unenthusiastic about accepting the implied capital loss, and that there would be an intra-European debate about how losses should be distributed (perhaps in proportion to the agreed capital shares in the ECB).
An alternative approach would be to establish a successor euro defined as a basket currency, with weights determined (for example) by the GDP weight of currencies in the euro. One could retain the ECB exclusively in the limited role of overseeing the liquidation of euro balances. Thus the euro would be equal to DM 0.273, plus FFr (French franc) 0.211, plus values assigned to other currencies, assuming that the initial value of each of the currencies were unity, and given that German GDP comprises 27.3 percent of euro area GDP. This would mean that the value of the (basket) euro was well-defined, but—given the stakes that the ECB has built up in the weaker currencies—the value of the assets held by the ECB would be less than the value of its liabilities.
The loss experienced by the ECB would be less than that which in the previous example was realized by the Bundesbank, because the euro is in this instance converted into a basket of currencies rather than the strongest currency. Nevertheless, one has to anticipate that a loss will be incurred. The loss would presumably be distributed among the member countries of the ECB in proportion to their agreed capital shares in the ECB.
Surprise has sometimes been expressed at the strength of the euro during the European crisis. Note that either of the futures envisaged for the euro would explain why. The fact is that no one envisages that the disappearance of the euro would involve expropriation of those currently holding euros; the worst that would be likely to happen is that they would be converted into a basket (with the leading alternative being the strongest currency), which would be unlikely to move far from its current value.
Out of Åslund’s recommendations, the one that might prove infeasible is that the countries should initially hold the value of their currencies rather constant ("maintain a rather strict peg in the short run when currencies are being exchanged"). It seems doubtful that the markets would permit this. There would surely be strong, perhaps overwhelming, pressures to push a new Deutsche mark up and a new drachma and escudo down. Indeed, the tendency is for markets to overshoot in the short run. In the example just given, the initial values of each of the component currencies was defined as equal to one, but this is purely for the purpose of valuing the basket; there is no implication that the currencies are to be held to approximately that value.
None of this is to be taken as implying that a breakup of the euro area is to be desired. However, the continued failures of the leaders of Europe to get to grips with the real problem suggest that it is necessary to start thinking about contingency plans.
Valuable assistance for this posting was rendered by Martin Kessler.