BUENOS AIRES – The tensions between the eurozone’s north and south, and the complex and politically costly transfers of money required to dampen the euro crisis, have led many people to think the unthinkable: saving Europe’s common currency may require that some countries abandon it. Indeed, talk about exiting the euro has intensified, particularly in southern eurozone countries that desperately need to regain competitiveness. But a look at what exiting the euro might mean in practice should stop such talk cold.
Adopting a stronger currency (as in “euroization”) is neither difficult nor particularly unusual. Introducing a new, weaker national currency to substitute for a stronger one in times of financial distress is an altogether different matter, about which most economists know almost nothing.
The closest experiment along these lines is probably Argentina’s exit in 2002 from its dollar exchange-rate peg (embodied in its currency board) to a floating regime that depreciated the peso by 300% in the first three months.
Despite Argentina’s obvious differences from the eurozone’s troubled southern economies, the Argentine currency rollercoaster provides sobering lessons for European policymakers to ponder. Do Europeans want to return to their own version of a flexible “peso”? At the very least, European policymakers will need to be willing to (a) “pesify” contracts, (b) impose heavy restrictions on commercial banking operations, (c) restructure debts, and (d) introduce capital and exchange controls.
Consider each facet more closely. First, a new currency needs to create its own demand as a means in which to conduct commercial transactions by displacing the euro as sole legal tender and unit of account. This, in turn, requires the forced redenomination of prices, wages, and financial contracts, which can create serious disruptions, owing to heavy and asymmetrical balance-sheet effects, as well as a massive redistributive impact. Argentina´s “pesification” of bank deposits and loans benefited debtors at the expense of depositors, inciting public upheaval.
Second, should any eurozone country quit the euro, the anticipation of forced pesification is likely to set off a bank panic, as depositors quickly switch their pesified holdings back into foreign exchange in order to move them out of the system and probably abroad. In fact, in Argentina, people started to withdraw their deposits almost a year before the exit from the currency board, fueling capital flight and feeding back into market pressures to abandon the peg to the dollar – a dynamic that could be even faster and more furious in financially integrated European economies.
In these circumstances, a selective deposit freeze appears to be the only option to avoid bankrupting the banking sector. Here, Argentina offers both a good and a bad example. When all deposit withdrawals were capped in November 2001, the resulting liquidity crunch deepened the recession and, eventually, brought down the government. By contrast, the restructuring of term deposits in January 2002 attenuated the bank run and kept the payments system alive, while allowing so-called “sight deposits” – which can be withdrawn immediately without penalty – to help build demand for pesos.
Third, while pesification removes balance sheet losses from domestic foreign-currency debts, external contractual obligations cannot be redenominated unilaterally. Thus, the exit from the dollar peg requires a restructuring of external debt, both sovereign and corporate.
Indeed, Argentina’s sovereign default happened almost simultaneously with the demise of the currency board, but corporate renegotiations were a protracted affair. Eventually, most companies avoided bankruptcy, mainly owing to the fourth ingredient in Argentina´s exit toolkit: capital controls that provided the legal umbrella to stop external corporate debt servicing.
Of course, controls are an inevitable ingredient in the exit mix. Adopting a weaker currency is predicated on the need to regain competitiveness and improve external accounts. But, in the short run, given the huge uncertainties involved in a regime switch, and the loss of access to capital markets that follows a debt renegotiation, foreign exchange becomes scarce, requiring a plethora of traditional restrictions – some more distorting than others – on capital movements.
In Europe, too, capital controls would be the only way to avoid the offshoring of financial settlements after the currency conversion and the freezing of bank deposits. At any rate, experience indicates that exiting the euro while preserving the freedom of capital movements is little more than a fantasy.
Some observers suggest, based on Argentina’s precedent, that countries should introduce their own weaker currency to denominate wages and selected prices without leaving the euro. We believe this analogy is misconstrued. While Argentina did issue quasi-money in 2001 before abandoning the currency board, this money was conceived to meet fiscal needs and remained stable vis-à-vis the dollar. Indeed, it is hard to imagine how this dual-currency scheme could have avoided the consequences of converting to a weaker currency if the quasi-money had depreciated, as the idea’s current promoters intend.
Argentina’s exit from its dollar peg was a traumatic experience, concentrating contract violations, wealth redistribution, defaults, bank runs, exchange restrictions, and severe limitations on capital movements into a short period of time. Even so, it was simpler than introducing a “new drachma” would be for, say, Greece. Because Argentina’s currency board never eliminated the peso as the main means of transactions, the basis for demand for it was there at the time of the blowup. Euro defectors, by contrast, would need to promote demand for the new currency from scratch – a much messier and nastier process altogether.