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The Eurozone trap

The monkey’s trap | Weekend Long Read

News in Europe

MADRID | By Raimundo Poveda | We should be be more careful with transfers of sovereignty. The next one will be the transfer of the banking supervision to the ECB.

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Now that we know how the euro works, one may have doubts about the convenience of being part of it. Its manager–the European Central Bank— is not well designed as a central bank. The ECB does not meet one of the basic functions of any central bank, which is to fund its government when necessary (don’t feel offended, it is like that). Its approach is monothematic and short-sighted. As in Orwell’s story, all its members are equal but some are more equal than others: we have not given monetary sovereignty to a council of sages but to a coterie of lobbyists for (some) national interests. The ECB has even failed to create a single financial and credit market : within the euro area there is still country risk.

Euro membership has its advantages, of course. There is no need to remind them. Probably, the net sum of advantages and disadvantages gives a positive balance. But it is no longer heretical to think otherwise, although it is still politically incorrect. It is not surprising to hear angry voices saying “Let’s leave the euro”, or even insidious, Anglo-Saxon voices whispering “You should leave.”

The question is: can a country exit the euro? Legalists would say no, because the foundational texts do not foresee an exit. Let’s forget about that and talk seriously. If a sovereign state wanted to get out, it would; or if others decided to throw him out, they would do it. Monetary Union and its laws would accommodate as necessary. However, once cleared this legal hurdle, the question remains: can a country actually exit the euro? The answer is “almost not”. I say “almost” because in extreme circumstances, some heroic ways to solve the following problems would be found.

First difficulty: the country that leaves the euro will need its own banknotes and coins. Preparing them is not a trivial matter. A banknote is an extremely complex piece of paper, full of tricks to prevent forgery. The ECB took more than two years to produce them. Of course it managed to do it by setting up committees for everything, which always delays things. But even without committees, the country that leaves the euro will remain for half a year, being optimistic, without its own notes. There are no short-cuts. The ECB will not, for example, let stamp a part of its euronotes to be used as local currency, among other reasons, because all European machines in which banknotes euro payments can be made would have to be adapted to recognize, and reject, the notes stamped by the deserter country.

During those long months the new currency will be used in accounting, prices and wages will be fixed in the new currency, bank accounts will open in the new currency, but on the street the euro will continue circulating in the absence of anything else. Nothing new: mutatis mutandis is what happened when the euro was introduced. With a difference: old coins were doomed to disappear at a known fixed rate. Many Germans would have kept their beloved marks, but that didn’t make sense. Now the euro will stay there, so it will be possible to keep euros. The new currency will tend to depreciate (that is one of the reasons a country gets to leave the euro!). Currency exchange adjustments would take place constantly, starting with a devaluation of some thirty percent (am I being again optimistic?) so that everybody has no doubts about the fate of the new currency. Those who charge their activities or services in cash will be converted into small money-changers; if they can, they will profit of it. Will vending machines, let us say, the metro tickets dispensers, be continuously adjusted? Or will a “small” distortion of prices be tolerated, granted in favor of the vending machine’s owner?

That old law, bad currency drives out the good one, has not been abolished. So the citizens’ natural reaction will be hoarding euros. The corresponding natural reaction of the Government will be ”corralito” and exchange controls. Illegal according to the European Union? After what happened in Cyprus, it seems that illegal does not mean impossible. In due time the Government will require their citizens to redeem their euro banknotes for national ones. It will be too late, though: by then, all the large pools of euronotes will have already left the country (except the cash at banks, if the supervisor acts quickly to block them).

Second difficulty: when the euro was created, all contracts defined in the old national currencies were changed to the euro at the established conversion rate. It could not be otherwise because those currencies were about to stop existing. But the scenario of a national currency’s return is different. Contracts in euros may remain in euros. Worse yet, one of the two contracting parties will be interested in keeping them in euros whereas the other won’t. Maybe the exiting state can impose automatic conversion to its residents and in its territory, resolving the conflict at a stroke. Maybe not. The courts will dust off the doctrine of the ‘ lex monetae’ and decide. What is certain is that there will be lawsuits, and that non-resident creditors will maintain their contracts in euros with the full support of its own courts and international tribunals. And such contracts include, among many other things, public debt held by foreigners.

Third difficulty: the deserter country’s banks will no longer be customers of the ECB but of their national central bank again. What to do with their outstanding ECB balance, the famous TARGET2, which, almost by definition (a weak country with significant external financing needs) will be huge? The ECB, an ECB irritated by the desertion, won’t be able to do anything but demand their reimboursment, obviously in euros. But neither the banks nor their central bank will have the necessary amount. And that is not the only mutual account between the ECB and the national central bank that will be necessary to undo. It will be a complicated negotiation. We are no longer talking about inconveniences, but about a potential rescue.

The fourth challenge is a political one. The announcement of an exit from the euro, or its mere suspicion, will trigger a speculative storm. To alleviate it, the exit will have to be prepared it in secret, and executed in a flash. But the preparation of the stock of the new notes cannot be done in secret. It will also be very difficult to negotiate secretly with Europe and the ECB all the adjustments required for an orderly exit; many important and controversial arrangements must be left for later. The secret cannot even be imagined in a national Parliament. We will therefore see the umpteenth decisive measure which will not be discussed democratically, although this time a decree-law and improvisation will be justified.

It is the monkey’s trap: we put our hand inside the pot and closed it on the fruit (cheap credit that we wasted). Now we can’t take the hand out without hurting ourselves. We must go where the masters of the pot want to bring us.

The moral of the story? We should be be more careful with transfers of sovereignty. The next one will be the transfer of the banking supervision to the ECB (I don’t know why that is called Banking Union). In due time, we will discover that this scheme is also poorly designed, that the criteria of the European supervisor may not suit us, that the distributions of tasks and responsibilities are arbitrary and confusing, and also that some members are more equal than others.

With the aggravating circumstance that in this matter it is difficult to list the advantages that countries can expect from this power transfer …Oh, yes! Our bank restructuring will be made with European funds: the lure of the trap, again. But who can assure us that, facing the dilemma of restructuring a problematic bank with European funds, or closing it at the expenses of the creditors and (national) deposit guarantee funds, the European supervisor will not systematically choose the second option, although being the most disruptive? And it will do it not for the reasons you may think, but invoking virtuously the doctrine of moral hazard.

But how to get away once we are inside?

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