Breaking Up (from Euro) Isn’t Hard to Do

03/02/2012 11:06 am EST


John Mauldin

Chairman, Mauldin Economics

Here is an excerpt from a lengthy primer on how a Eurozone country could step out of the currency with far less trouble than many expect, notes John Mauldin and Jonathan Tepper in Outside the Box.

"A nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity." â€"Paul Volcker and Toyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership

While each currency exit is unique historically, one can draw some general conclusions.

What to do with existing currencies: Almost all the case studies continued to use old notes, but mandated that they bear either an ink stamp or a physical stamp. This was the first step in the changeover of notes and coins. Typically, only stamped notes were legal tender during the transitional phase.

Once new notes had been printed, old notes were withdrawn from circulation in exchange for new ones. Often old currencies were taken across borders to be deposited into the older, stronger currency.

Announcements and surprise elements: While almost all devaluations are "surprise" announcements, there is no clear pattern for currency exits. Surprise was important in some cases, because the more advance notice people have, the greater the ability to hoard valuable currency or get rid of unwanted currency.

However, countries with less inflation and credit creation and strong political identity were able to avoid surprise, as people were eager to hold the new currencies and get rid of the old, eg the Baltics and the ruble.

Capital controls and controls on import/export of notes and coins: Allowing notes and currencies to move across borders would open up the possibility for leakage of currency and for arbitrage between the old currency and the new currency, depending on expected exchange rates. In most cases, countries imposed capital controls and de-monetized old currency quickly.

Denomination of cross-border assets and liabilities: In most cases, cross-border liabilities were negotiated in advance by treaty, or were assumed to convert at announced exchange rates on the date of the exit.

Monetary and fiscal independence is crucial once countries exit: The states that introduced new currencies to provide seigniorage revenue to cover fiscal deficits experienced higher inflation and depreciation of their currencies. Countries with independent central banks unable to lend to the government experienced more stable currencies and more stable exchange rates.

How to Leave the Euro: Historical Precedents
There is ample historical precedent for currency union break-ups. They need not be chaotic or have long-term damaging effects.

The main caveat is that a full or partial dissolution of the euro would happen with the backdrop of a much more globalized world with a higher volume of cross-border capital flows than previous breakup episodes. In the following section, we use the historical examples we have highlighted above, and how they can be used to guide policy in the event of a breakup of the euro.

We recommend that any country exiting the euro should take the following steps:

  • Convene a special session of Parliament on a Saturday, passing a law governing all the particular details of exit: currency stamping, demonetization of old notes, capital controls, redenomination of debts, etc. These new provisions would all take effect over the weekend.
  • Create a new currency (ideally named after the pre-euro currency) that would become legal tender, and all money, deposits and debts within the borders of the country would be re-denominated into the new currency. This could be done, for example, at a 1:1 basis, so 1 euro to 1 new drachma. All debts or deposits held by locals outside of the borders would not be subject to the law.
  • Make the national central bank solely charged, as before the introduction of the euro, with all monetary policy, payments systems, reserve management, etc. In order to promote its credibility and lead towards lower interest rates and lower inflation, it should be prohibited from directly monetizing fiscal liabilities, but this is not essential to exiting the euro.
  • Impose capital controls immediately, over the weekend. Electronic transfers of old euros in the country would be prevented from being transferred to euro accounts outside the country. Capital controls would prevent old euros that are not stamped as new drachmas, pesetas, escudos or liras from leaving the country and being deposited elsewhere.
  • Declare a public bank holiday of a day or two to allow banks to stamp all their notes, prevent withdrawals of euros from banks, and allow banks to make any necessary changes to their electronic payment systems.


  • Institute an immediate massive operation to stamp with ink or affix physical stamps to existing euro notes. Currency offices specifically tasked with this job would need to be set up around the exiting country.
  • Print new notes as quickly as possible in order to exchange them for old notes. Once enough new notes have been printed and exchanged, the old stamped notes would cease to be legal tender and would be de-monetized.
  • Allow the new currency to trade freely on foreign exchange markets and float. This would contribute to the devaluation and regaining of lost competitiveness. This might lead towards a large devaluation, but the devaluation itself would be helpful to provide a strong stimulus to the economy by making it competitive.
  • Expedited bankruptcy proceedings should be instituted, and greater resources should be given to bankruptcy courts to deal with a spike in bankruptcies that would inevitably follow any currency exit.
  • Begin negotiations to re-structure and re-schedule sovereign debt, subject to collective bargaining with the IMF and the Paris Club.
  • Notify the ECB and global central banks so they could put in place liquidity safety nets. In order to counteract the inevitable stresses in the financial system and interbank lending markets, central banks should coordinate to provide unlimited foreign exchange swap lines to each other and expand existing discount lending facilities.
  • Begin post-facto negotiations with the ECB in order to determine how assets and liabilities should be resolved. The best solution is likely simply default and a reduction of existing liabilities, in whole or in part.
  • Institute labor market reforms in order to make them more flexible, and de-link wages from inflation and tie them to productivity. Inflation will be an inevitable consequence of devaluation. In order to avoid sustained higher rates of inflation, the country should accompany the devaluation with long-term structural reforms.

The previous steps are by no means exhaustive, and should be considered a minimum number of measures that countries would have to take to deal with the transition.

We will later explore which countries are best placed to exit and which ones should stay. Greece and Portugal should definitely exit the euro. Ireland, Spain and Italy should strongly consider it.

The countries that should stay in the euro are the core countries that exhibit the highest symmetry of economic shocks, the closest levels of inflation, and have the closest levels of GDP per capita. These countries include: Germany, France, Netherlands, Belgium, Luxembourg, Finland, etc.

Steps for the Countries that Remain in the Euro
The countries that remain within the euro will have to take steps of their own in order to deal with the unilateral exit by a departing country.

  • Print new currencyâ€"In order to limit large inflows of "old" euros from the any country that has exited the euro, the core countries should print new euros and then de-monetize old euros.
  • Recapitalize banks exposed to peripheral countries that have exited and defaultedâ€"European banks in the core are already in the process of re-capitalizing, but they would undoubtedly need a much larger recapitalization in the event of periphery defaults.
  • The ECB should stabilize sovereign bond yields of solvent but potentially illiquid sovereigns in order to restore stability to financial markets. In order to counteract the inevitable stresses in the financial system and interbank lending markets, central banks should coordinate to provide unlimited foreign exchange swap lines to each other and expand existing discount lending facilities.

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