How to take apart the Eurozone, without sovereign "default"

1. Canada prints up 17 batches of banknotes. The first batch is called "New Drachmas"; the second batch is called "New Liras"; etc.; and holds them till D-day.

2. Canada prints up one batch of very good counterfeits of Euro banknotes, and holds them till D-day+365.

3. The 17 Eurozone governments jointly announce D-day. Canada delivers the 17 batches of banknotes, one to each Eurozone government.

4. Each Eurozone government then announces that henceforth, all its existing creditors, and all its banks' creditors, and all creditors of its domestic debtors, have the option of having their Euro debts converted at par into its domestic New Drachmas, (New Liras, etc.).  Or, they can continue to have their debts paid in Euros, if they wish. They have one year to convert existing debts. Existing Euro banknotes are included in the offer. (Each Euro banknote is technically a liability of one of the 17 countries' central bank.)

[Update: to try to make this clearer, that means that Greeks' debts can be converted into New Drachmas, Italians' debts into New Liras, etc. How exactly we define who's "Greek" and who's "Italian", I will leave to others.]

5. The Canadian government promises that on D-day+365 it will release the counterfeit Euros into circulation, in massive quantities if need be, until the exchange rate of the Euro drops below par for each of the 17 new currencies.

6. The 17 Eurozone governments agree not to prosecute Canada for doing this.

7. Alternatively, steps 2, 5 and 6 could be replaced by the European Central Bank promising to do what Canada promised to do, if it has the credibility.

This was inspired by Tyler Cowen's plan. But I think my plan is better. Just another worthwhile Canadian initiative.

Comments

[JP Koning]

"4. Each Eurozone government then announces that henceforth, all its creditors, and all its banks' creditors, and all creditors of its domestic debtors, have the option of having their Euro debts converted at par into New Drachmas, (New Liras, etc.). "

The unintentional result here will be an immediate bank run in Italy, Greece, Portugal, Ireland, Spain, (and maybe France, Belgium, and a few others).

After all, we're not just talking about New Drachmas and New Liras, but also New Deutsche Marks and New Guilders. Getting your money as quickly as possible into any of the healthy banking systems like that of Luxembourg, Austria, Finland, Holland, and Germany will become priority number one... you don't want New Drachmas, you want New Deutsche Marks.

[Nick Rowe]

JP. German banks will immediately refuse to accept transfers of deposits from Greek banks at par. Because the German bank would be agreeing to redeem a New Drachma liability for a New Deutschmark liability at par. The New Drachma/New Deutschmark exchange rate drops, and the run stops.

[Nick Rowe]

But I have added the word "existing" before creditors, to make it clearer what I meant.

[JP Koning]

All Italians, Spaniards, Greeks and whatnot will race to their local bank and withdraw Euro banknotes. They want to bring this cash with them up to Germany so as to deposit it in the German banking system so they can get New Deutsche Marks. The PIIGS's banking system still collapses, this time due to an old fashioned dash for cash.

[Nick Rowe]

JP: Existing deposits at German banks are a promise to pay Euros plus an option to covert to New Deutschmarks. A "Greek" Euro banknote (one with the Greek Central bank on it) is a Euro plus an option to convert to a New Drachma. Since the second option is worth less than the first, the German bank will refuse to accept deposits of "Greek" Euro banknotes at par.

[Nick Rowe]

Any bank or individual with an existing liability in Euros will want to discharge that liability in "Greek" Euro banknotes, by Gresham's Law, since the option value is (presumably) the lowest. Unless the creditors exercise their option to convert. And they will immediately exercise that option, except for Greece, where they might wait until D-day+364, when Canada releases the counterfeit Euros, and drives the Euro below the Drachma.

[K]

Nick: "The Canadian government promises that on D-day+365 it will release the counterfeit Euros into circulation, in massive quantities if need be"

Great! What shall we buy with them? I always wanted a Greek villa! :-)

[Nick Rowe]

K. If I am right, Canada won't need to carry out its promise, unfortunately.

[Nick Rowe]

But K, yes, that is exactly what will make the promise credible! I'll maybe take a BMW.

[Paul Friesen]

But "Greek" Euro coins and "German" Euro coins are held by people all over Europe. You can tell the difference by the pictures on one side. Are you suggesting that a German who happens to have his pockets full of "Greek" coins on D-day will be out of luck?

And how do you propose to get 17 governments (18 if you count Canada) to agree to this and still keep it secret until D-day?

Perhaps my suggestion on your last post has only a snowball's chance in hell of being adopted, but this has way less.

[Nick Rowe]

Paul: "Are you suggesting that a German who happens to have his pockets full of "Greek" coins on D-day will be out of luck?"

Yep. Just like a German bank that happens to have its portfolio full of Greek bonds.

"And how do you propose to get 17 governments (18 if you count Canada) to agree to this and still keep it secret until D-day?"

Well, would it be any less of a secret than the current expectation that the Eurozone may break up? Canada is deniable. Nobody can stop us doing 1 and 2. Canada doesn't need to get agreement from anyone until 1 and 2 are done. And Canada has a better chance of doing 1 and 2 in secret than 17 governments do. Canada could just do 1 and 2, then wait till the Euro starts to break up anyway.

All I need to argue is that it's better than what will happen otherwise.

[J.V. Dubois]

I'm not sure I get it right. So for 1 year, every creditor will have ability to convert the debts they issue (for banks) or deposits thay have (for saving accounts in banks) at par into the currency of their choosing at par (meaning 1:1). If I understand this correctly, Greek banks would be able to convert the loans they gave to greek households and firms into New Deutchmarks - which is what they will do, because that is the best alternative they have individually.

So what you basically achieve is a situation when the whole Europe has their debts denominated in "sound" currencies such as Deutchmark. Any change in exchange rate will have huge impact on debtors. This is actually something what is now happening in Hungary. During good times of domestic currency appreciation many people took loans in Swiss Franks so that over 60% of mortgages are now denominated in Swiss Francs. You may guess what happened to the real debt burden of these people last few years.

[Nick Rowe]

JV: "If I understand this correctly, Greek banks would be able to convert the loans they gave to greek households and firms into New Deutchmarks - which is what they will do, because that is the best alternative they have individually."

I can't have been clear enough. Greek banks will have the option to insist that Greek households and firms repay that existing Euro loan (i.e. one that was on the books on D-day) in New Drachmas, not into New Deutschmarks. German banks will be able to require payments from German households in New Deutschmarks.

[Nick Rowe]

JV: I have added a couple of words ("its domestic") to that sentence to maybe make it clearer.

[jesse]

Step 5: Below par of what currency, exactly? Chances are the relative valuations will "scramble".

As a creditor, which door would you choose? The door that is guaranteed to devalue your asset or the one that has at least a chance that it won't?

[Phil Koop]

The part I'm missing is what the 1-year option window adds? What's the advantage over a straightforward coordinated re-denomination?

[Neil]

I think I'm getting hung up on this:
"A "Greek" Euro banknote (one with the Greek Central bank on it) is a Euro plus an option to convert to a New Drachma"

I don't have any in my pockets at the moment, but AFAIK, while coins have national images on them, banknotes are not differentiable. Euro cash is Euro cash. Unless you're proposing that Euro notes + Greek passport = Greek Euros, in which case you're still left with the problem of non-Euro zone passports + Euros, and Greeks permanently residing in Germany.
---------------
On a related-but-different subject, I've found myself quite confused by panic over Greek default. For a couple reasons:
1 - Partial default appears to be priced in to Greek bonds on the open market. Doesn't this mean that the associated losses should already be booked by those that hold them? Certainly German taxpayers seem to already of the opinion that the bailout money is a transfer rather than a loan.
2 - Why is default-by-inflation better than default-by-haircut?
3 - Didn't Iceland default on Euro- and Pound-denominated debts a couple years back? While this caused a lot of short term pain (at least partly because it coincided with several other catastrophes), it seems to be a temporary pain from which they're now on the way to recovery.

[Bob Smith]

"Great! What shall we buy with them? I always wanted a Greek villa! :-"

Even if we don't use the Euros, what's to prevent us from churning out bundles of New Drachmas, New Liras, New Deutchmarks, etc? Although the notes would, technically, be counterfeit, they'd would also be identical to the "real" notes. Moreover, if Canada printed new batches of notes in secret, they could (at least in the short-run) flood the market without the market knowing that it is being flooded. And as for plausible deniability, well, what's more likely, that Canada is trying to devalue the New Drachmas, the New Lira, or the New Punt, or that the Greeks, Italians and Irish are trying to devalue their respective currencies to gain a competitive edge over their neighbours?

Mind you, the gig would be up when we try to evict the Spanish and Portuguese from our new province, but it'll be fun while it lasts.

[david stinson]

Good post, Nick.

Now how about the option of Germany only leaving? Germany leaving on its own might make the rest sustainable as a currency area. The ECB could print money as it saw fit, etc.. Fiscal union, were it necessary, might cause less moral hazard with the rich guy (Germany) gone.

[Simon van Norden]

I think JPK is right that the banking system collapses on announcement of this plan.

It seems to me that, as a holder of euro bank deposits, I want to ensure that these will be converted into "hard" currency (NeueDeutscheMarks?Über-Marks?). There is no way to force this legally at present. The existing law treats all "national" euro notes as interchangeable and all are legal tender. The latter means that my bank can force me to accept Greek-euros, Irish-euros, etc.

Gresham's Law means that everyone starts hoarding "good" euros and trying to dump "bad" euros. But the only way to do so (at present) is with currency. As soon as we try to deposit funds in the banking system, we're at risk of being paid with "bad" notes. This should force everyone to flee the banking system. That in turn will force the degree of credit in the economy to converge towards the amount of currency.

The amount of currency in circulation is a small fraction of total banking deposits. What follows sounds like a game of musical chairs with very few chairs. But scarier.

Will someone please tell me that I'm wrong?

[Simon van Norden]

There are no national versions of euro banknotes; only coins.
http://www.ecb.europa.eu/euro/banknotes/html/index.en.html

[Nick Rowe]

jesse: "Step 5: Below par of what currency, exactly? Chances are the relative valuations will "scramble"."

Below all 17. Canada would make sure that the Euro is the least valuable of all 18 currencies. It needs to do that to get people to exchange their Euros for the new domestic currencies.

Phil. Not a lot really. Just gives them a bit of time to do the converting.

Neil: AFAIK (hope I'm not totally wrong on this) there's a way to tell the banknotes apart. Serial numbers, or something. Anyone know? How easy is it to tell them apart?

"2 - Why is default-by-inflation better than default-by-haircut?"

The Greek economy would recover a bit with easier monetary policy, so would be able to afford to pay more, which would be good for Greeks and their creditors too. The total pie gets bigger.

Bob: I think one country counterfeiting another country's currency is not just an act of war, but outlawed by the Geneva convention? I'm not sure on that.

David: thanks! There's always going to be weaker and stronger members, some who need tighter and some looser money. And too many vetos for the ECB to work as lender of last resort. Best go the whole hog all at once. Plus, once some start to leave, contagion will I think be unstoppable.

[Nick Rowe]

Simon: if I have a Euro account at a Greek bank, under my plan I will have the option to demand New Drachmas, instead of Euros. I will not have the option to demand New Deutschmarks. Since Canada will ensure that the Euro will depreciate below even the New Drachma, I will exercise my option to convert it into New Drachmas.

[Jim Rootham]

Do we really need to blow up the whole Euro? Wouldn't Germany + France and the Benelux countries be a reasonable currency area?

[Bob Smith]

"I think one country counterfeiting another country's currency is not just an act of war"

But happily we'll only be counterfeiting the currency of European countries (and not our neighbours to the south) so we don't have much to worry about on that front (the risk, I suppose, is that we might win the war and have to take care of the Europeans - see "The Mouse that Roared"). As an aside, I gather the United States tried counterfeiting Confederate money during the civil war - didn't work too well, the fake money was readily identifiable because it was better than the real thing.

[Nick Rowe]

Jim: I used to think the Holy Roman Eurozone could survive the fall. http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/04/the-ecb-as-pawnbroker.html
Now I think it's too far gone. Belgium has high debt and hasn't even had a government for the last year or two. French banks are weak, and will get weaker still if the Greek and Italian bonds they hold are worth less. France won't be able to afford to bail out its banks without doing an Ireland, and Germans sonner or later will refuse to bail out non-Germans.

[Nick Rowe]

Simon: "As soon as we try to deposit funds in the banking system, we're at risk of being paid with "bad" notes. This should force everyone to flee the banking system."

Since Canada will ensure that Euros are badder than any of the 17 new currencies, everyone will exercise the option to convert to the domestic new currency.

[Phil Koop]

Simon: I do think that given Nick's premises, you are wrong.

However, I see another problem. Assuming that the operation is value-neutral, then some of the new currencies will be worth more than the euro - we can view the old euro as a weighted average of the new currencies. People with the right to re-denominate their assets in strong currencies will therefore have a windfall gain, absent default effects; weak currency assets will suffer a windfall loss. In the short run, this will exacerbate Europe's existing imbalances.

It would be better to re-denominate by domicile of liabilities rather than assets, as that would adjust balances in the right direction. It would also mitigate moral hazard: profligate Germans who made foolish loans to Greeks would be punished, and wily Greeks who shifted their deposits to Germany would be stymied. Technically, it would also make the treatment of currency consistent with that of broader money (assuming one could actually distinguish the origin of currency.)

[Neil]

Reading further, it seems you are correct that the commissioning country is identifiable from the first letter in the serial number. Still, given that Euros are supposed to be fungible, would there not be a significant downside to one day just announcing that you'd better check your serial numbers, because turns out you may have some "bad" euros in your pocket. Also, might trigger a drive for certain denominations, since it appears all €500 notes are from relatively safe countries (Germany, Austria and Luxembourg).

I think Simon's question was more along the lines, "If I hold a Euro-denominated bank account at RBC or some other non-EZ bank."

Similar issues seem to arise for non-cash, Euro-denominated paper, such as bonds, Euro-pegged foreign currency, and bank deposits in Euro-ised economies (Kosovo, Montenegro, San Marino, etc.). Does a German company get stuck denominating its debt in Deutschmarks, while their Italian competitor gets Lira? What about transnational companies?

The whole plan is just seeming quite arbitrary.

[Neil]

Side point - how does your 365 day overlap matter? The day a Cypriot serial number becomes different from a Finnish serial number, your 18th currency no longer exists, and a French Euro is just a Franc. If the currency that people are allowed to convert to is locked in, the whole inflating "Euros" to ~zero becomes a pointless exercise, since Euros no longer exist.

[Phil Koop]

Err ... I guess that should have been "re-denominate assets, rather than liabilities", making the treatment of currency inconsistent with that of broader money, from a the view of practical possibilities.

I still think the point is right.

[Nick Rowe]

Phil: "It would be better to re-denominate by domicile of liabilities rather than assets,..."

I think that's what I meant. A german holding Greek government bonds has the option to convert to New Drachmas.

The value of the euro *was* a weighted average of new currencies (synmettalistic conversion of banknotes is also an alternative). But Canada will destroy the value of the euro.

[Nick Rowe]

Neil: "Side point - how does your 365 day overlap matter?"

I'm not really sure it does. Just gives everyone time to get the news and look behind the sofa.

[Sergei]

And what does it solve exactly? You simply exchange credit risk for fx-risk. No big deal as whatever you call it there is a loss out there that has to be realized by all foreigners holding Greek etc debt.

[K]

I case you are wondering how your plan might be greeted in Germany . Pretty funny. Better get the printing presses running, Nick!

[Nick Rowe]

Sergei; "And what does it solve exactly? You simply exchange credit risk for fx-risk. No big deal as whatever you call it there is a loss out there that has to be realized by all foreigners holding Greek etc debt."

Understood.

It gives each of the 17 countries its own monetary policy back. It gives them each their own lender of last resort. The real value Greek bondholders will get will probably be higher if the Greek economy recovers and can afford to pay more of a bigger pie. It avoids all the legal mess associated with sovereign default.

[Nick Rowe]

Neil "I think Simon's question was more along the lines, "If I hold a Euro-denominated bank account at RBC or some other non-EZ bank.""

Good question. I think the best answer is synmetallism. Anyone with 100 Euros credit outside the Eurozone has the option to covert it into 30 New Deutschmarks, 20 New Francs, etc., in whatever portions the countries are shareholders in the ECB.

[Gregory Sokoloff]

There is a common assumption that the ineptitude of leadership in Germany will continue, and thus the Euro is moribund. This may not necessarily be the case. Both the SPD and the Greens have offered to support Merkel if she gets the gumption to propose a bold solution, which would have to be something tantamount to Eurobonds and fiscal integration (see the article in the FT by Frank-Walter Steinmeier and Peer Steinbrück last year, and more recently in July). As the crisis reaches a head, Merkel may have to seek a "grand coalition" with the left or have her government fall leading to new elections. And both the SPD and the Greens are surging back in the polls so that a pro-European left coalition could be back in power. It might not be pretty, but politics could end up saving the Euro after all.

[Simon van Norden]

Nick (and Neil): " if I have a Euro account at a Greek bank, under my plan I will have the option to demand New Drachmas, instead of Euros. I will not have the option to demand New Deutschmarks. "

So consider the following strategy. I'm a Greek holder of euro deposits in a Greek bank. I withdraw my euros on (D-day + 1) and deposit them in a German bank. I now have the option to get Neue-Über-Marks instead of Neo-Drachmas.

(This is not just hypothetical; Greek banks have been reporting major deposit losses this year as depositors worry about their solvency and deposit funds in non-greek banks. During the Argentine crisis in 2000, the flood of Argentines relying on Uruguay's banks for cash almost imploded Uruguay's banking system when the Argentine banks seized up. In 2008, the Irish govt.'s unlimited deposit guarantee started to cause important deposit losses in the much larger British banking system, forcing the Brits to up their deposit guarantees. etc. etc.)

To stop Nick's plan from causing a banking panic on anouncement, it has to prevent deposit movements from "bad-money" to "good-money" accounts. That will be very, very hard. (Easier under autarky, but might be as bad as the panic.)

[Simon van Norden]

Nick: "Anyone with 100 Euros credit outside the Eurozone has the option to covert it into 30 New Deutschmarks, 20 New Francs, etc., in whatever portions the countries are shareholders in the ECB."

Um....what stops people inside the eurozone moving their money outside to take advantage of this? You're giving them a valuable option if they do so, right?

Before you answer "we'll make it illegal", think hard about how to stop Goldman-Sachs, UBS, DeutscheBank, ING, Sociète Generale, etc. setting up swaps between (a) a greek bank, (b) a non-Eurozone bank, and (c) a German bank, that effectively does the same thing.

[JP Koning]

"The New Drachma/New Deutschmark exchange rate drops, and the run stops."

It is not clear that the clearing price between Greek Euros and German Euros will be arrived at before or after a run on Greek banks renders them insolvent. I’d say probably not.

As the exchange rate falls to its clearing price the rich get out of the Greek banking system first as they can better exploit the loopholes so as to get their funds into the German system. The poor keep holding their crappy Greek deposits or Euros.

I’d call this post "How to take apart the Eurozone, without sovereign "default", but with a banking system collapse, and a huge increase in intra-nation income disparity"

An Argentinean deposit freeze might do your trick. But this brings with it a whole slew of other problems... like a collapse in trade.

I don’t believe that thinking along the lines of “How do we create a new system” will resolve anything. If anything, the collapse of the Eurosystem is ultimately about the failure of “How do we create a new system” style thinking. There are no free policy-dollars lying on the ground… the logic of markets will drag this thing to whatever end it deserves.

[JP Koning]

Keep in mind too that if the market clearing price of Greek Euros is 0, which could very well be the case, in announcing this plan the Greeks will be immediately deprived of a medium of exchange. Reversion to barter will be the result. So will dollarization and the spontaneous adoption of German Euros as the medium of exchange. In the end, Greece still doesn't have its own monetary policy.

[Sina Motamedi]

Why don't we just build a time-machine and go back in time to stop the creation of the Euro in the first place?

Easiest solution IMHO.

[Sina Motamedi]

Why don't we just build a time-machine and go back in time to stop the creation of the Euro in the first place?

Easiest solution IMHO.

[Nick Rowe]

Simon: "I now have the option to get Neue-Über-Marks instead of Neo-Drachmas."

No. The option only applies to deposits in a German bank that were there on D-day. German banks can make any deal they like on deposits made after D-day. They are going to look at the Euro notes closely. They won't accept Greek Euro notes at par with German Euro notes.

[Nick Rowe]

JP: "There are no free policy-dollars lying on the ground… the logic of markets will drag this thing to whatever end it deserves."

That's the line of thinking I had been following, and was trying to escape in my previous is/ought post. Or, thinking like Sina: I wished we had a time machine. Can't we economists say anything that might make things a bit less bad, given where we are now, and what is likely to happen?

Gregory: it's not just the Germans. Any one of the 17 could veto the deal, Including Greece, if it doesn't agree to what would satisfy the Germans or Finns, or whoever. Or if Greece *can't* deliver. And even if they get agreement this time. What about next time?

[Simon van Norden]

Nick: As pointed out in the ECB link I posted yesterday, there are no national notes; only national coins. Euro notes are identical across the zone. (I also checked my euros downstairs; no national characteristics.)

[Nick Rowe]

Simon: Neil above says:
"Reading further, it seems you are correct that the commissioning country is identifiable from the first letter in the serial number. Still, given that Euros are supposed to be fungible, would there not be a significant downside to one day just announcing that you'd better check your serial numbers, because turns out you may have some "bad" euros in your pocket. Also, might trigger a drive for certain denominations, since it appears all €500 notes are from relatively safe countries (Germany, Austria and Luxembourg)."

I remember reading on Willem Buiter's old blog a couple of years back, about news stories of how some Germans were checking the serial numbers.

[Nick Rowe]

But yes, if it's deemed impractical to check all the serial numbers, then you have to close the banks for one week(?), and allow only 1 week to exercise the option to convert notes into a basket of new currencies. And then let Canada demolish the Euro before you reopen the banks.

[Simon van Norden]

Nick: "The option only applies to deposits in a German bank that were there on D-day. "

Fair enough; sounds like a step in the right direction. Let me try to find other stumbling blocks.....

Consider any contract payable in Euros on or after D-day. That would include everything from credit card bills to exchange rate forward contracts to construction contracts to auto leases to real estate leases to pensions to government debt. All debtors will want to pay in Euros; creditors will want anything but (and will look for ways to get Neue-über-Marks.)

Under existing laws, only euros are legal tender. Government bonds grant bondholders the option of conversion to the new currency; no other contracts do.

So you'll make a wealth transfer from all the above creditors (i.e. holders of euro-denominated private claims excluding bank deposits) to all their debtors, is that right?

[Nick Rowe]

The law would have to treat unpaid bills, and contracts signed before D-day and payable after D-day, like debts. The creditor would have the option to insist on payment in the debtor's new national currency, and would want to exercise that option.

[Nick Rowe]

Yes, it's a wealth transfer, *relative to the status quo*, but the status quo, especially if it involves (local) disinflation, is also a wealth transfer, relative to what was expected, as is default. Almost any solution will harm some creditors (those holding safe Euro assets). But the taxes to pay for the bailouts would harm those same people anyway.

[ac]

"All Italians, Spaniards, Greeks and whatnot will race to their local bank and withdraw Euro banknotes. They want to bring this cash with them up to Germany so as to deposit it in the German banking system so they can get New Deutsche Marks."
Totally ridiculous, have you ever been in Europe. Do you really think that spanish in Spain will travel to germany to deposit money in German banks. Not only one probably.
I think in North america you have o vision where business and money are too important.
Have you ever really mith a spaniard ? People will not react like that, they won't react at all anyway.

[Simon van Norden]

yep, definitely a wealth transfer either way (and I'm happy to assume that the status quo is govt. debt default, just for concreteness.)

That's not to say that the size of the transfer is constant across alternatives, or that we're indifferent between any two sets of such transfers. Trying to figure out which transfer to choose is beyond me.....

But I think you nicely solved the bank run problem.

[RebelEconomist]

If economists spent half the time considering how to manage the existing experience-based money systems wisely that they now spend devising ever more convoluted ways of cheating holders of nominal claims for one last farewell performance of the moral hazard show, we might never have had these problems in the first place.

[Sina Motamedi]

Nick, if you clean this up a bit and make it look more formal, you might get a big pay cheque out of it. "Economists offered cash for eurozone exit-strategy"