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Unscrambling the egg

16 April 2012 By Hugo Dixon

Can the euro omelette be unscrambled without provoking the mother of all financial collapses? With the crisis heating up again as Spanish 10-year bond yields hit 6 percent last week, the question has renewed urgency. The conventional wisdom is that such unscrambling is impossible. The economic, political and legal complications of bringing back national currencies are so immense that the euro zone’s 17 nations are effectively locked in a prison with no exit.

A 250,000 pound prize offered by Simon Wolfson, a UK businessman, has aimed to turn this conventional wisdom on its head. In offering what is the second-largest economics prize after the Nobel, Wolfson hoped to stimulate creative juices. In one case, he has – although even it is no silver bullet.

Of the myriad problems with returning to the drachma, peseta and lira, the most intractable is how to prevent it triggering bank runs and ultimately financial chaos. Depositors would flee if they thought their euros were set to be converted into a national currency certain to suffer dramatic and immediate devaluation. This has already been happening to some extent in Greece. If the Greeks knew for sure that their old currency was coming back, the current fast walk would turn into a stampede. Even worse, the damage wouldn’t be confined to Greece.

Depositors in other peripheral countries would pull savings from their banks. Bond markets in these other countries would also seize up. Why would anybody want to lend money to Rome or Madrid in euros if they thought they were going to be paid back in devalued liras or pesetas?

The solution proposed by most Wolfson Prize finalists is secrecy. Plans for a country’s exit from the euro should be kept under wraps and then sprung on the unsuspecting world on a Friday evening. But this is impractical. How could 17 governments keep secret something that will involve lots of wrangling? Would a democratic country really be able to foist such a momentous decision on its people without a parliamentary debate? Even if secrecy was possible, it wouldn’t stop contagion to other countries.

Catherine Dobbs, a private investor who used to develop algorithms for an investment firm in the City of London, has come up with an ingenious solution. At the point of break-up, every euro – wherever it is located – is replaced by a basket of two (or more) new currencies. This is a radical shift in thinking. Until now, most people had envisaged all economic activity in the exiting country being redenominated in its new local currency while all the other countries kept the euro.

Dobbs illustrates her idea using the unscrambling the egg metaphor. The euro zone is broken up into two sub-zones: the yolk and the white. For some bizarre reason, she equates the yolk with the periphery (Greece, Spain etc) and the white with the core (Germany, the Netherlands etc). But I’m going to flip it round as it’s more intuitive to think of the yolk as the core. The idea is that every euro is swapped for a fixed ratio of yolk currency and white currency, roughly in proportion to the relative size of the two sub-zone’s economies. Say for every euro, people got 70 percent of a yolk and 30 percent of a white.

Once this has happened, the yolk and white are free to float – with the yolk presumably appreciating and the white currency depreciating. New contracts are denominated in yolk or white. But existing euro contracts have to be honoured by delivering the fixed proportion of yolks and whites in the basket.

The one exception to this – which Dobbs hints at but doesn’t spell out – would be employment contracts: they would need to be redenominated into their new local currency. This would effectively allow wages in the periphery to fall, which is vital if competitiveness is to be restored.

The beauty of the scheme is that there’s no incentive for citizens in the periphery to grab their savings in the run-up to such a switchover and pop them into a core bank. Their euros will be worth the same wherever they are located. As a result, the detailed planning for the break-up can be done in public rather than in secret.

Neat as Dobbs’ idea may be, the politics of it are problematic. While savers in peripheral countries would like receiving a mixture of yolk and white for their euros, those in core countries could hate it. They would feel that a chunk of their savings was being forcibly swapped into the weak white currency even though, in theory, the value of the basket should still be one euro. Workers in the periphery who would be paid only in the depreciating white currency wouldn’t be happy either. While their wages would effectively be slashed, their debts, rents and other costs wouldn’t be. Many would face hardship and bankruptcy.

Perhaps that is just too bad. Somehow wages have got to come down in the periphery and devaluation would be a faster way of getting there than the current grinding austerity, which isn’t pleasant either. The snag is that such vested interests mean it’s most unlikely that heads of government could discuss the yolk/white scheme one day and back it. Rather, there would be lots of debate over what the right plan was. And before any decision had been reached, there would have been a massive capital flight. Sadly, the euro egg looks pretty well scrambled.


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