Nouriel Roubini's Global EconoMonitor

A Divorce Settlement for the Eurozone

From the FT:

The European Central Bank has averted disaster, sparking a powerful relief rally – but nothing fundamental has been resolved. Greece may need another debt restructuring; Portugal and Ireland may need restructuring too. Spain and Italy may yet come under the gun. Banking crises are hardly ever resolved without removing toxic assets or recapitalisation. The eurozone still lacks essential features of monetary unions that have stood the test of time; and planned reforms may exacerbate latent fiscal, banking and external imbalances, leaving it less, rather than more, resilient to regional shocks.

Splitting up may be hard to do, but it can be better than sticking to a bad marriage. The periphery debt crisis threatens to engulf the core in huge bank capital shortfalls and fiscal liabilities, trapping both in protracted stagnation. This reflects possibly intractable eurozone design flaws. So we propose the following amicable divorce settlement.

Countries leaving the eurozone must rebalance away from growth led by debt, towards export- and income-led growth. Members of a “rump” eurozone should rebalance toward domestic demand. The EU free trade arrangement is critical to this end. Ideally, five distressed peripherals – Portugal, Ireland, Italy, Greece and Spain – would exit, negotiating bridge financing.

Currency realignment would aid this adjustment. It is far better to restore competitiveness through devaluation than by changing relative prices with a fixed nominal exchange rate, which implies protracted debt deflation, potentially ending in disorderly defaults and exits in any case, or sustained inflation above target in surplus countries. There would of course be disruption even in a cooperative, partial dismantling of the currency union, but it would be in everyone’s interest to minimise the damage by adhering to the agreed exit strategy.

This strategy would ensure exiting countries’ viability and the euro’s credibility. It would maintain the EU customs union to the benefit of all member states; and set a monetary framework for the rump ECB and exiting national central banks.

A transitional monetary framework would effectively reverse the exchange rate mechanism that led to the euro: FX targeting by exiting national central banks, with ECB support to avert currency collapse, capital flight and a resultant surge in inflation. New FX trading corridors would be widened in steps as inflation and exchange rate risk premia returned to normal.

After the transition, independent national central banks and the ECB would implement congruent inflation targets, averting protectionism in the wider EU by restraining competitive devaluation. Exiting countries would be small, open economies relative to the rump eurozone, where FX movements would quickly pass into inflation, inducing them to avoid maxi-devaluations that could provoke wage price spirals.

Unlike other currency regime changes, FX corridors would not be threatened by the inadequate FX reserves of exiting countries. The ECB would buy the new currencies at the floor of the trading band, to mitigate losses from currency collapses and disorderly defaults. This element of the plan would put the burden of financing adjustment and exit on the ECB and remaining eurozone members. But transitional alimony or one-off settlements are often the key to amicable divorces; transitional official financing would mitigate losses and defaults, as in many currency regime changes, and facilitate EU survival and cohesion – helping to avoid the de-globalisation that often follows financial crises.

A clear, consistent legal framework for exit is crucial. We would redenominate all contracts made under domestic laws into the new currencies at the time of exit. We would retain euro denomination for contracts made under foreign law, subject to the territorial connection of the contract or obligor, in line with consensus legal opinion.

Exiting countries should accelerate the “domestication” of external debts before the transition to minimise balance sheet mismatches. Imbalances in the payments system would be redenominated by negotiation and netted between the ECB and national central banks. The widening of FX trading corridors as risk premia fell would lessen balance sheet effects. An eventual free float of currencies by inflation-targeting, independent central banks would restore macroeconomic shock absorbers and aid policy credibility.

Banks and financial markets pose the gravest immediate threats to the exit strategy. Pursuing domestication prior to exit would reduce credit losses and currency risk. The ECB’s currency support would allow time for hedging and repayment of euro-denominated obligations. These policies would mitigate damage to the banking system and support economic activity and investment. However, doubts about the strategy might spark capital flight, requiring temporary bank nationalisation, curbs on deposit withdrawals and greater use of non-cash payments, as well as temporary capital controls.

We have divorce laws because amicable divorce is better for all concerned than enduring the chronic depressions that accompany bad marriages. The eurozone should devise plans for orderly exit sooner rather than later, because delaying often makes break-up more costly.

The writers are managing director and chairman of Roubini Global Economics

19 Responses to “A Divorce Settlement for the Eurozone”

Mark AllanApril 3rd, 2012 at 10:35 am

Seriously Nouriel do you think Brussels will give your excellent idea more than a cursory glance? Not a hope in hell! They’re hell bent in pursuing the dogma of austerity,causing untold misery to thousands,making the rich richer and the poor poorer!
These supposedly intelligent people are lending money,via bailouts,to countries who haven’t or as things stand,will ever have the means to pay it back.
This is sub-prime lending on a grand scale and forgive me but isn’t that the reason we are where we are now because of that?
I’ve said it before,the Euro is a busted flush and the odd 100bn here and there in bailouts is akin to applying band aid to open heart surgery.

diatoo1April 3rd, 2012 at 3:35 pm

I cannot imagine the core countries would be willing to shoulder all the burden. Then what? Global financial crisis or melt down? If yes, let the industrialised countries and BRICS shoulder their part.. No reason that the core countries shoulder it alone.

Pedro LexApril 3rd, 2012 at 5:46 pm

I'm from Portugal, one of the mentioned countries, and i have to say that Nouriel Roubini e completely right. The only thing that the Euro Zone has to offer to countries like Portugal, Greece, Ireland, Spain, etc. it's more austerity and nothing else. Take Portugal as an example, today we had new numbers on unemployment, Portugal has reached the 15% unemployees, just one of the consequences brought by the Euro Zone strategies.
For europe's politics people don't matter anymore and are suffering and being left behind, the only thing that matters it's money and keeping the Euro a strong currency.

paulApril 4th, 2012 at 11:48 am

sorry Pedro, the problem with Portugal is deeply entrenched socialism and an expectation that the state will provide everything for you if you sit at home on the sofa

R. CoutinhoApril 8th, 2012 at 12:09 pm

One way for Portugal to "go it alone" in remaining in the EZ but gaining on their unemployment would be to issue a new currency that is the only currency they would accept for tax payments. Although this would not be the 'ideal' way to get the economy moving, it would help. The Portuguese government would 'spend' the new currency into existence. Meanwhile, it would automatically become valuable (to those who need to pay taxes). Thus the country would have competing currencies for a while. Then the country could look to employ citizens in doing projects that it deems are needed by the government.

GabrielApril 4th, 2012 at 4:17 am

Well, that would be a great solution for the so called peripherical countries, I'm not sure what is the gain for Germany, France & the other which will stay the EZ…. PIIGS boosting their exports and economic growth can only be done at the expense of the competitiveness of those which will stay in the EZ.

R. CoutinhoApril 8th, 2012 at 12:12 pm

It is impossible for the periphery countries to pay off their debts if they do not get a net positive in exports. How else could they possibly do it and stay with the Euro? No matter how much the "core" countries want to scream, if they want the debts paid, they will have to accept more goods from the periphery countries than they give to them (in net Euros). That is simple math.

Incidentally, if they could find a new source to buy their products (outside of the EZ), they might be able to pay the debts. This is highly unlikely in our current economic environment.

Mantenidis KostasApril 5th, 2012 at 11:01 am

Greeks, still strong believe, stay in EZ is the best solution for the citizens and the country.
Corrupted politicians, controlled MME from state's money "businessmen", mafiozopolitical parties is the biggest problem!
They created a system of impunity for their crimes!
Until now, only poor and mid class citizens paid the crisis!
Is incredible but true, that the President of Greek "republic" results to be paid more than Obama!
Troika's first interest should be to create an impartial judiciary, push for money flow control, bring to court for punish the corrupted and put some of them in jail!

Pedro LexApril 5th, 2012 at 2:32 pm

And who permits that mafioso/political parties on the Euro Zone get away with impunity? The Euro countrys of course, they all eat at the same table, and punish the midle and poor classes by stoping the growth and betting on austerity and more austerity. Yesterday Peter Weiss told that the cuts made on the middle class salary in Portugal should be permanent. That is the cuts that are punishing the portuguese economy and stoping growth as a country.

rodeneugenApril 6th, 2012 at 6:55 am

It sound to me misleading to suggest, that the return to national currencies will solve the problems of Europe with relatively little pain. The reason for European sovereign debt crisis of the G.I.P.S. countries (i am not including Ireland, where the problem is different) is their national income that exceeds their economic production capacity, creating gap that had to be covered by loans that came in the past from European financial institutions. With the beginning of economic crisis in US, that started because of entirely different and not connected reasons, suddenly the leaders of the financial institutions, that bridged for G.I.P.S. their financial gap, by purchasing their bonds, realized that they were fooled and they fooled themselves, believing that every sovereign debt of Euro Zone country has AAA rate, (as assumed by most of the credit rating agencies). Now that these respectable financial institutions have to write of most of these loans and it doesn't matter if it will be by devaluation, write offs, or European Central Bank loans, that will have to be eventually transformed into equity in a process of diluting the previous owners, the result will be drying the money flow in Europe. Other consequence of sovereign debt crisis will be, that the financial institutions will have to fold their sleeves, and instead to continue to channel the financial resources to finance new sovereign debts, they will have to create effective system of investment financing in existing and new economic ventures, that have the potential to creating real economic ad-values (Not like sovereign debt that financed waste and overconsumption). If this change in credit availability will happen, eventually it may help to bring economic growth to Europe.
As to the economic misery of the G.I.P.S.I. country population, again the return to national currencies will not solve their problems with less pain than the alternative measure of income reduction. As a main problem in the G.I.P.S. countries i see the huge unemployment of the well educated youth, who to my understanding are better equipped to function in modern economy than their veteran predecessors, but are not recruited to work, due to the labor policy imposed by the political leadership of the unions and national leaders, that have no guts to oppose them. The G.I.P.S.I. countries have to learn how to create new economic ad-value and i am not expecting it will come from the old veteran employed, who were part of the system that created this economic unbalances, and who will not be reluctant to make any change in their current situation.

National currency or not, release of labor market from the grip of inflexibility has to happen and better earlier than later.

Mantenidis KostasApril 6th, 2012 at 9:25 am

I don't believe they gave mass loans at AAA rates, without a plan for the "next" day!
I agree that "the return to national currencies will not solve the problems with less pain than the alternative measure of income reduction" of the G.I.P.S countries.
Release of labor market from the grip of inflexibility has be done in Greece!
Self dependent, small, mid size businesses failed or are going to fail! No one is regurarly paid in the private sector!
A humanitarian drama, in slow motion, happens in "modern" Greece.

rodeneugenApril 6th, 2012 at 10:23 am

Agree 100%. I personally would put 99.9% retroactive tax on the last 10 years income of all the bankers and other financial oligarchs involved in BANKIZATION (synonym derived from nationalization) of financial recourses they used for personal bonuses and loans to irresponsible politicians, instead of using it to support real economy by giving credit to small and medium sized businesses, that as everybody knows are the main potential for real economic growth. Then probably they would understand what grievances they caused (without or as you say with intention) by their financial policy.

R. CoutinhoApril 8th, 2012 at 12:22 pm

According to MMT, the change to a national currency can definitely help. The government could issue money to pay for its needs. It would require taxes to be paid in that money–thus creating a demand. This permits the government to take in goods/services exactly what it needs. Next, the private sector of the economy would set up prices and wages based on the relative value of demand. If imports were limited (not sure if Greece could do this safely due to food requirements) then the goods and services within the country would reflect what Greece could produce (it would consume what it produced minus what the government needed).

If a net import of certain goods was needed, then Greece (or any other country) would have to find a way to create some net exports (which could include tourism). In the end, although this would require time and a serious reevaluation of what goods/services the people could afford, it would at least have the benefit of eliminating the destructive policy of having the nation try to pay back loans with interest while its people were producing less and less.

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emiliojosechavesApril 9th, 2012 at 10:37 pm

It seems to me that when euro was adopted the centerzone of the EU lost its capacity to extract free incomes from the peri-zone through manipulation of currency exchange rates (ERD). So they decided to compensate it by all the finantial tricks and floods of credits that generated the crisis among simple people, which decreased consumption, payment capacity and smaller tax payments, and fiscal deficits. Germany, France, Holland, et al, know that if they increase salaries they will loose part of their exports to the peri-zone of the EU and the rest of world. I do not see clear Roubini reasons and his solution project. I suppose that was the reason why UK did not enter the EU, and perhaps they are the designers of all this crisis.