Can the euro omelette be unscrambled?

By Hugo Dixon
April 16, 2012

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.

17 comments

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Think hard-boiled

Posted by whyknot | Report as abusive

Finance did not create the inter-country endemic unemployment problems that have now gone on for decades. The European response to any problem is precisely what Reagan described as the natural response of liberals in this country: “If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”

No real surprise that Schumpeter moved to the U.S. and stayed here. No real surprise that Keynes didn’t.

Posted by ARJTurgot2 | Report as abusive

Suggesting that the EURO zone be unscrambled is like suggesting the US should also be prepared for the day when the US could separate the solvent states from the insolvent states and put them on separate currencies. New York city went into receivership for a few years during the Ford term. That put the city on a better footing but they didn’t decide to cut the city from the state or country or to quarantine it. NYC has a little over half the population of Greece The metro area is larger. And it still requires subsidies.

Greek austerity seems to be falling hardest on the lowest income people of Greece while the upper income groups – especially the uber rich – seem to be able to weather most financial stress and seem determined to keep that mega advantage. Since the major commotion passed (to be back for the May elections), there haven’t been any stories I noticed about attempts by the Greek Government to revise their own tax code. But I haven’t looked very hard either. Why don’t the Europeans write a suggested tax policy for Greece and see if that will be approved? Nothing I read suggested that they had done that. I read about spending cuts, wage cuts, land sales, utility privatization but nothing about revenue increases. It’s a small country and possibly not that complex?

You can’t unmake an omelet. If anything, it isn’t mixed enough. In a real omelet the yokes and whites are thoroughly combined and are filled with other ingredients. The yoke color dominates and the whites disappear. The EURO zone should have better contingency plans for under performing states that more resemble the bankruptcy protection laws we have. They would fall under Chapter 9, I believe?

What would be the difference between aiding a contiguous failing state (Greece isn’t a failing state but only runs short of Euro zone rules on indebtedness) from within or outside the zone? Once outside the EURO zone, what influence could Europe exert over Greece after it had slipped away? Europe would still feel it necessary to aid an area they could not afford to let become a Zimbabwe (the government prints money to keep it’s people employed and it turns to garbage)? Peace keeping forces aren’t cheap either. If conditions were bad enough and the Greek government was so corrupt that no attempt at domestic fiscal reform worked, how bad could it get? Very severe conditions will produce very severe attitudes. In a state of constant torture, a state could go crazy.

If it was happening here wouldn’t the desire be for the less populous and, very likely, more self sufficient states to want to sever themselves from the heavily populated and perpetually fiscally challenged bigger states? Don’t most of the states resemble the federal government in the kinds of fiscal problems they have?

Posted by paintcan | Report as abusive

Maybe there’s not much to gain by breaking up the eurozone, which is why it’s stuck together through its recent crises, even though the eurozone now looks like a great example of why political and fiscal union might want to precede monetary union. But since the eurozone already did it the other way around, it may be that the best option is to stick together for at least another decade.

Besides during the depths of a crisis, another good time to think about exiting might be during a period of stability, so in between, people can try to figure out how to make leaving the euro as graceful as possible. That is, instead of trying to reconstruct the eggs from the omelette, the eurozone would eat the omelette, try to digest it to gain some muscle, tend their chickens, and take care to eliminate the inevitable waste without soiling itself, however nauseating the metaphorical prospect may be. Then they can split up the farm, if they wish.

ARJTurgot2 – Looks like Keynes is still outperforming Hayek, Schumpeter and President Reagan. The US Treasury is now set to profit from the bailouts of finance and the auto industry (http://www.treasury.gov/resource-center  /data-chart-center/Documents/20120413_F inancialCrisisResponse.pdf).

President “Bobby”: Mr. Gardner, do you agree with Ben, or do you think that we can stimulate growth through temporary incentives?
[Long pause]
Chance the Gardener: As long as the roots are not severed, all is well. And all will be well in the garden.
President “Bobby”: In the garden.
Chance the Gardener: Yes. In the garden, growth has it seasons. First comes spring and summer, but then we have fall and winter. And then we get spring and summer again.
President “Bobby”: Spring and summer.
Chance the Gardener: Yes.
President “Bobby”: Then fall and winter.
Chance the Gardener: Yes.
Benjamin Rand: I think what our insightful young friend is saying is that we welcome the inevitable seasons of nature, but we’re upset by the seasons of our economy.
Chance the Gardener: Yes! There will be growth in the spring!
Benjamin Rand: Hmm!
Chance the Gardener: Hmm!
President “Bobby”: Hm. Well, Mr. Gardner, I must admit that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time.
[Benjamin Rand applauds]
President “Bobby”: I admire your good, solid sense. That’s precisely what we lack on Capitol Hill.

Posted by TobyONottoby | Report as abusive

paintcan,

Good points – but just a note on your slight against New York. New York City runs a huge budget that is often in the red. However the Federal Taxes that New York City contributes – both personal and business are a gigantic amount. Our small block in Manhattan alone probably has 5000 millionaires and businesses generating billions of dollars in revenue. The amount of money the city receives back from the Federal government is insignificant. While the rest of the country gets trillions to pay over highways, we cant get a federal funds to build another rail tunnel or god forbid get faster trains.

People forget that the total tax flow out of New York city is much much higher than the city spends on itself even in the bad 70′s. If you see a highway in Kansas a large part is paid by New York, If you see a tank in Iraq, a large part is paid by New York, If you need to clean up a toxic waste area near Detroit, most of the money comes from New York.

Please dont equate Greece with New York. Greece gives almost nothing to the EU.

Posted by John2244 | Report as abusive

@ARJTurgot2 – I enjoyed your comment and agree there is truth to it. Although you and I are obviously diametrically opposed in our economic perspective, there is a ying and yang (balance) to our disagreement. Thanks!

Posted by SeaWa | Report as abusive

Although Europe is indeed locked in the Euro prison today, is it possible that after decades more of financial and economic failure that Europe will emerge with true unification and this will be but a part their dark dismal unified history?

Without minimizing the catastrophic effects on real people today and while realizing that these problems will drive large scale cultural and political changes perhaps this is just a dark period that will be looked back upon as a renaissance.

Posted by SeaWa | Report as abusive

Keep thinking. An effective unilateral exit requires dictatorial powers which none of the Eurozone governments have. Chances are that an overnight economic power grab would simply end up being ruled unconstitutional. The possibility of a consensus breakup is unrealistic because it involves the countries agreeing on exit rates from EUR to the new currencies which would be impossible to agree on since by setting these rates value would be transferred across the countries. The entry rates to EUR were different since they rested on traded currency rates and there was a spirit of cooperation and exuberance. The divorce would not be such a happy affair.

That said, it is probably an illusion to think that an exit would solve anything that a simple default wouldn’t. A weak exchange rate would produce inflation, but not growth in countries that lack an industrial base and would need massive investment to build up exporting capability. Where would that investment come from after the massive default/redenomination of debt?

Chances are that there is no policy choice that involves less pain, just a choice between suffering massively in a short period or chronically over an extended period.

Posted by Rollo | Report as abusive

Eggs? Omelet? Nonsense. We are speaking of finance, not farming. The entire scheme of the Euro was flawed from the beginning, and the only solution would be a political union, which is not going to happen.

It is all going to fall apart, sooner or later (and I’m guessing sooner, as the southern countries encounter more and more social unrest); the costs of austerity are simply too high for the local populations. When it happens, the countries that have exercised more fiscal discipline will have some problems but recover rapidly, and the countries that have been prodigal will really suffer until they can recover their national currencies and economies.

The article is correct in saying that a structured departure would be preferable, but I don’t really think the political will is available for such a solution. If it had been, the Euro zone would never have gotten to this point.

Posted by stevedebi | Report as abusive

@SeaWa

For a good time research why the Burgundy regions of France can only grow Pinot Noir grapes (or Chardonnay). Losing market share, rather than de-regulate, they tapped the EU’s subsidies via the Common Agricultural Policy, and lost the market to Oregon, New Zealand, and anyone else that was able to innovate. Sadly, some of their best people understand exactly why they are getting creamed, but can’t do anything about. Check out the details of Hollande (and his ex-wife’s) economic plan and it’s something from the 1838 Commune.

Everyone sneered at Bush for his famous quote on there being no word in French for Entrepreneur, and completely missed his point.

Posted by ARJTurgot2 | Report as abusive

Agree with this article, but I believe the power which put the EU together is far greater than that which some suggest will pull it apart.
Behind the scenes, powerful people are orchestrating a world government, of which this is a pilot project meant to show the way.

Posted by mick68 | Report as abusive

Find a 5 or 7 year old entry level global Economics university text and the first chapter will sing the sweet song of the Euro… History only proves the obvious point…Economics is the new Alchemy. Talking heads spout ideas that time proves wrong, and the next day the same talking heads explain the new thesis. Individuals and groups act in their own self interest. Many Individuals and groups will lie, cheat, steal, and take what they want. Now you have a free Online Master’s Degree in Macro-Economics… the rest is rubbish.

Posted by Farkel4 | Report as abusive

John2244 – I’m not slighting New York. I just remember some of what was said at the time and it wasn’t kind. And a lot of the suggestions were stupid. Many non New Yorkers were talking about the city the way many talk about Greece today.

When New York City has fiscal problems, they are larger than many smaller countries. It’s “awesome”.

And I think I agree with Mick69 that a world government is on the way but I will probably not live long enough to see it. Sometimes I wonder if anyone will live long enough to see it? As long as it doesn’t turn into the first episode of Lexx, I’d probably think they were doing pretty good.

Posted by paintcan | Report as abusive

Scrambling or unscrambling is not really the issue here.
Although we keep focusing on the currency and the financial institutions the problem is structural.
Europe tried to get the best of both worlds.
They tried to keep national independence as much as possible but create a common market and currency so they could compete with the North American and Asian competitors for increased profit.
Although on selfish grounds, they started going in the right direction with the Union, and financial cooperation since our world is becoming more and more global, and interconnected, thus mutual cooperations lead to prosperity, success.
But there are no half measures. In an integral system either all elements work for the same purpose or none of them, and after the initial honeymoon period, while the constant growth machine was still working, the upswing covered the false foundations, but this is not the case any more.
No superficial, political or financial measures can help, only further integration, a true Union with a supra-national mutual/democratic structure.
Unscrambling, and separation is a dead end. In our global system no individual or nation is capable of going alone, sustaining itself, any such attempt would most likely lead to far right or far left leaderships and very volatile scenarios.

Posted by ZGHerm | Report as abusive

@ZGHerm – As you say, self-contradictory half-measures can’t work. It has to be either “all in”, with the EZ becoming a new “country” and the existing nation-states disappearing, or the Euro has to go – unscramble the egg.

Either one works, doesn’t it? But of course, citizens don’t care to see “their country” disappear, and pols pander to that impulse – with success. Euro elites want the opposite, and pander scare-stories of calamity if the Euro is scaled back.

If Germany and a few others left the EZ, it wouldn’t be the end of the world for those who depart, would it? If they did, then the Euro could be weakened to a level appropriate for the weak states that continue to use it, and they would not have to deal with the problem of recasting existing Euro-denominated obligations into another currency. ‘Course, it sucks if you’re a creditor on such an obligation – but somebody has to eat the loss – who better than the people who were dumb enough to lend good money to Greeks et.al.?

Posted by MrRFox | Report as abusive

My prior comment critical of Economics as a study as practiced was not allowed to be shown. Another truth of Economists as a whole… weak.

Posted by Farkel4 | Report as abusive

The Americans caused the GFC and now they will have to just put up with the fact that the EU is going to take a while to sort out its fiscal unity. The Euro will survive and the world is going to be using both the Euro and the Yuan for international trade, including the purchase of oil.

Posted by LMOB | Report as abusive