Thursday 25 October 2012

Grexit. Lessons from history.

The current Eurozone crisis is not unprecedented. In fact, Europe has seen a number of monetary unions in the past, some successful, others less so. History can teach us a lesson or two about the present. For instance, not many people know that Greece was already punished for misbehaving by being ejected from a monetary union – in 1908, from the so-called Latin Monetary Union (this perhaps should have given food for thought to the European Commission before they declared Greece fit for EMU membership in 2001).

The last monetary union formed in Europe prior to the introduction of the euro was the common currency zone of the Czech and Slovak Republics. It was created on 1st January 1993, in the wake of the break-up of Czechoslovakia. The two new nations embraced political independence but pledged to maintain close economic ties: customs union, common labor market, and, yes, common currency. In short, a mini-EMU, at a time when the real thing was still being discussed.

In the end, however, this mini-EMU turned out to be so short-lived that it didn’t even earn a name. Let’s call it therefore the Czech-Slovak Monetary Union, or CSMU.

When the rules for the EMU were laid down in the Maastricht Treaty, several features were notable by their absence. The Eurozone was to have no fiscal-insurance mechanism, no central bank supervisor and no political leadership with executive powers. In other words, it was designed to be an economic and monetary union, but not a fiscal union, banking union or political union. As it happens, this is exactly what the Czechs and Slovak had in mind for their monetary union. So what does the example of CSMU teach us about the prospects for the EMU?

Lesson 1: Both sound institutional design and strong political commitment are crucial. 

The CSMU was institutionally weak: besides having no fiscal-insurance mechanism and no common bank supervisor, it also lacked a common central bank. Instead, monetary policy was set by a central committee composed of equal number of representatives of each side: an institutional set-up that invites impasse. More importantly, the monetary union was announced as a potentially temporary measure: initially for six months, with the possibility of further extensions thereafter. Saying publicly that the end-point might be in sight invites investors (individual and institutional ones alike) to bet against the common currency. Not surprisingly, the investors took the cue and did the CSMU in: not in six months but in less than six weeks. It is worrying to see that European politicians are making the same mistake now by using the possibility of a Grexit as a bargaining chip. Again, investors are taking the cue: Greek (and Spanish) banks have been haemorrhaging deposits for months.

Lesson 2: Betting on the collapse of the common currency is cheap while the potential profits are huge. 

In the late 1992 and early 1993, Slovak households and firms sought to hedge against the possibility of the introduction of a new and weaker Slovak currency by converting deposits into hard currency or transferring them to Czech banks. They were rewarded by a handy profit of approximately 20 percent after the currency separation. For Greeks, betting on Grexit is even easier because they do not even have to transfer funds out of Greece: keeping their savings in paper currency rather than in banks will suffice. The cost of this is a trip to the bank, foregoing interest for a few weeks or months and renting a bank safe-deposit box (or keeping a stash of €500 bills in a shoe box at the bottom of one’s wardrobe). The risk is very low too: assuming the euro will continue circulating outside Greece, the value of €100 held in a shoebox will stay the same whereas €100 held in a Greek bank will be automatically converted to drachmas – and then devalued – if Grexit happens.

Lesson 3: Breaking-up is easy to do. 

The decision to disband the CSMU was announced in the evening of 2nd February 1993 (Tuesday). Payments between the two countries were suspended and border controls increased during the remainder of the week. No new coins and banknotes were issued during the changeover. Instead, each country distinguished the notes in circulation on its territory by means of a paper stamp affixed to the face of the banknote. Strict limits were imposed on the amount that individuals were allowed to convert in cash, thus ensuring that most currency was converted as bank balances. By Monday morning, 8th February, the two currencies were fully separate. Both countries continued using the same coins, and stamped banknotes, for considerable time: new coins and banknotes replaced the old Czechoslovak currency only gradually over the next six months.

In Greece, it is unlikely that much currency will be submitted for conversion into drachmas, given the incentive to hold on to euros until the new euro-drachma exchange rate is stabilized. This will make the task of the Bank of Greece easier but will pose an additional headache for the ECB which will need to deal with the influx of Greek euros. That is, unless the ECB can come up with some unconventional solution such as, for example, treating euros issued in Greece (those with serial numbers starting with a Y) as Greek currency not valid in the remainder of the Eurozone.

In summary, the prospect of a Grexit still looms large – and the Eurozone unraveling need not involve only Greece. The costs of betting against Greece staying in are small and the potential gains to individuals and investors from such bets so are large. If the situation becomes unsustainable – for instance, if Greece does not meet the conditions for another installment of the bailout package – the Grexit can be executed quickly and without much advance notice. To avert it, both the Greeks and their creditors in the rest of the Eurozone need to display more political commitment to pull through than so far. In the longer term, the Eurozone itself needs to be reformed. And this is my positive message to conclude this article: this crisis will hopefully serve as a catalyst for reform that will leave us with a better designed and more robust monetary union. Even if it may not count Greece among its members by the time the reform is over.

 Jan Fidrmuc