How a Country Rationally Exits the Eurozone

Tue, Jul 24, 2012 - 9:46am

We are about to experience the Euro Exit Crisis.

Mish Shedlock and I have a private bet as to whether Italy or Spain will exit first—he says Italy, I say Spain. But either way, it’s gonna pretty much suck.

The whole point of exiting the eurozone is because a country no longer has the money to finance its continuing operations. Insofar as Spain, Greece and possibly Italy, that moment will arrive shortly—possibly within days in the case of Spain. So if a sovereign government reaches this moment, it will have no choice but to exit the EMU and revert to a local currency which the government can then devalue.

By doing this, the government simultaneously has all the cash it needs to continue operations, and also inflates away its debts. The private sector gets a shot of adrenaline insofar as foreign trade is concerned, because its goods and services become that much cheaper on the foreign markets. And the employment situation gets a boost, as those producers selling their cheap goods and services overseas begin to hire more workers to fulfill demand.

The downside is that the government gets shut out of foreign bond markets, its financial sector takes a huge hit, and prices for essential goods and services rise dramatically, hurting the poor, the lower middle-class, the elderly, and the unprepared.

Even with these negatives, though, a forced conversion and devaluation is a boon to bankrupt nations. It is, basically, a reset of the economy: And historical experience shows that though it hurts a lot in the short term, it helps to reignite an economy, and get the people moving once again. This has been true of the United States in 1933, Germany in 1948, Latin America in the 1980’s, Argentina and Uruguay in 2001.

But it’s crucial to understand both the sequence and the mechanics of the process, in order to be able to anticipate what will happen, and thus make sound investment choices.

Once the political decision to exit the EMU has been taken by a country’s leadership, this is what it has to do:

1. The government decrees the creation of a new local currency, and establishes its convertibility on a one-to-one basis with the euro. (Let’s call the new local currency the nueva peseta.)

2. The government makes these nuevas pesetas available to the local financial sector, and orders everyone to convert. Thus the local Central Bank takes all of the local banks’ euro-denominated deposits and converts them into nuevas pesetas. And all the local banks in turn convert their retail customers’ euros into nuevas pesetas as well—all of these conversions taking place on a one-to-one basis.

The government thus has exchanged all these newly minted nuevas pesetas it has created for euros—euros which are now in the government’s coffers.

3. At the same time as it obliges the financial sector to convert to the nueva peseta, the government by decree says that all local debts of the government are now to be paid in nuevas pesetas. Any euro-denominated bond or contract that the government signed is now automatically—and irrevocably—in nuevas pesetas. All pensions and government salaries are also in nuevas pesetas.

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