WSJ: How to Leave the Euro

4/7/2013

Abandoning the single currency doesn't have to be hellish.

By Ross McLeod*

The euro zone is full of stricken countries these days, yet near-hysteria usually greets the idea that these countries' best way forward would be to leave the currency bloc.

The great fear is that to reintroduce a national currency, a country would have to forcibly redenominate private assets and liabilities in the process. For firms, households and investors, uncertainty about whether their euros will eventually be confiscated and replaced with a debased national currency could lead to capital flight, economic chaos and years of litigation, if not worse.

But there is an alternative to forced redenomination. Greece or any other country in the euro zone could easily reintroduce a national currency without generating the kind of financial and economic calamity envisioned so far—provided it got the mechanics right.

The key is to fix the initial amount of new currency to be issued while allowing the market to set the price at which the exchange takes place. In this scenario, the central bank would announce that it is willing to purchase euros from domestic banks, the Greek public and anyone else, using newly issued drachmas as payment. All such transactions would take place during a specified transition period and be entirely voluntary. This would not be an exercise in confiscation.

After the transition period, the Greek government would deal only in drachmas in its day-to-day financial transactions. Nobody would be forced to hold drachmas, but those wishing to transact with the government would need drachmas to do so.

At the start of the transaction period, the central bank would announce the initial rate at which it offered to exchange drachmas for euros, but it would explicitly make no promise about what the rate will be in the future. The initial rate would be entirely arbitrary, as indeed would the name of the new currency.

But let's suppose they kept the same name and opted for, say, 360 drachmas per euro. This is close to the rate at which Greece adopted the euro and, along with the old name, would give the new currency a familiar feel. In economic terms, however, the initial rate is largely irrelevant.

The central bank would also promise to issue a precise amount of drachmas over the course of the transition period. This amount in our example would be 360 times the central bank's estimate of the total amount of euros held as cash by Greek residents and as clearing deposits by banks operating in Greece—that is to say, roughly the amount of currency in circulation in Greece.

The central bank would also fix the duration of the transition period. If for instance it were set at three years, or 36 months, then the central bank would announce that monthly sales of drachma for euros would be at least 1/36th of the total amount to be issued during the transition. The monthly rate might eventually be higher if the demand is strong enough—that is, if people quickly gained confidence in the new currency.

The price offered for euros would be adjusted on a daily basis to generate sales of euro to the central bank of the required magnitude. Sales on the first day may well be zero. But as the offered buying price increased, gradually some people would be willing to have a gamble. Eventually a price would be found at which there were significant demand for the new drachmas. People would be taking the risk that the price of euros will increase in the future—that is, that the new drachma will depreciate.

On the other hand, there would also be the possibility that the drachma will appreciate, in which case failure to unload one's stock of euros will imply a speculative capital gain forgone. There are always people willing to take such risks for the right price.

Once such a price were found, the flow of drachmas to the general public and banks would roughly match the envisaged minimum volume. As people began to realize that other people and financial institutions were willing to take the risk of buying this new financial asset—the future value of which could only be guessed at—more and more would be willing to take that risk. There may well be such strong demand that the offered price to buy euros could eventually be reduced.

It wouldn't really matter where the exchange rate ultimately settled. The central bank would be getting something (euros) for nothing (pieces of paper or metal carrying the label "drachma"). This is known as seigniorage.

Once there were sufficient drachmas in circulation, a market for exchanging drachmas for euros would develop alongside the central bank's "drachma window" and eventually take over. At that point Greece would be able to have an independent monetary policy again—for better or worse.

Returning to the drachma would not cure all of Greece's woes. The consequences of years of irresponsible fiscal policy, bad microeconomic policies and inadequate supervision of commercial banks cannot be put right simply by reintroducing a national currency.

But it's important to understand that abandoning the euro wouldn't unleash hell upon Greece, either. An orderly, market-based solution is available if and when the decision is made to pull the trigger.

* Mr. McLeod is an adjunct associate professor of economics at the Australian National University's Crawford School.

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