Solo run on currency would be economic suicide

This is an article published in the irish Times on Friday 6th August 2010.

Unless David McWilliams can refute this thesis, then his credibility is in shreds. I have come to the same conclusion as Mr Fell some time back and have written so here on January 11th this year.

SERIOUS MONEY: SOME POPULAR economists have championed solutions to our current economic woes that would prove catastrophic to the nation’s financial health. The nuclear option of a euro exit combined with sovereign default may make for good theatre, but it’s an awfully dumb solution, writes CHARLIE FELL

A decision to leave the euro and introduce a new currency would pose serious technical challenges and could not be done overnight. ATMs, cash registers and vending machines would all require reprogramming, which means that the impending changeover would be in the public domain. Businesses and households with domestic deposits would attempt to secure the value of their funds and move them offshore in anticipation of devaluation. The capital outflows could not be blocked by decree, since there is unrestricted capital movement in the EU. Thus, only an exorbitant rise in interest rates could prevent a banking system collapse.

The pressure on the banking system would result in a sizeable reduction in the availability of credit and economic recession would prove inevitable.
The shortage of credit would be aggravated by foreign creditors, who are likely to curtail lending to a probable defaulter ahead of a euro exit.
Additionally, both stocks and bonds would suffer a substantial decline in value, as investors adjusted their allocations ahead of the impending devaluation.

The reduction in capital market liquidity would mean that the corporate sector would be unable to secure either debt or equity financing at a reasonable rate. The economy would simply come to a standstill and a dire employment situation would deteriorate.

The new national currency could depreciate by as much as 50 per cent and the increase in the outstanding stock of euro-denominated debt would prove unbearable. The Government would have to introduce a new law that provided for the conversion of former euro debts into the new currency.

The redenomination of outstanding euro liabilities into the new currency would need to apply not just to government debt, but also to the borrowings of the banking, non-financial corporate and household sectors if a catastrophic decline in consumption and investment was to be avoided.

The redenomination of euro debts would undoubtedly be subjected to legal challenges, which could prove successful, while the de facto public and private sector default would shut the nation out of international financial markets.

Populist economists argue that capital markets have no memory and, consequently, that access to external borrowing would resume quickly. It is true that those countries that defaulted during the 1990s took an average of just 3½ months to regain market access after defaulting. However, the current external economic climate is hardly comparable to the 1990s.
Perhaps the 1980s average of 4½ years would prove to be a more appropriate benchmark.

It is also conceivable that once market access had been regained, new debt issues would be priced at a punitive rate as investors demanded a sizeable inflation and liquidity risk premium. History confirms that international financial markets do indeed have a memory; defaulters are typically awarded a lower credit rating and charged higher borrowing costs than non-defaulters of similar financial strength. The effect tends to be particularly pronounced for surprise defaults and small economies. Both characteristics would seem to apply to Ireland.

It is also unclear whether the competitive devaluation would provide sufficient impetus to the economy to even consider a euro exit.

First, a unilateral withdrawal from the single currency is a breach of the Maastricht Treaty and it is thus improbable that Ireland could continue as a fully functioning EU member. Foreign-owned businesses account for roughly 90 per cent of Irish exports and, without euro and EU membership, a substantial share of this business is likely to relocate elsewhere.

Second, the import content of Irish exports is the third highest in the OECD, behind Luxembourg and Hungary, such that a sharp fall in the purchasing power of the new currency and increase in import costs would limit the improvement in competitiveness.

Finally, the examples used to support the case for devaluation, including the relatively recent defaults in Argentina, Russia and Uruguay, provide little, if any, merit to the nuclear option. Each country benefited from high rates of import substitution, buoyant external demand and rising prices for commodity exports. None of these factors applies to the Irish case. There are no easy solutions to Ireland’s economic predicament, but the nuclear option is simply unthinkable and akin to economic suicide.