How exactly might weaker members of the euro zone, like Greece or Portugal, exit the currency bloc?
The economists at Capital Economics have been pounding the table, arguing it's all but inevitable that one or more countries will leave. Now, they've also done some creative thinking on how such a seemingly calamitous break up might be accomplished.
The firm believes Greece will likely leave this year, followed by Portugal and perhaps Ireland next year. Capital Economics thinks Spain and Italy will remain in the euro for now because authorities want to avoid the financial turmoil that would accompany the exit of those larger economies.
Even though Greece has received another bailout and the European Central Bank has been making money available to private banks through its longer term refinancing operations, these positive developments "have not solved the euro zone crisis," contends Jonathan Loynes, Capital's chief European economist.
The first step in leaving the zone will be to establish a new currency, a process known as redenomination in the economics profession. Capital Economics outlined how it sees that process working at conferences last week in a number of North American cities, including Toronto.
Jennifer McKeown, senior European economist at the firm, says one approach would be for a country to secretly print new currency, and then spring the change on the public. The drawback is that it would take a month to print up all the new money, and keeping such a radical move hushed up that long may be impossible.
Another approach would be to announce an immediate currency switchover and then wait for the currency to be printed up and distributed. In the meantime, banks would have to close to prevent a run by depositors seeking to withdraw their money. The economy would be forced to run on non-cash payments, such as credit cards, or keep on using the euro until the new currency is available.
The new currency would, of course, be subject to a massive devaluation, reflecting the very different levels of economic vigour within the euro zone. Capital Economics contends that this disparity in competitiveness is the basic problem with the currency bloc. The nations in trouble can't match the high levels of business prowess exhibited by Germany, so if they stay in the euro zone, they can restore competitiveness only through drastic cuts in wages and product costs. This adjustment would require years of painful deflation.
The economics firm figures that Greece and Portugal would need a slump of about 40 per cent in the value of a new currency to regain competitiveness. Spain and Italy would need new currencies to drop around 30 per cent, and Ireland around 15 per cent.
Drops of these magnitudes would spur economic growth in the troubled countries by making their exports more competitive and by forcing domestic consumers to cut down on imports. However, there are risks from such a large devaluation.
One is the danger that a cheaper currency would spark inflation. Ms. McKeown, though, says the troubled countries have so much economic slack as a result of recession that they might be able to dodge a lot of inflationary pressure.
A second problem facing the euro's weaker members is that their governments have lofty and unsustainable debt levels. They may have to default on their debts to restore their finances to levels their economies can support.
Capital Economics estimates that the total value of a Greek default would be a manageable 3 per cent of the euro zone's GDP, and Portugal's an even more modest 1 per cent of GDP. However, the amount of Italy's debt that would have to be written off equals about 11 per cent of the zone's GDP, suggesting that European policy makers will do everything they can to keep the country in the currency zone.