If you can't divorce, take a lover

South European know-how
for fixing divorce obstacles

The founders of the euro thought they were forging a rival to the American dollar. Instead they recreated a version of the gold standard (The Economist, Charlemagne column, April 7, 2012).
Gold or euro, if the problem is the same, so should be the solution... In two words: paper money.
The previous post argued that the euro was a mistake, and that time has come to talk about it. But such a discussion can only happen if it is based on the prospect of a solution. As the Economist points out: one reason the euro holds together is fear of financial and economic chaos on an unprecedented scale.
Such a fear may be widely exaggerated. A euro exit will not necessarily trigger chaos, but might instead reduce the risk of chaos. It does not have to be economically painful, and it does not even have to be a real exit, let alone a complete break-up.


First, let's look at the political implications of a euro break-up:

• In theory, members of the Eurozone are not allowed to exit the euro, or they would have to quit the European Union. This is unlikely. After the mandatory screaming and warnings, Brussels will accept whatever it takes to avoid a European implosion.
• A euro break-up would sanction the failure of the biggest European project so far. Obviously, it won't look good for the European construction. But it was an ill-conceived project from the start, and nothing threatens more the European Union right now than the current crisis. Politically, a euro break-up would be less damaging than further deterioration of the economic situation.

Economists tend to think of a break-up in the same fashion: the lesser of two evils. That may not be imaginative enough.
The standard view is that a country (call it Spain, for the sake of the example) could quit the euro by switching overnight to the peseta, possibly forcing the conversion of bank accounts and  internal debts, which would most likely result in a bank-run and further economic collapse (chaos). But it does not need to happen that way. That's the kind of things that happen when an economy is bankrupt and the currency must be sharply devalued (like in Argentina in 2001). Spain is in a very very different situation.

• Spain is not a failed economy. It experienced a housing bubble, its banks are over-indebted, and its labor regulations are notoriously rigid. But it's got schools, infrastructure and institutions. Its budget was balanced before the crisis, and it just experienced twenty years of robust growth (arguably a bit inflated by the euro in the early 00's).
• Spain needs to eventually restore its competitiveness, but more urgently, it needs a bit of cash.
• The euro is not a failed currency at all. In fact, it is rather strong and (on average, for the Eurozone as a whole) correctly valued.

So, it does indeed look like an old-fashion crisis, when gold was the standard. And the remedy might be the same as in the 19th century.

• Spain may well keep the euro as its main currency. But on top of that, it might print a few pesetas for the daily expenses its government is not able to finance through taxes.
• The peseta will be seen as a weak currency, but in a cash-strapped economy, that's better than no cash at all. Spaniards will rather receive their allowances in pesetas than see them cut. And they should have no problem spending them, as in a depressed economy merchants will prefer to get paid in pesetas than miss a trade.
• If the peseta needs a bit of help, there are ways to encourage its use, for example through a lower VAT rate for transactions held in peseta.
• Banks (especially near bankrupt Spanish ones) will have no choice than to accept pesetas in repayment of their loans.
• This should restore confidence in Spanish banks and put an end to austerity and its death-spiral effect. As Spain would be back on the growth track, the Spanish government would even increase its tax intake of euros. It could then slow down its printing of pesetas  (and possibly even withdraw some from the market).

Too good and too simple to be true? Let's look at three issues: conversion, inflation and competitiveness.

• Conversion is a good question. It would probably have to be restricted and kept at a par with the euro. As long as the euro remains the main currency, this should work.
• Inflation is more of a worry. A budget deficit in the area of 7% of GDP, entirely financed with money printing, would mean a significant increase of the monetary base in Spain. But until the economy reaches its equilibrium growth path again, inflation should remain moderate (authorized opinions would be welcome in this respect). In the worst case, only part of the deficit should be financed that way.
• Such a solution would not restore competitiveness by itself and structural reforms might still be necessary. At least, it would provide the breathing space for Spain to engage in such reforms.

Maybe I'm missing something. Maybe there is a serious flaw in this reasoning. But as John Kenneth Galbraith illustrated in Money, whence it came, where it went, the history of money is filled with innovative solutions that were first deemed too good to be true. And as Brad DeLong recently showed, there was a better understanding of monetary policy in the 19th century than today.


This said, it is clear that the introduction of a parallel currency requires some caution and credibility from the authorities that will conduct it. It is necessary that governmental debt is not already out of control, and that the economy is not structurally too weak. For those reasons, such a scheme has far better chances to succeed in Spain than in Greece.


Finally, unless the crisis is solved in some other providential way, this is something that is likely to happen, because there's no need of a deliberate political will to apply it. Read again the article, and replace peseta with IOU. The mechanism won't be too different.
When there is no money at all, IOU is the only way for the public authorities to keep functioning. In some areas of the USA or Europe, that time is near.