The NEWNEY approach to unscrambling the Euro

Catherine Dobbs

5 June 2012

Contents
1. The threat to the global economy ..................................................................................... 7 Very different economies in the eurozone This time might be different: a bigger shock than Lehman The need for a Plan B Yolk and White countries Possible endgames for the eurozone 7 13 17 18 18

2. Achieving an orderly exit through the NEWNEY approach............................................. 25 Assessing different approaches to the exit of one or more states from the Euro The impracticalities of a surprise redenomination The NEWNEY approach in concept Key steps in the NEWNEY process 25 28 31 36

3. Specific details on the NEWNEY approach .................................................................... 39 Setting the exchange ratio Allowing FX movements and getting the exchange to happen in practice Different monetary policies 40 45 49

Implications for private savings, domestic mortgages and international contracts 51 Implications for government debt The stability of the banking system The NEWNEY with more than 2 regions Applying NEWNEY with a phased exit or with a small initial exit 52 54 55 55

4. Winnings and losers, and the politics. ............................................................................... 58 Evaluating winners and losers The politics 58 61

Conclusions ........................................................................................................................... 65 Biography, contact details and acknowledgements .............................................................. 67

ii

Unscrambling the Euro

The bankruptcy of Lehman Brothers provides a pertinent lesson for the eurozone. Prior to the Lehman collapse, there were clearly substantial underlying problems with global debt levels in general, and with the subprime mortgage and housing market in particular. These problems would have been painful to work through in an orderly way, but the disorder in the financial markets that followed the collapse of Lehman, resulted in a seizing up of credit markets, and substantially greater impact on the global economy. It is evident that some of the problems around Lehmans collapse resulted from regulators and policymakers having had no contingency plan in place for how to deal with a situation such as Lehman, and how to prevent the domino effect as the loss of confidence shifted from Lehman to other financial institutions around the world. These other financial institutions, in turn, then faced a collapse in liquidity and so withdrew credit from their real economy customers. The reduction in lending and credit, especially in areas such as trade finance, slowed the real economy. This domino effect magnified the impact of the collapse of Lehman, resulting in a global credit contraction and loss of confidence, which in turn caused the first global recession since the Second World War. One or more member states leaving the eurozone, if this were to happen in a disorderly way could, as will be shown, be a five to ten times larger event for the global economy compared with the Lehman collapse1. There is an analogous domino effect to that seen with Lehman, with the exit from the eurozone of even one country. If one country leaves the eurozone, it will be clear that membership of the eurozone is not forever. And so financial markets, speculators, corporations, and even citizens could start anticipating which country could leave next. They would move deposits and assets out of financial institutions in what they perceive to be the countries that might exit next, resulting in a catastrophic loss of liquidity and credit in these domino countries. This loss of liquidity and credit could,

This paper in no way forecasts that any country will, or should leave the eurozone. It was written to contribute one idea to a debate on possible options should a country decide to leave.
1

in itself, precipitate the need for some of these domino countries to exit the eurozone as the ECB and other government mechanisms might be unable to provide sufficient liquidity through various firewall mechanisms to offset these speculative flows and even if they are able to provide sufficient liquidity, they might be unwilling politically to take the risk of loss of some of their commitment to the firewall, if a country were to exit eventually. The UKs exit from the ERM is a pertinent lesson in this regard: the Bank of Englands firewall was insufficient to offset the speculative flows which eventually drove the Pound out of the ERM, creating as loss for the Bank of England on the capital deployed in its firewall. At a minimum, these domino countries might need to introduce capital controls, which combined with the loss of credit, could result in a substantial reduction in economic growth for all the members of the eurozone, and the global economy. Whether the eurozone will or should remain together is beyond the scope of this paper. Indeed, it is hard to forecast, as it is may be more a question of politics than a question of economics. There are very strong economic and political forces pulling the Union apart and very strong economic benefits and political will keeping the Union together. Countries in the Union such as Greece need to restore their competitiveness, and a devaluation following an exit from the eurozone would be the natural way of providing the headroom for the structural changes in their labour markets needed to restore their competitiveness in the long run. Across the eurozone, there are political parties such as Syriza in Greece that will make this exit a core part of their economic election policy. But also core eurozone countries, such as Germany or the Netherlands, might become weary of making ongoing transfer payments to other countries in the Union, and the enduring moral hazard of repeated failures to meet austerity targets. All countries might grow concerned on the loss of sovereign authority involved in a move to a greater fiscal union. However, the eurozone has also delivered substantial benefits including the reduction in transaction costs and uncertainty that comes from currency volatility, and from lower interest rates. And some countries, such as Germany that in the early years of the eurozone took major steps to improve their productivity and

competitiveness, have subsequently benefited from a lower exchange rate than they would have had without their membership of the eurozone: a flight to a safe haven Deutschmark, and the consequential appreciation of that currency, would have undone some or all of the improvements in productivity and competitiveness though of course this appreciation would have made foreign goods cheaper for German consumers, and German consumers richer. In addition, the exit of several countries from the Euro could also completely devastate the banking system of the core countries, as a substantial part of the banking assets are held in the exiting counties and so would get devalued, while the banks liabilities (mainly deposits) will remain in the Euro. However, the eurozones policymakers face a dilemma. While an exit of one or more countries from the eurozone is by no means certain, policymakers need to develop a Plan B for how one or more countries could leave the eurozone so as to minimise the shock to the members of the eurozone and to the whole global economy. These are such uncharted waters, that they need to have a wide debate on options. But if they were to initiate a discussion of exit mechanisms, they run the risk of increasing the likelihood of exit by encouraging even more speculative flows. The debate on options by the Wolfson Economic Prize is therefore to be welcomed. Even if the right answer is to keep the Euro together, a debate on the elements of a Plan B is needed. Policymakers cannot run the risk that comes from the lack of preparation that occurred before the Lehman collapse. And indeed, the development of a plan B could also, paradoxically, support the Euro Zone remaining intact for two reasons. First, it could increase the pressure on all countries that benefit from the eurozone to work on their plans for keeping the eurozone together. Secondly, if the plan is such that there is no incentive for capital to flow out of countries that might exit, the risk of destabilising capital flows should be reduced. And as has been discussed, these destabilising capital flows themselves could result in a country being forced to exit the Euro, or bring about other fundamental changes in the eurozone such as the removal of the free flow of capital.

A badly managed process by which one or more country leaves the Economic Monetary Union is, therefore, in itself probably the biggest threat to the future growth and prosperity of the current membership of the eurozone. To contribute to the debate on a wider set of options, this paper comes at the problem from the perspective of an investor, and presents a very non-traditional way for how the economic processes could be managed to allow the orderly exit of one of more member states from the eurozone. This suggested approach borrows from that used by corporates with equity spinouts. It therefore removes much of the incentives for destabilising capital flows though some might still occur because of the risk of banking failures - so in fact could also support the eurozone remaining together. For reasons that will become apparent, this plan is called NEWNEY. At the heart of this plan is the NEWNEY Principle, namely that all Euros, wherever they are in the Union, get treated equally. And the exit of one or more countries is not viewed as an exit, but a split of the Union into a core region and a set of separating counties (or country). This paper builds on the unscrambling analogy2 to call these the White region and Yolk countries, where it is the Yolk countries that need to restore competitiveness through devaluation, and the White that are the core countries to the Euro3. The Yolk could clearly be a single country such as Greece or a set of countries such as Greece, Portugal, Ireland, and Spain. Each of the White region and Yolk countries would have their own central banks, monetary policies and currencies in this paper these currencies are called the New Euro-White (NEW) and the New EuroYolks (NEYs). The Yolk countries would be able to pursue a devaluation of their currency over time. This could be achieved

2 3

Many have used the omelette analogy. For instance, Wolfsons prize is impossible to win by Tim Harford, Undercover Economist October 21, 2011 Financial Times If you approach this as a fried egg analogy, you end up thinking of the core countries as the Yolk and the periphery countries as the White. However, as Tim Hartford (ibid) has pointed out, the Euro is more of an omelet than a fried egg. Its the sunny yolk countries that have too much cholesterol (debt) but maybe for some are a bit more yummy. The White countries are snowy, and some believe that we need to move to more of a lower cholesterol egg white omelet. For a detailed nutritionist discussion, see Hugo Dixons Reuters BreakingViews: http://www.reuters.com/video/2012/04/16/reuters-tv-breakingviews-can-the-euro-omelette-beu?videoId=233383502&videoChannel=117766
4

gradually without a run on their currency through higher interest rates and higher inflation. The transfer to the new currencies, and equal treatment of all Euros throughout the eurozone, can be achieved by the central banks agreeing that every existing Euro gets exchanged for a fixed combination of the two currencies, the New Euro-White (NEW) and the New Euro-Yolk (NEYs). As an example for a single country exiting, a Euro could get exchanged for 0.8 NEWs and 0.2 NEYs how this exchange ratio could be set is discussed later. As NEWs and NEYs become the legal tender, it would still be possible to determine the value of the old Euro denominated in NEWs or in NEYs from their relative exchange rate and the exchange ratio that was fixed at the start. This approach, therefore, allows for the automatic redenomination of currently Euro-denominated assets, contracts and liabilities. The equal treatment of all Euros removes the incentive for much of the speculative capital flows that could easily destabilise the eurozone though some could be triggered by the risk of country default. This full NEWNEY approach is designed for the exit of a number of countries. This paper also suggests a NEWNEY-lite approach that can be used for the exit of a small country such as Greece. This entry for the Wolfson Prize focuses on defining and detailing the execution of this NEWNEY approach. 4 The entry has been submitted with the intention of contributing to the debate for options around a Plan B that would allow one or more countries to leave the eurozone in an orderly way, and so as to prevent Lehman type shocks to the global credit system. It is important to stress that it does not suggest that the break-up of the eurozone is in any way desirable or inevitable. Indeed that is a decision for the people and politicians of the eurozone, and, as Vince Cable has pointed out, it is not inappropriate for someone from Britain to be seen lecturing the countries of the eurozone on how to run their economies. However, a Plan B is needed so that if a transition becomes required, it can
4 A number of others have described approaches with some similarities to NEWNEY. These include: I'm claiming the 250,000 Wolfson prize for how to break-up the Euro by Jeremy Warner, Daily Telegraph 6 January 2012. Why we must break up a failing Euro by Martin Jacomb, Financial Times May 23 2012. Olaf L. Mueller: "Eine Zentrifuge fuer den Euro". Neue Zuercher Zeitung NZZ No. 37 (February 14th, 2012), p. 19.
5

be managed so as to provide a minimum impact on European and global growth and welfare. The NEWNEY approach in this paper provides some components that could be included in this plan, as a contribution to the debate. But the NEWNEY approach could also support the eurozone remaining together as it reduces the risk of speculative capital flows that could destabilize the Union. So paradoxically, a plan that would allow a member state to leave the eurozone, could allow the Union to remain together. The real power of NEWNEY might come from it never being used.

1. The threat to the global economy

There are substantial tensions inherent in the eurozone that raise serious doubts on whether the Union can remain together in its current form. Capital outflows from some of the southern countries are at the moment containable, but these flows could become a flood that could in the end force a country or countries to leave the union. However, a precipitous exit of one of more players from the Union could result in a major shock to the global economy, a shock that is orders of magnitude larger than the collapse of Lehman Brothers. Therefore, policymakers need to develop a plan for how an exit could be managed in an orderly way and how the capital outflows can be managed. This chapter explores the tensions inherent in the eurozone, the risks of a disorderly exit, and explains why a Plan B that could allow an exit of one or more countries is needed. It also lays out some possible endgames for the Union, which while they are outside the direct scope of the Wolfson Economics Prize question, are a necessary ingredient to solving the political aspects of the process of separation which are in the scope of the prize.
Very different economies in the eurozone

There were clearly substantial differences between the economies and monetary policies of the Euro countries before the creation of the eurozone. Probably the most substantial difference was around differences in educational levels and demographics, but also their approach to productivity, currency depreciation and inflation. As can be seen from Chart 1, Germany historically retained competitiveness despite a strong currency through productivity growth and low wage inflation. At the other end of the spectrum, Greece, prior to their entry into the Euro, had higher wage inflation but remained relatively competitive through a long run depreciation of the drachma. Other countries such as Italy and Spain had higher currency depreciation than Germany and this also allowed higher wage inflation, without loss of competitiveness.

The creation of the eurozone on the 31 December 1998,5 changed this situation. The Euro no longer depreciated at the historic rate seen by the Drachma, Lira, Peseta, or the Escudo. However wage inflation in many of these countries remained more in line with the historic rates that workers, managers and the government had grown up with. While Germany was undertaking the difficult steps (Gerhard Schrder puts his 2005 election loss down to the unpopularity of these measures) to increase their productivity and competitiveness in the earlier years of the Euro, many other countries did not. From 2000 to 2010 German unit labour costs only increased around 2% while those in Greece, Italy and Spain increased by nearly 30%.6
CHART 1

45 40 35 30 25 20 15 10

Sources: Oanda; OECD

With the benefit of hindsight, it is clear that the introduction of the eurozone was not accompanied by the required changes in attitude and mindset on inflation, productivity and wages across all of the eurozone, and the introduction of the required programmes to improve productivity and competitiveness. Labour mobility is still limited. Ten years later the competitiveness of the southern countries
5 6 While the Euro notes and coins were not introduced until January 2002, two years later, the exchange rates between countries were locked on the 31 December 1998. Wage data from OECD dataset.
8

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in the eurozone, in particular, has substantially deteriorated. Their governments have been able to take up some of the slack (or avoid the immediate need for structural change and productivity improvements) by borrowing more, taking advantage of the lower interest rates and easy credit that have come from their membership of the Euro. The growth in government debt for these countries is illustrated in Chart 2. However, it isnt just governments that borrowed. Household debt has also risen. For example, in 2000 Greek household debt was around 10% of GDP, but by 2010 this had risen to 60%. Portugals household debt in the same period rose from around 55% of GDP to around 95%.7
CHART 2
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While this sudden growth in debt masked underlying productivity issues for a while, it is clear that southern European economies are now suffering from a loss of competitiveness, increased government deficits and high unemployment. In Greece and Spain, for instance, unemployment is running at around 19% and 23% respectively compared to around 10% for the EU as a whole. 8 The financial

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Sources: ECB Statistics Pocket Book

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markets and credit rating agencies have lost confidence in some governments ability to repay debt, making the cost of raising new debt very high and even maintaining existing debt levels very expensive. And some governments have become reliant on transfer payments and guarantees from the northern countries, as well as the European Central Bank buying their sovereign debt and funding their foreign exchange reserves, often indirectly through the banking system and the Target 2 interbank payment system. The experience of developing countries has shown that devaluation is not, in itself, a growth strategy. It purchases competitiveness by making the country poorer and so in the long run is not a substitute for productivity growth as a source of competitiveness. But it can help in some situations to restore competiveness. It is clear that a number of the eurozone southern countries could benefit from the improved competitiveness that could come from a devaluation of their currencies, if they were to leave the eurozone. A devaluation via an exit would allow competitiveness to be restored more quickly than through an combination of internal devaluation and austerity programmes, and so could help restore growth and reduce unemployment. But this only works if wage inflation does not erode any benefits in terms of external competitiveness. An exit could also help address government deficits and debt levels because growth would be restored though their deficit and indebtedness would also be dependent on the treatment of their sovereign debt in the restructuring around their exit, and their eventual creditworthiness. Contrary to popular belief, it would not allow debt levels to be reduced by printing money as in the long term this will result in higher interest costs. 9 While there are benefits from some countries exiting the Union and devaluing their currency, there are also continued substantial benefits to be gained from the eurozone remaining together. Transaction costs and uncertainty that comes from currency volatility is reduced substantially. Various estimates put the increase in trade that resulted from the Euro at around Euro 100 to Euro 300

See The euro: love it of leave it? By Barry Eichengreen, VOX 4 May 2010.
10

billion per annum10. Capital has flowed much more between Euro countries than prior to the Union as a result of the near removal of exchange rate risks within the eurozone. This capital flow has helped contribute to lower interest rates, on average, across the eurozone. And in recent years, some countries such as Germany have benefited from the competitiveness that came from a lower exchange rate than they would have had without the eurozone. As the Boston Consulting Group points out: Germany, where unemployment has fallen steadily despite the recession and debt crisis, presents a relatively positive picture within Europe. By holding wages steady, rather than raising them, the country has improved its competitiveness without increasing unemployment.11 But it seems certain that in a non eurozone world, the Deutschmark would have strengthened considerably, given the productivity improvements achieved in earlier years on the Euro. In this, it is pertinent to look at the performance of those other currencies that are viewed as safe havens. From August 2008 to the end of 2011, the Swiss Franc outperformed the Euro by 32%, though the Swiss Franc has subsequently weakened as a result of the recent government announcements and intervention. The Japanese Yen, another perceived safe haven currency strengthened by 54% in this period against the Euro, despite considerable domestic problems including a debt to GDP ratio of 220% and a declining population. Gold has also strengthened by 125% when valued in Euros. If the Deutschemark had still been in existence, it is likely to have substantially appreciated, hurting the competitiveness of German exporters. German exports would likely have been reduced by hundreds of billions of Euros12 if they had retained the Deutschmark currency and this currency had appreciated in this way, though clearly the wealth of Germany would have also benefited from a stronger currency.

10 See The Euro's Trade Effects, Richard E. Baldwin (2006) 11 Tracking Consumers Through Europes Debt Crisis by Ivan Bascle, Camille Egloff, and Catherine Roche, BCG May 17, 2012 12 Authors estimate.
11

The benefits from holding the eurozone together might well be sufficient to compensate for the costs and lack of competitiveness of some of the members. Indeed, the competitiveness of the southern countries could be restored though austerity, salary cuts, other internal devaluation, productivity programmes and potentially a more Euro inflation, especially in the core countries. Germanys experience in the earlier years of the Euro has shown that it is possible to achieve this productivity improvement though structural change, though they did have a much healthier global economic environment when they did this. The ongoing transfer payments, largely from Germany to the southern countries could be viewed as good value for the competitiveness the eurozone brings German exporters from a weaker exchange rate, as well as the benefits from a reduction in volatility and the associated transaction costs, even if they perpetuate a defective growth model and change the incentives for the countries receiving the payments. In addition, any separation is bound to be expensive and a major distraction. Talk of it is already causing massive market volatility and reducing investment. The value that comes from the avoidance of the pain and cost of separation is significant. But the tensions of the loss of competitiveness of the southern member states and the political cost of these transfer payments will be substantial Countries such as Greece the over 40% gap in competitiveness measures such as GDP per hour worked compared to Germany would be a long and painful process to close fully. The German experience also showed that structural changes can be detrimental politically, with the German Chancellor Gerhard Schrder now saying that he believes he lost his job because of the programmes. 13. How this plays out will be more of a political process than an economic process. As a result it is hard to forecast. Will the voters of all the southern countries accept the path of austerity, wage reductions and unemployment or could populist candidates get elected in one of more country on a platform of an exit from the Euro, a devaluation, and maybe a default on some sovereign debt? Will the
13 Interview with Robert Peston on The Great Euro Crash. BBC
12

voters in the northern countries accept the ongoing need to subsidise countries in the south? And be prepared to accept them missing their targets? Will the leaders of the core countries, be prepared to abandon the political capital they have already spent as well the capital tied up in the various firewalls. Will the voters of the eurozone understand the pros and cons of different options? How will the relationship between the leaders of the different countries evolve in terms of working together? How will all of these issues play out in the coalition governments that exist in a number of countries?
CHART 3

Note: The Intrade volumes are relatively thin in this market. SOURCE: www.intrade.com

Given all of this, there is a substantial risk that one or more country could decide to exit the eurozone. And indeed, the prediction market, Intrade now puts at around 65% the probability that one or more country will announce its intention of leaving before the end of 2014 see chart 3.
This time might be different: a bigger shock than Lehman

There have been many examples of other countries leaving monetary unions or the break up of the other currency unions. Indeed a

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number of the other entrants to the Wolfson Economics Prize have done a phenomenal job at documenting these. 14 However, the challenges of the eurozone are of a different proportional order of magnitude than these historic examples because of the relative scale of the eurozone and extent of the interconnection with the global economy. Lets look at some back of the envelope numbers to get some sense of the scale. In 1992, Czechoslovakia represented around 0.4% of global GDP. In 1913 (i.e., before the destruction of the First World War), the AustroHungarian Empire was around 5% of global GDP though clearly by the time the currency union was dissolved the First World War had bought a degree of additional chaos to their economy. While Greece today at around 0.4% of global GDP could be considered analogous to Czechoslovakia, the eurozone as a whole now represents over 20% of global GDP, so 4 times the war shattered Austro-Hungarian Empire and 50 times the Velvet Revolution of the Czechoslovakia break up.15 In addition, the global economy has become much more linked. Angus Maddisons research shows that for the last two centuries, global trade volumes have grown roughly 1.7% faster than growth in global GDP.16 This would suggest that the global trade to GDP ratio will have risen by around a factor of 4 since the Austro-Hungarian Empire dissolution. And a similar increased linkage comes from cross border capital flows. In 1980 (which is the first year we can get data), cross border capital flows were around 4% of global GDP. By 2005 these had reached 15%. Similarly the stock of foreign investment assets (i.e., assets held cross border) has grown considerably. In 1990, foreign investment assets were around $10 trillion or around 55% of global GDP. By 2010, this had increased by nearly a factor of ten to $96

14 For instance see A Primer on the Euro Breakup: Default, Exit and Devaluation as the Optimal Solution by Jonathan Tepper, Wolfson Economics Prize entry, April 2012. Available from policyexchange.org.uk 15 The calculations are very approximate and draw data from Paul Bairochs Europe's Gross National Product: 18001975; the IMF; and Angus Maddisons Contours of the World Economy, 12030 AD. Essays in Macro-Economic History; and the IMFs Report for Selected Countries and Subjects. 16 We have been unable to find country specific numbers so are using global numbers as an estimate. Numbers are from Angus Maddsions Growth and Interaction in the World Economy.
14

trillion, or 160% of global GDP. 17 So in 20 years, the foreign investment assets to GDP rose by a factor of 3. If this rate of change had been maintained (and this is a big if), over 90 years this would have increase by over 100. So the eurozone is at least 4-50 times larger and could be 4-100 times more linked, both as a proportion of global GDP, to the rest of the global economy than other currency unions that have been dissolved. It is therefore clear that one or more member states leaving the European Monetary Union in a disorderly way could be an orders of magnitude larger shock for the global economy than the exit from previous monetary unions.
CHART 4

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1 The comparison is made to illustrate the scale of the shock but is not an exact like for like comparison. Not all of Lehmans assets were exposed to bankruptcy because of netting, and not all of the countries cross border debt will be exposed to redenomination as there might be matching assets. The analysis assumes approximately 30% of total debt as of Q2 2011 is held cross-border for Greece, Ireland, Italy, Portugal and Spain and that 90 days of annual export and import contracts are at risk before contracts are renegotiated. The 30% cross border assumption is based on EBAs estimate that around 30% of Greek sovereign debt and interbank lending is held by overseas banks, and around 40% of sovereign debt for Ireland and Portugal. Detailed cross-border debt data is generally not available. These are the authors assumptions for this comparison. You can make your own but the message remains similar with most assumptions. 2 As of May 2008, Lehman Brothers had $639.4 billion of assets, $613.2 billion of liabilities and $26.3 billion of equity. Sources: Data from McKinsey Global Institute; national sources; Lehman Brothers 10Q filings May 2008; author analysis

Indeed, an exit could also be an order of magnitude shock to the global economy compared with the Lehman collapse. While the comparison is not exact, the outstanding contracts Lehman had at the point of collapse can be compared to a rough estimate of the size of cross border sovereign, financial institutions, corporate and household debt, as well as three month of imports and export contracts. This debt and these import and export contracts would be
17 Data from McKinsey Global Institute, Mapping the Global Capital Markets 2011.
15

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exposed to changes in value, and uncertainty on their value, as one or more member state leaves the European Monetary Union, and their unit of exchange gets renegotiated. This is analogous to the Lehman contracts that were exposed to changes in value, and the corresponding uncertainly because of the Lehman bankruptcy. Chart 4 compares, as an illustration, the value of outstanding debt and an estimate of what might be the existing import and export contracts that are exposed to changes in value the footnote explains the basis for the comparison. This rough estimate suggests that even a small economy in the eurozone such as Greece has existing debt, and import and export contracts that could be around half the size of Lehmans contracts. For Italy, this number would be 3 to 4 times the size of Lehmans contracts. If Portugal, Ireland, Italy and Spain are also included, their cross border debt and import and export contracts could be as much as 7 to 8 times the Lehman contracts. An exit of one or more of these countries from the Euro, would make all of this cross border debt and import and export contracts potentially open for renegotiation, raising questions on the solvency of financial institutions and corporations outside the exiting country. This risk is clearly particularly acute for financial institutions in countries such as France and Germany which have largely domestic liabilities but disproportionately the southern countries sovereign and other debt as assets. But all European banks and other financial institutions are exposed to cross border interbank lending and sovereign debt. The EBA estimated that around 30% of Greek sovereign debt and interbank lending is held by overseas banks. And that this number is around 40% for sovereign debt for Ireland and Portugal. 18 The exit and disorderly devaluation of one country could impact the solvency of financial institutions in other countries. But with the Lehman collapse, there was another problem. At the time, it was unclear whether the solvency of some of Lehmans counterparties had been impacted by Lehmans collapse. And Lehmans collapse itself raised issues on the viability and business models of other players. These two factors resulted in a domino
18 European banking authority, 2011 EU-wide stress test, aggregate report
16

effect as the loss of confidence shifted from Lehman to other financial institutions around the world. These other financial institutions, in turn, then faced a collapse in liquidity and so withdrew credit from their real economy customers, especially in areas such as trade finance. This domino effect magnified the impact of the collapse of Lehman, resulting in a global credit contraction and loss of confidence which in turn caused the first global recession since the Second World War. The exit of one country from the eurozone could have a similar domino effect. If one country leaves the eurozone, financial markets, speculators, corporations, and even citizens could start anticipating which country could leave next. They would move deposits and assets out of financial institutions in what they perceive to be a country that might exit next, resulting in a catastrophic loss of liquidity and credit in these domino countries.
The need for a Plan B

Prior to the Lehman collapse, there were clearly substantial underlying problems with global debt levels in general, and with the subprime mortgage and housing market in particular. These problems would have been painful to work through in an orderly way, but the disorder in the financial markets from the collapse of Lehman, resulted in a seizing up of credit markets, and so had substantially greater impact on the global economy than would have come from an orderly work out of the underlying problems. It is evident that part of the problems during the Lehman collapse resulted from regulators and policymakers having no contingency plan in place for how to deal with a situation such as Lehman, and how to prevent the domino effect as the loss of confidence shifted from Lehman to other financial institutions around the world. This domino effect magnified the impact of the collapse of Lehman, resulting in a global credit contraction, near collapse of the global payments system and loss of confidence. As has been shown, the exit of one of more countries from the eurozone could be or orders of magnitude larger event for the global economy. As such, a disorderly break up, beyond, say, the exit of
17

small country such as Greece, cannot be allowed to happen. Policy makers need to have a Plan B for how an exit can be managed.
Yolk and White countries

In line with the wording of the Wolfson Prize Question, this entry also does not take a view on which countries could be likely candidates to leave the eurozone, though the analysis above shows which countries could benefit most from a devaluation of their currency to restore competitiveness. Indeed which countries are likely to leave could be determined as much by domestic politics, success of austerity programmes and internal devaluation (including those that reset wage levels to better align to productivity levels) and inter government relations within the eurozone, as it will be by fundamental economics. As a labelling convention, this paper draws from the unscrambling the omelette analogy to use the label Yolk to describe the countries, or single country that leave/leaves the eurozone. And White for those that remain inside the Union. The assumption is that Yolk-zone countries or country are those that require a external devaluation to restore their competitiveness, while White-zone countries are those that are already competitive or that have a chance of restoring their competitiveness through austerity programmes. This paper starts by considering the case of a single country leaving, and then extends the approach to multiple countries leaving. And the paper also tests whether the approaches could work in several phases so for instance one country leaves and at a subsequent point another country leaves, though clearly the uncertainty and costs of a repeat exercise will be higher with a two stage process.
Possible endgames for the eurozone

The Wolfson Economics Prize deliberately does not ask whether countries should leave the Euro, or which countries should leave. Indeed, the decision on any exit depends as much on the political negotiation between countries as on the economics of the Union. As such, a discussion of the different end games for the eurozone is outside the direct scope of this entry. However it is necessary to lay
18

out some possible endgames as these can inform some of the later analysis on how the political processes can be managed around any exit. There are three equilibrium endgames for the eurozone and a potential unstable scenario. 1. Greater fiscal union. Much of the current commentary on the eurozone crisis masks an important fact: the current eurozone crisis is a eurozone political leadership crisis and not an inherent crisis of the overall economics of the eurozone. The eurozone in aggregate has a current account balance, fiscal balance and debt levels significantly better then the US, Japan or the UK (with the exception of Japans current account balance). None of these countries are experiencing problems of a similar magnitude. Indeed, various research efforts have highlighted how the benefits of the Euro in aggregate offset the costs. These research efforts include an estimate of an annual benefit of over Euro300 billion. However much of these research efforts, also show that the individual eurozone countries received very different shares of the benefits, with almost half of the benefits accruing to Germany. 19 A more equitable sharing of the benefits could increase the chances of the eurozone to remaining together, but this will require a grand bargain that Germany, France and other Euro countries were not willing to strike prior to the introduction of the Euro. Germany would have to pay a lot more than it wanted; France and other countries will have to concede a lot more sovereignty than they wanted. On the Fiscal (paying) side Germany will probably have to accept some type of joint and severable liability for the whole of the eurozone. Given their perceptions of the historic irresponsibility of some Yolk countries, especially Greeces history of defaults, it will be a tall order for the White countries politicians to convince their electorates to accept additional liability. Indeed, one of the key questions for this equilibrium is whether there will be a German
19: Euro Benefits Germany More Than Others in Zone by Floyd Norris, New York Times, April 22, 2011; Germany and the Benefits of the Euro by Antonio Fatas; Germany cashes in on Euro benefits, for now by Annika Breidthardt, Reuters.
19

political leader with the courage to put his or her survival on the underwriting of the firewalls and introduction of transfer payments. There will be a concern in the White countries that the Yolk countries could turn into an even bigger bottomless pit as Southern Italy has been for Italy since the Italian monetary and fiscal union in the 19th century. And that they are facing classical political moral hazard that might get worse if they are bailed out. As such the introduction of Eurobonds, and changes of the ECB statues to allow the ECB to act as lender of last resort could be tough to achieve politically even in a fiscal union at least until there is further progress on rebalancing in Italy and Spain. It might be easier to introduce a banking union, including eurozone-wide deposit insurance and bank resolution and supervision, and through targeted transfer payments that can be withheld if conditions are not met. 20 In addition, the pace of internal devaluation could be accelerated though higher eurozone inflation, and further debt relief for Yolk countries. Finally, a growth compact could be introduced with some relaxation of the current austerity measures in place for Yolk countries and the introduction of levels of transfer payments between the White countries and the Yolk countries in line with those seen in the other fiscal unions such as the United States. As the analysis by Zsolt Darvas in Chart 5 shows, the transfer payments made between similar US regions are around 10 times as large as currently exist between similar regions in the EU.21 A back of the envelope calculation would suggest that in a Fiscal transfer union of the same scale as the United States, Germany would need to make transfer payments of around 4% of GDP, equivalent to Euro100billion every year. On the back of the same envelope, Germany would still benefit from the Euro by around Euro50billion a year, so these transfer payments could be justified economically.

20 For a discussion, see Euro bonds wont cure what ails Europe, by Kotz, Krahnen and Leuz. 21 Note this analysis was done for the EU and not the eurozone. Fiscal federalism in crisis: lessons for Europe from the US by Zsolt Darvas, Bruegel Policy Contribution, July 2010
20

CHART 5
snoiger SU snoiger UE

-2

-4 60
Note:

65

70

75

80

85

90

95

100

105

110

115

120

125

In exchange for this, on the Union (sovereignty) side, France and Yolk countries will have to accept the surrender of most national fiscal sovereignty to Brussels with the introduction of some type of eurozone finance ministry, with the right to reject national budgets, supervision of structural reforms (labour markets, public sector, tax collection, etc.) and enshrinement of no/low deficit laws in national constitutions. While both of these might sound hard to achieve, the political capital that the eurozone elite has invested in the Euro should not be underestimated. It is difficult for many outside the eurozone to understand how a project with such unclear economic benefits and evaluation at the start, could have attracted so much support. But even now with all the turbulence, surveys show that 50 70% of eurozone citizens want to keep the Euro 22 . For many eurozone citizens the Euro still feels like the right historic step in the right direction. 2. A smaller fiscal union. The second possible equilibrium end game would involve most or all of the Yolk countries reverting to their
22 Euro Isnt Loved, but Few Want to Drop It, Poll Says by Paul Geitner, New York Times, reporting the Pew Reseach Centres Global Attitude Project.
21

PPP ta atipac rep PDG

001 = UE ro 001 = SU

CEE10: Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia; MED5: Cyprus, Greece, Malta, Spain, and Portugal; UK&IE: Ireland and the United Kingdom; NORD3: Denmark, Finland, and Sweden; ABLN4: Austria, Belgium, Luxembourg, and the Netherlands; Italy (IT), France (FR) and Germany (DE) are shown separately; Gradients of lines are -0.002 and -0.002. SOURCE: Fiscal federalism in crisis: lessons for Europe from the US by by Zsolt Darvas

4NLBA

dnalgnE weN citnaltA elddiM

3DRON ED

UE eht htiiiiw derapmoc snoiiiiger neewteb UE eht ht w derapmoc sno ger neewteb UE eht ht w derapmoc sno ger neewteb UE eht ht w derapmoc sno ger neewteb stnemyap refsnart eht sem t 01 dnuora sekam SU ehT stnemyap refsnart eht sem t 01 dnuora sekam SU ehT stnemyap refsnart eht semiiiit 01 dnuora sekam SU ehT stnemyap refsnart eht sem t 01 dnuora sekam SU ehT
0

EI&KU

UE eht dna snoiger SU rojam neewteb noitubirtsider lacsif fo nosirapmoC

6 4 2

5DEM lartneC htroN tseW niatnuoM citnaltA htuoS

RF

lartneC htroN tsaE

cificaP

TI

lartneC htuoS tsaE lartneC htuoS tseW 01EEC

130 135

PDG %

own national currency, with a core group of White countries remaining in a fiscal and monetary union. Others have written on what might be a sensible set of countries in this group building off Robert Mundells work on Monetary Unions, but this is outside the scope of the Wolfson Economics Prize question. The main uncertainty that this research raises, would seem to be whether France would want to remain in this union and this is more a question of politics than economics. 23 3. Revert to national currencies. This third possible equilibrium endgame would involve all countries reverting to their individual national currencies. Some believe that this abandonment of the Euro is the only end game if a single country were to leave. 24 4. Single country exit or perhaps Picking them off gradually. This path would start with say Greece leaving the Euro, and the rest of the eurozone trying to move towards some type of fiscal union. However, it is really unclear whether this can be a stable equilibrium once it is shown that the Euro is not forever. As Martin Wolf put it so ever eloquently in the Financial Times: the eurozone either is an irrevocable currency union or it is not. If Greece goes: An exit is likely to shatter faith in the eurozones integrity for ever and the Euro is then an exceptionally fixed-currency system.25 And we know that fixed-currency systems can come under attack with the weight of speculative capital flows potentially forcing other countries to leave, in the same way that the UK was forced out of the ERM. How might this play out? Following a Greece exit and devaluation, companies, financial institutions and more market-savvy individuals are likely to fear a possible departure of a number of other countries, the redenomination of bank accounts and bonds and a subsequent devaluation. They would therefore move their deposits and financial assets from the countries concerned to either Germany or outside the eurozone entirely. This outflow of capital, which has already started
23 See appendix Leaving the Euro: A practical guide by Roger Bootle and Mark Pragnell, Wolfson Economics Prize entry, April 2012. Available from policyexchange.org.uk 24 See Jens Nordvig and Neil Records Wolfson Economics Prize entries, April 2012. Available from policyexchange.org.uk 25 A permanent precedent by Martin Wolf, Financial Times, May 17, 2012
22

(the so called bank jog), could start to restrict the very investment needed by these countries to move from austerity to growth. While the eurozone firewall might be sufficient to offset capital flight for a country the size of Greece, it is less clear that the ECB and the White countries could offset a similar exodus for countries nearly ten times the size such as Spain or Italy, especially if an earlier exit by Greece had shown that the Euro is not forever. In addition, the earlier exit of Greece would have made very transparent the cost of any exit to the ECB and core eurozone countries given their substantial existing exposure though the European Financial Stability Facility, the European Financial Stabilisation Mechanism, Emergency Liquidity Assistance, and the Target 2 net claims of national central banks. The losses made by the Bank of England in supporting the Pounds peg in the ERM in 1992 are a cautionary warning in this regard. So any ECB plans to create a larger firewall, would face extreme political scrutiny from countries at the core of the eurozone such as Germany and the Netherlands. It is unclear that a further increase in core countries exposure to the risk of a further exit would pass the Bild test of political acceptability in those economies. So without a sufficiently large firewall, the exodus of capital from other Yolk countries could end up forcing them out of the eurozone. Hence it is unclear that this case is a stable equilibrium endgame. A likely (and unfortunately lethal) escalation of this would be Greece, followed by Portugal, then Spain, then Italy. Greeces exit from the eurozone would prove that the eurozone is not an irrevocable currency union. The next country in line for devaluation (Portugal), would be escorted to the exit by the markets. Spain would follow due to its banks exposure to Portugal - but only after the eurozone had fought its last heroic battle to save Spain and exhausted the appetite for the core countries to fund a firewall. Ireland might be picked up along the way. With no more firewall, Italy would collapse after runs on its banks and bonds. With Spain and Italy gone no more eurozone the speculators retire to their yachts. The ongoing pain of this scenario should not be underestimated, partially because it could result in several years of massive turbulence. The ongoing uncertainty will result in curtailed
23

corporate investment, constrained liquidity and rising unemployment. The currently forecast lost decade26 of many of the eurozones countries could become a lost two decade. For some, the impact will be for longer. The career prospects will be scarred for life for the generation that faced over 40% youth unemployment for a decade.27 Even the UK and Sweden who have anecdotally already started to benefit from increase inward investment at the expense of the eurozone, will suffer in this scenario given the difficulties in their core export market. Which of these scenarios will play out will be determined by political choices, negotiation and a game of brinksmanship as much as economics. As such it is hard to forecast.

26 GDP per capita for Southern European countries is forecast by the EIU to not reach its pre crisis level until at least 2018. 27 For a discussion see Unemployment Scarring by Wiji Arulampalam, Paul Gregg and Mary Gregory, The Economic Journal
24

2. Achieving an orderly exit through the NEWNEY approach

The exit of one or more country from the eurozone could be achieved through a surprise redenomination in those countries, followed by a devaluation. However this approach raises a slew of legal and contractual issues and is likely to be a very regressive move with the rich and speculators making money and the poor being hit. To contribute to a debate on other approaches, this paper presents the NEWNEY ordered approach to the exit of one or more countries. This chapter starts by laying out some criteria that should be used when assessing different approaches to the exit of one of more countries from the eurozone. It also considers the practicalities and downside of a surprise redenomination, and then lay out, at a high level, how the more signalled NEWNEY approach might work.
Assessing different approaches to the exit of one or more states from the Euro

There are several ways that one or more states could leave the eurozone. This paper proposes eight criteria that could be used to assess different approaches for how one or more member states could leave the eurozone (these criteria build on some of the criteria highlighted in the various Wolfson Economics Prize documents): 1. Does the approach provide clarity on how Euro denominated contracts, assets, liabilities and sovereign debts are redenominated in the new multi currency regime? For instance, how will loans or contracts evolve when they are between players based in the different zones? So how should a Euro denominated mortgage for a Greek household, borrowed from a German Bank be redenominated after separation? 2. How well does the approach result in the matched treatment of assets and liabilities (and supply and sales contracts) for corporations, governments and individuals? Having clarity on how contracts work in the new multi currency regime, is only a start. If the assets and liabilities of an institution (corporation, financial institution or even
25

households) are redenominated into different mixes of currencies and these currencies then change in value relative to each other, the solvency of the institution could come under threat. This problem is most acute for a number of the banks which have assets (including government debt) disproportionately in what could become Yolk countries but liabilities in White countries.
CHART 6

28 European Banking Authority, 2011 EU-wide stress test, aggregate report

26

yt uqe yt uqe ytiiiiuqe yt uqe knab no noitanimoneder tbed ngierevos a fo tcapmi laitnetoP
0
Note: excludes the impact of corporate and bank debt 1 Based on BIS data as of Q2 2011. We have not factored in complications of domestic cross-funding and inter-linked obligations for this illustrative comparison Sources: BIS

As the European Banking Authority report shows, 30% of Greek Sovereign debt and inter bank liabilities are held by banks outside Greece, 28 and for countries such as Italy the value of debt held outside will probably be even higher. The forced redenomination of Yolk countries government debt into the new local Euro-Yolk currency and the depreciation of this currency could result in the equity of a number of banks being substantially reduced. Chart 6 shows the level of Yolk country sovereign debt held by banks in other countries. These banks are unlikely to have corresponding deposits in the Yolk

286

tbed ngierevos niapS dna lagutroP ,ylatI ,dnalerI ,eceerG

200

400

915

nlb $

,seirtnuoc rehto ni sknab yb dleh

600

700

061 69 14

sdnalrehteN ynamreG muigleB ecnarF airtsuA

countries, so a 30% devaluation in the new currency used for Greece, Ireland, Italy, Portugal and Spains sovereign debt could wipe out around 30% of the equity of banks in these other countries. A similar effect could occur for corporations with long term contracts, for instance, the long run purchase of Russian gas with contracts to sell electricity in a Yolk country. 3. How can the migration pace and process be managed so as to provide minimal disruption? For instance, there is a risk that the process of separation would require the Yolk countries to put in place capital controls to prevent a flight of capital to financial institutions in White countries or outside the eurozone. They might need to impose border controls to prevent bank notes being moved. They might also have to limit the withdrawals of Euro notes from banks and take steps to prevent hoarding of these notes. All of these could have a major disruption to normal business and personal activities. 4. Does the migration treat individuals roughly evenly? There is a substantial risk that any exit of one or more countries from the eurozone could be very regressive in nature so hitting poorer members of society. Richer members of society are more likely to be able to anticipate the separation and rearrange their finances so as to benefit from it or at least to be hit less by, for instance, moving their assets outside the Yolk countries, while leaving their liabilities there. As the UK exit from the ERM showed, speculators could be some of the biggest winners of an exit from of one of more countries from the eurozone it was hedge funds, such as that run by George Soros, that reportedly made 1billion from betting ahead of the UKs decision to leave the ERM 29 . In contrast, poorer members of the Yolk countries would have less opportunity to reposition their assets and so would have their wealth hit disproportionately. 30 Such a regressive move could well be politically unacceptable.

29 Billionaire who broke the Bank of England, By David Litterick, Daily Telegraph, 13 Sep 2002 30 This point has been made by Nobel economics laureate Christopher Pissarides in Euro Exit Would Cost Poor Greeks, reported by Jennifer Ryan in Bloomberg Businessweek
27

5. How doable is the approach politically? There are clearly considerable political challenges to one or more member states leaving the eurozone. Currently, the treaties are such that they would have to leave the European Union though they could potentially remain part of the European Economic Area. While the political processes are outside the scope of the prize question which focuses on the economic process, the political acceptability will be an important criteria and so will be considered. In particularly, it will be important to assess whether cooperation is required from all eurozone countries for the exit. 6. The macroeconomic effects of exit including inflation, confidence and the effects on debt. How quickly will the economy of those countries exiting, and the global economy for that matter, recover from the shock of an exit? 7. Does the mechanism, and its application, reduce the risk of speculative capital outflows? As has been discussed, there is a risk that the eurozone could suffer from speculative capital outflows. The UKs experience with the ERM demonstrates the risk that the eurozone could lose control of its own destiny as a result of these capital outflows. An important test of any mechanism by which a country could leave the eurozone, is whether the mechanism reduces or increases the risk of speculative capital outflows. This needs to be both before the event, but also after one country leaves so how to avoid the Picking them off gradually scenario discussed above. 8. Does the discussion of an exit approach within governments circles, in itself, result in destabilising the eurozone? There is a risk that the discussion of an exit approach could become self fulfilling as capital moves speculatively.
The impracticalities of a surprise redenomination

Many other changes in Monetary Unions and Currency pegs, such as in Argentina or the exit of the UK from the ERM, have been achieved through a surprise devaluation or disorderly exit. Currencies were devalued overnight. The benefits of competitiveness that came from new levels of currencies were delivered almost immediately. A
28

surprise redenomination removes the opportunity for substantial speculative capital outflows at least relative to a signalled or orderly change though, as has been discussed, clearly some speculators made significant profits from the UK exit from the ERM. However, in the case of Argentina and the UKs exit from the ERM, the new physical currencies were already in place, and all that was required was a devaluation. It was clear what currency each individual contract was denominated in, notes and coins were already in circulation, etc, even if the value of the currency changed. So an overnight change in relative currencies values was possible, though clearly companies, financial institutions and the government itself had to cope with the matching issue (as described in the previous sections second criteria) from the unequal changes in the value of their assets and liabilities or supply and sale contracts. The biggest challenge in pursuing a surprise redenomination for the eurozone is that the new currency, notes and coins do not exist for the country or countries leaving the Union. Companies, governments and financial institutions will also need time to change their systems to reflect the change of some part of the eurozone to a new currency. The production of new physical notes and coins is one of the greater challenges with a surprise redenomination. It seems unlikely that the printing of new bank notes and minting of new coins could be achieved in secret. This printing problem could be overcome by having banks in the Yolk region defacing existing Euro notes (eg with an ink stamp) drawn in the Yolk region.31 This would signal that the notes are the new currency, until the actual new Yolk currency is printed and distributed. This approach could be harder to achieve for coins. And could be very difficult to police and would be hard for vending machines, to be reprogrammed quickly to reflect the change.

31 The approach to stamping notes, has been suggested by Eric Dor in Leaving the Euro Zone: a users guide published in October 2011. The approach is similar to that used in the dissolution of other currency regimes such as Czechoslovakia see Teppers A primer on the Euro Breakup, Wolfson Economics Prize entry, April 2012. Available from policyexchange.org.uk.
29

Maybe a bigger challenge would be that multi national corporations and financial institutions would need time to adjust their systems and accounts for the new currency. As a reference, two years were allowed between the Euro exchange rates being locked and the launch of the Euro as legal tender, including the use of physical notes and coins. But preparations for the new currency had started before then, though there was also considerable focus on addressing Y2K software issues at the time of the switch over. Given the time required, an overnight redenomination is therefore not possible and there would need to be some hiatus period of a minimum of three months up to the formal launch of the new currencies. During that period, consumers, corporations and speculators are likely to try to move their cash and savings that will be redenominated in the new Yolk country currency to financial institutions where they will remain in Euros. They would have an incentive to withdraw and hoard old Euro notes in cash. And if capital controls were imposed, as would seem necessary, Euro notes could still be smuggled over the border, though the governments could try to force the notes to be redenominated32 . These capital controls are illegal under EU law, resulting in potentially years of litigation. It is also likely that the approach would be very regressive in nature and result in a windfall gain to Yolk country banks (see later). Indeed, it seems likely that the better informed have already positioned their assets for any exit. It is also unclear how international contracts would work with this crash redenomination. Financial institutions in White countries would face solvency issues as they do not have matched assets and liabilities across the White and Yolk zone. All of this could be very disruptive to economic activity. So this paper proposes an alterative approach to how a signalled or managed transition to a multi currency regime might work.

32 See Greece should leave the Euro. How do you do that? by Jurre Hermans. Wolfson Economics Prize entry, April 2012. Available from policyexchange.org.uk
30

The NEWNEY approach in concept

The challenge with a signalled approach to one or more countries leaving the eurozone is how to ensure that, during the period up to the switch to the new currency, destabilising speculation does not occur as companies, financial institutions, governments and individuals position their financial assets so as to be in the stronger currency. With a signalled exit, there is a certainty that individuals and corporations will withdraw their deposits from the Yolk country banks and bonds either electronically or in cash. It will probably be necessary for Yolk country banks to impose constraints on cash withdrawals and the Yolk governments to put in place some type of exchange controls, though, as has been discussed, it seems hard to envisage that these will be effective given individuals could literally drive across customs-free borders with suitcases of cash. A signalled or orderly approach needs to remove the incentive for speculative capital flows. The existing approach for dealing with this speculative capital flows is a progressively larger firewall. However a firewall is only treating the symptoms of the problem. Instead, this paper proposes the NEWNEY approach which treats the root cause of capital flight, namely the unequal treatment of different Euros in different parts of the Union. Individuals, companies or speculators are moving money out of banks and bonds in particular countries less because of a concern on default but because of a concern on devaluation this can be seen by the capital outflow from countries such as Greece being across the board. To remove the gain (and so incentive) for speculative capital flows, we need to follow what we call the NEWNEY principle, that every Euro, wherever it is in the Union, or world for that matter, needs to be treated equally during any exit. The NEWNEY approach does this by borrowing from the techniques used in a share spin out as opposed to a traditional currency union redenomination and devaluation. Lets first illustrate this through one country leaving. Instead of an approach where assets in a particular country leaving the eurozone gets redenominated, every Euro instead gets replaced by a basket of two currencies. Following our naming convention, these currencies are referred to as the New
31

Euro-White (NEW) and the New Euro-Yolk (NEY) currencies, and hence the NEWNEY name for this approach. This approach could have a number of modifications, but in its purest form would be designed around the following principles: 1. Every Euro unit in the eurozone should be treated equally in the migration to multiple currency regions, whether the individual Euro be physical cash, electronic money, or a unit of exchange in a contract, and more importantly whichever country they are in. We call this the NEWNEY principle. 2. The process of migration to a multi currency regime of two currencies, will be achieved in an orderly way, to allow time for corporations to adjust, currency to be printed, and distributed, etc. 3. Each of these new regions would have their own central bank, monetary policy, and currency unit. The ECB will need to be maintained for a while to manage the transition and to support the new central banks. It is likely that the Yolk countries will have higher interest rates, inflation and a depreciating currency relative to the White countries. 4. Each existing Euro, in perpetuity, gets exchanged for a basket of the New Euro-Yolk and New Euro-White currencies, in fixed proportions determined by an exchange ratio. As an illustration, the exchange ratio could be set as 1 Euro can be exchanged for 0.7 NEW currency units and 0.3 NEY currency units. How this exchange ratio might be set is discussed later. If the Union was to split into more than two regions, this could also be achieved by including all the currencies for all the new currency regions in the basket. 5. Across the eurozone, everyone will have their Euros changed into the currencies in the basket in the proportions set by the exchange ratio. No one is forced to switch into any particular currency, but over time, individuals would be able to exchange the other currencies in their basket, to the currency of their home region. As will be discussed, central banks might need to support the exchange through a one off offer or through the provision of liquidity.
32

6. Salaries and government payments in the Yolk countries gets switched to the new currency on switch over day at the rate of that day. Any inflation escalators in employment contracts will need to get removed this will be a particular issue with Spain as 50% of firms have automatic wage indexation mechanisms, as Roger Bootle points out in his paper.33 The treatment of these contracts are an exception to the NEWNEY principle, but this is required to restore competitiveness. Legislation might be required in support of this. 7. The gradual devaluation of the Yolk country or countries currency or currencies would be achieved through higher nominal interest rates in the Yolk countries. If true risk free rates (not government rates) in the Yolk countries are say 5% higher than in the White countries, then the currencies would be expected to depreciate by 5% a year. This difference in interest rates could need to be announced in advance and is more likely to come predominantly from higher inflation than a higher real risk free rate. The gradual devaluation would allow the start of a process of restoring competitiveness in the Yolk countries, more quickly than the approach of internal devaluation. However it is important to stress that this devaluation provides a short term boost in competitiveness only if wages do not rise at the same rate. In effect, devaluation provides headroom for the austerity and structural reform measures that are required, but in itself is not sufficient. Indeed, this seems to be becoming a major misunderstood point among some of the Euro exit enthusiasts. Devaluation is a necessary but not sufficient condition: or to put it another way, continuous devaluation is not a growth strategy. 8. Any renegotiation of, or default on, debt by these countries could also be managed separately and subsequently. Greece has shown how debt restructuring can be managed in a negotiated way. Indeed, as Chart 6 below from Reinhart and

33 For details on automatic wage indexation see Figure 7 Leaving the Euro: A practical guide by Roger Bootle and Mark Pragnell, Wolfson Economics Prize entry, April 2012. Available from policyexchange.org.uk
33

Rogoff shows, the global economy has had extensive experience in managing these types of debt default or renegotiation. 9. For the sake of contracts (including debt) that are currently denominated in Euros, the value of the Euro for the contract could continue to be determined through the market exchange rate between the different currencies in the basket and the exchange ratio which will be set at the start. The exception of this would be employment contracts that need to remain in the NEY so that competitiveness can be restored. 34
CHART 7
stluafed fo rebmuN
30 40 50

1800 or year of independence if later, 2006

airtsuA

10

20

Source: This Time is Different: A Panaromic View of Eight Centuries of Financial Crises, by Reinhart and Rogoff

The NEWNEY approach meets our matching criteria - there will be no impact on the solvency of financial institutions that have Euro denominated assets and liabilities that are unmatched in terms of the eventual region in which they end up, as the NEWNEY approach has equal treatment of all Euros. However, clearly any default by one or more country could itself provide an issue for the solvency of financial institutions, though this is no different in the current eurozone set up. The equal treatment of all Euros, means that there is

34 Thanks to Hugo Dixon for pointing out the need to clarify this point explicitly.
34

% ,tluafed ni sraeY
60

st uafed ng erevos fo yrots H st uafed ng erevos fo yrots H stlllluafed ngiiiierevos fo yrotsiiiiH st uafed ng erevos fo yrots H
ynamreG ainamoR yragnuH lagutroP eceerG dnaloP aissuR niapS ecnarF

no incentive for capital to move between countries prior to the establishment of the new currency or for individuals to make withdrawals from their bank accounts and hoard Euro notes. CHART 8
How the exchange ratio and market exchange rate can be used to determine the value of a Euro in a contract

Exchange ratio set at transition

1 Euro =

0.7 NEW (new euro-white)

+ 0.3 NEY (new euroyolk).

So everyone can exchange a Euro for 0.7 NEWs and 0.3 NEYs. This exchange ratio remains fixed. But the relative exchange rate between the NEW and NEY changes as the NEY gets devalued

Subsequent market determined exchange rate

1 NEW =

1.2 NEY

The implicit spot value of the Euro in a contract can be solved for algebraically from the two equations above These change as the exchange rate changes

1 Euro=

1.14 NEY

Or

1 Euro=

0.95 NEW

The NEWNEY approach also allows contracts that are denominated in Euros to run their course as the value of the Euro (and how this relates to other currencies such as the NEY, NEW, Pound or dollar) could always be determined from the exchange ratio and the value of the NEW and NEY, against each other. For an illustration of how
35

this would work, imagine that the exchange ratio was set at 1 Euro can be exchanged for 0.7 NEWs and 0.3 NEYs. And subsequently the Euro Yolk devalues such that new currencies trades such that 1 NEWs is 1.2 NEYs. Simple algebra allows the value of a Euro in an existing contract to be determined in NEWs or NEYs see Chart 8. A more detailed discussion of aspects of the NEWNEY approach follows later. But first this paper explores the steps that would be required to put the NEWNEY approach into practice.
Key steps in the NEWNEY process

A number of sequential steps would need to be followed to implement the NEWNEY approach:
1.

Political agreement of how many monetary regions will emerge and setting a timetable for the process. This would need to be an intergovernmental negotiation between all the countries in the eurozone and would clearly also need to start with whether separation is necessary at all, and the approach to be followed. While the process of separation could be repeated, with other countries leaving the eurozone at a later date, the costs and disruptions are such that it would be better for the countries to separate in one go. While renegotiation of debt levels can be separated from the implementation of the NEWNEY transition to a multi currency world, it is seems certain that these would also be part of this political negotiation. A first step in this discussion would be the agreement of the NEWNEY principle that all Euros get treated equally. We will come back to the politics a little later. Establishment of central banks and monetary policy committees, development of monetary policies, and the designing the new currencies for each of the new regions or countries. Each of the new monetary regions or countries would need to establish their own central bank, monetary policy process and their own currency, including the name to be used. It will also be necessary for each country to determine a rough target valuation of their currency so should it be in line with the Euro or in line with historic currencies such as the Drachma or Lira? The level of the currency will be important psychologically as the Yolk countries
36

2.

use devaluation to restore competitiveness this will be discussed in more detail later.
3.

Setting the exchange ratio for the new currencies and launch of trading in the new currencies on a shadow basis. The process of setting the exchange ratio will be discussed in more detail below, but will be based on the target valuation of the new currency as well as the anticipated required money supply and debt levels for each of the new monetary regions. Once the exchange ratios have been determined, and monetary policies have become clear, trading in the currencies can start on a shadow basis. Establishment of a one off governments sponsored currency exchange option. The governments of the eurozone could choose to provide liquidity to support what would be undoubtedly the largest set of exchange rate transactions in history as individuals trade the currency they receive in their basket that is not their home currency. As discussed below, this might be through offering a fixed tender price for a limited period at a market price based on the shadow price from trading prior to switch over day. However, it is important that this be on a voluntary basis. Move to different monetary policies. Once the new currencies are established, the governments in the new regions or countries would be able to pursue different monetary policies. As has been discussed, the Yolk countries are likely to want to have a currency that depreciates over time. This could be achieved by having higher nominal interest rates and inflation in the Yolk countries. Switch over day. Prior to this date, bank accounts and invoices, would remain denominated in Euros but shadow trading will start in the new currencies to get some sense of value. After the switch over date, the legal tender for settlement of payments would switch to the new local currency. As the Chart 8 above shows, it will always be possible to derive a Euro-NEW or EuroNEY exchange rate for contracts and debt with long duration. Redenomination of contracts. Over time contracts (including loans) would get renegotiated to be redenominated into one currency, but there would always be a fall back that the value of the Euro as a unit of exchange in contracts could still be

4.

5.

6.

7.

37

determined in the new currencies from the value of the exchange ratio and the value of the new NEW and NEY currencies.
8.

Renegotiate Yolk countries debt, if needed. This is not required for the NEWNEY process to work but the Greece experience to date shows that the level of debt for some of the Euro countries could be unsustainable, both within and outside the Euro. And this debt level could get worse as their currency devalues given the debt will be denominated in Euros so will need to be repaid in a mix of NEWs and NEYs as set by the exchange ratio. So it seems likely that some renegotiation of debt will be required this will be discussed in more detail below. Winding down the ECB. The ECB will play an important role in the migration. Over time its role will need to be wound down and its assets and liabilities will be devolved to the countries central banks.

9.

38

3. Specific details on the NEWNEY approach

There are a number of aspects of the NEWNEY approach that need further exploration. These include setting the exchange ratio, getting the required foreign exchanges to happen, different monetary policies, debt levels and renegotiation, and how NEWNEY could be applied with the exit of only one small country such as Greece. A discussion of these will be the focus of this chapter. As has been discussed, which country or countries exits the eurozone will be as much a political decision as an economic one. But determining which country, if any, should exit is not part of the Wolfson prize question. However to make the discussion of the specifics more tangible, this paper will illustrate points with the case the Yolk countries or country exiting the eurozone being a large country or set of countries which represents around 20% of the eurozone. This paper will assume, to begin with, that if it is more than one country, they will form a new single Yolk eurozone though this paper will later consider how the NEWNEY approach would work with multiple regions. The key statistics for the new Yolk Zone are set out in the Chart 9.
CHART 9

Illustrative data for Yolk zone exiting the eurozone

EUR BILLIONS

Eur Billions

% eurozone

GDP Money supply Real economy debt

1,800 1,850 6,600

20% 20% 22%

39

Setting the exchange ratio

Before the exchange ratio is set, the Yolk government(s) would need to decide what the target level of their new currency is. The eurozone countries had a wide range of different levels of their currencies before joining the Euro. A similarly priced coffee could cost 6,000 Liras, 6 Deutschmarks or 2.5 Punts. Chart 10 shows the exchange ratios used for converting into the Euro.
CHART 10

Euro conversion rates

Belgian Franc Luxembourg Franc Deutsche Mark French Franc Dutch Guilder Austrian Shilling Irish Punt Portuguese Escudo Spanish Peseta Italian Lira Finnish Markka 40.3399 40.3399 1.95583 6.55957 2.20371 13.7603 0.78756 200.482 166.386 1936.27 5.94573

Source: European Central Bank

The Yolk government(s) could decide to make a clean break and return to the currency levels seen in their pre-Euro days. Alternatively, they could aim to have their new currency trade at around the same level as the Euro. The choice on this is largely driven by individual consumers and workers perceptions. It is probably easier for individuals to have a currency with roughly the same value as the current Euro as they will have got used to this level. There was a popular belief that the move to the Euro caused some short term inflation as companies rounded up their prices

40

though the evidence on this is less clear and the eurozone clearly did result in lower inflation for most member countries in the long run35. There might be a benefit for the Yolk government(s) in setting the value of the NEY at a slight discount to the NEW so as to start the process of regaining competitiveness. However, it could be argued that setting it at a slight premium would provide markets and consumers in the Yolk countries with greater confidence on their new currency. It also might be hard in practice to forecast how the level will play out. The relative importance of these could be tested through market research of consumers and workers in the Yolk countries. It seems likely that the White countries will want to keep the NEW close to the value of the Euro. For the purpose of this paper, it is assumed that the Yolk and White governments target that their new currencies start at levels close to parity with the Euro. The second step in targeting the exchange ratio is to estimate the monetary supply and debt (less double counting) that is likely to exist after the separation for each of the two new monetary areas. This is required because the exchange ratio determines how many NEWs and NEYs get created from the transfer to the new regions. How this works can be shown from an example.

35 "Did Prices Really Soar after the Euro Cash Changeover? Evidence from ATM Withdrawals". Paolo Angelini; Francesco Lippi;. Fnf Jahre nach der Euro-Bargeldeinfhrung War der Euro wirklich ein Teuro? [Five years after the introduction of Euro cash Did the Euro really make things more expensive?] Irmtraud Beuerlein; Did the introduction of the Euro impact on inflation uncertainty? - An empirical assessment, Matthias Hartmann and Helmut Herwartz; source Wikipedia
41

CHART 11

Estimating the demand and exchange ratio

EUR BILLIONS

Pre Separation Euro Zone

Post Separation White Zone Yolk Zone Comment

Currency in circulation

847

886

141

Need to adjust for reserve currency status remaining in the White Zone and frictional effect Pro rated by GDP and GDP multiplier

Overnight deposits

3,942

3,154

788

Deposits with an agreed maturity of up to 2 years and deposits redeemable at notice of up to three months Money market funds

3,801

3,041

760

Pro rated by GDP and GDP multiplier

1,185

948

237

Pro rated by GDP and GDP multiplier

Real Economy Debt Less double counting as held by financial institutions

30,000 - 20,000

23,400 - 16,400

6,600 - 3,600

Higher debt levels in Yolk Zone Higher bank holdings in White Zone

Total

19,775

15,028

4,927

Exchange ratio

0.75

0.25

42

If the exchange ratio was set at 1 Euro converts to 0.8 NEWs and 0.2 NEYs, there will end up with 4 times as many NEWs in circulation as NEYs. If the demand (measured in a third currency) for the two currencies are roughly in this 4 to 1 ratio (this paper will come back shortly to defining what the demand is for currencies), then the NEW, NEY and Euro will start with around the same exchange rate. If instead the exchange ratio was set at 1 Euro is equal to 0.8 NEW and 400 NEYs, then there will be around 500 more NEYs in circulation as NEWs. If the demand for the two currencies are in line with the 4 to 1 ratio used earlier, then the NEY will be in effect devalued by a factor of 2000 relative to the earlier case. And so the NEY would have a value of around the level seen for the Italian Lira prior to the eurozone. So how can the demand for the NEWs and NEYs be forecast? Any error in forecasting demand for the two currencies, is not a major problem as it will result in the market determined shadow price of each currency diverging prior to the switch over. The demand for the currencies will come in two main types: classic monetary supply; and Euro denominated financial instruments that are not included in the monetary supply, but which will be redenominated into the new currency. The latter includes government debt and corporate bonds, but probably excludes most equity, and other assets such as housing which do not have a fixed principal and interest obligation in a particular currency. The reason that debt instruments need to be included in the calculation is because the demand for them is a close substitute for the demand for NEW and NEY currency: an individual wanting to hold NEY has a choice between cash, bank deposits, governments debt or corporate debt. In doing this calculation, it will is necessary to remove the impact of the double counting of financial institutions holdings of debt instrument in estimating the aggregate demand. So, some bank deposits are used to fund the banks holding of government debt but the aggregate end demand for a currency is the bank deposits and not the banks holdings of the debt instruments. To see why this is the case, consider an illustrative conversion process. The consumer withdraws their deposits from the bank, which the bank funds by selling the bonds it holds to the
43

government. The cash that then needs to be converted to the new currency is the monetary value of the deposits, with no conversion requirement for the bonds that are held by the banks funded by deposits. Consider instead, if the government bonds are held by the consumer. Then the conversion process is that the consumers sells the debt for cash. The cash gets converted. So bonds held by consumers (and corporations for that matter) do need to be converted. Hence the demand for the new currency will be driven by classic monetary supply and Euro denominated financial debt that are not included in the monetary supply, but which will be redenominated into the new currency and which are not held by a financial institutions to match deposits. For the current Euro area, the ECB estimates that M3 is around Euro 9.775 trillion36. For the sake of this analysis, lets assume that there is roughly Euro 30 trillion real economy debt (so household, government and corporation) of which say two thirds is held by financial institutions funded by deposits and so is double counted. An illustration of how these might break up after separation is included in Chart 9. There are a few additional comments on this analysis. A proportion of the Euro money demand comes from the reserve currency status of the Euro. In the pre crisis year of 2008, the ECB estimated that around 20% of Euro currency notes and coins were held by non residents. The number for the US is incidentally around 50%. It could be argued that a substantial majority of this is as a result of the reserve currency status of the Euro. So maybe around Eur 160 billion. It seems likely that the majority of this money will remain with the White Zone currency. The total money supply after separation is likely to increase by a small factor because of frictional effects the analysis in Chart 9 assumes that this be Euro 20 billion. Countries within the eurozone historically had different monetary supply to GDP multiples as a result of factors such as different relative uses of cash see Chart 12 for M1. These could need to be taken into account the analysis on Chart 11 has not.

36 ECB Statistics Pocket Book, January 2012

44

The debt holdings for the Yolk Zone will be higher than the GDP split (20%). However the offsetting bank holdings will be more likely skewed to the White Zone (in this example this is assumed to be 82%). In this calculation it is assumed that debt and bank holdings overtime revert to their home region currency. This will probably not be fully the case as some in the Yolk countries might want to hold White currency as a hedge against excessive devaluation. Further research would be required to understand this. Once the demand is estimated, it is then possible to set the exchange ratio so that the amount of each of the new currencies created by the swapping of the Euros for the basket of currencies, is in line with the eventual level of demand for each currency (this demand being driven by its use in monetary supply and debt) at the target exchange rate. As can be seen above, this will have a little more of the Yolk currency needing to be created than the relative GDP proportions because of the greater debt affecting the Yolk countries.
CHART 12

Allowing FX movements and getting the exchange to happen in practice

Under the NEWNEY approach, all players will receive a basket of the two currencies in exchange for their Euro. Individuals in the
45

reiiilllpiiitlllum PDG ot ylllppuS yenoM niii secnereffiiiD re p t um PDG ot y ppuS yenoM n secnereff D re p t um PDG ot y ppuS yenoM n secnereff D
8991 ,PDG yb dedivid ylppus yenom 1M
0.12 0.34
Sources: Eurostat; national sources;

ynamreG

lagutroP

eceerG ecnarF dnalerI niapS ylatI

0.16

0.28 0.30

0.24

0.29

White-zone will largely want to trade out of their NEY currency. And individuals in the Yolk-zone will want to trade out of most of their NEWs though clearly they might decide to retain some NEWs as a hedge against a collapse of the NEY or because they are nervous around the NEYs prospects. Chart 13 shows an estimate of the new money supply and debt that will be created on switch over day. If the majority want to switch to their home currency, around Eur 4 trillion of trading will be required to switch over the different monetary and debt instruments. The need to trade will be particularly acute in the Yolk Zone as the majority of the new money received will be the NEWs.

CHART 13

Required currency exchange

EUR BILLIONS

Pre Separation Euro Zone

Post Separation White Zone Yolk Zone

Money supply and net debt

15,028

4,927

Money Created

NEWs NEYs

11,318 3,710

3,710 1,217

Clearly not all of the debt instruments will need to be swapped to the home currencies on day one. So not all of these trades need to occur immediately. Because of this and the fact that the debt and money supply are in different proportions in the two regions, there is likely to be somewhat of an imbalance in cash trading. In addition, the trading volumes are almost certainly too large to be left to the free market.

46

The BIS estimates that the daily FX volumes are around $4 trillion37, but this number includes swaps, forwards and derivatives, and of course is global. To overcome this, the ECB (which will need to play a transition role) and the central banks of the White and Yolk regions could offer, for a limited period, a fixed exchange rate between the currencies, providing the liquidity for White and Yolk companies, households and financial institutions to trade to the other currencies. These trades will be at market prices which could be derived from the pre switch-over day shadow price. In offering this, it will be important that these trades are not compulsory. Individuals in the Yolk countries are clearly going to be concerned that they end up holding the NEY currency that runs the risk of a substantial devaluation, and if they think they are going to be compelled to switch to the NEY currency, there would be a substantial risk of exactly the capital flight that the NEWNEY approach was designed to avoid. So how might this work in practice? Every Euro bank account holder would have the right to have their Euro denominated bank account replaced by two accounts. One denominated in the NEY and one denominated in the NEW. All Euro cash holders would have the right to change their cash holdings converted to the combination of NEW and NEY set in the exchange ratio. For some corporations and individuals (for instance those with houses or family in both zones) keeping the two accounts, cash holdings, etc might be their desired end state. But for other corporations and for most individuals, they would prefer to switch to their home currency. So prior to switch over day, they could be given a choice. End up with two accounts, cash holdings, bonds. Or have them switched to their home currency at the Government exchange rate offered on switch over day. Some techniques drawing on behavioural economics could be used to encourage switch over. In the Pension Commissions Turner report, the benefits of using inertia or soft compulsion were identified. 38 A similar approach

37 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2010, Bank for International Settlement. 38 See for instance, The controversial benefits of opting out Financial Times December 1, 2005
47

could be adopted with bank accounts by default opted into a switch to their home currency unless the holder explicitly opts out. All Euro redenominated bonds would be replaced by two sets of bonds, one denominated in NEW and one denominated in NEY. The issuer of the bonds could either let their bonds run to maturity in the currency mix. Or they could offer their bond holder the opportunity to exchange into another mix the fair exchange rate would be dependent on forward exchange rates and so would be slightly different from the Government spot exchange rate described above. Corporations would decide in which NEW or NEY currency or other currency too such as the dollar for that matter they would denominate their accounts and dividends but as there is no fixed obligation with dividends (as there is with debt interest and capital) they can decide this with input from their shareholders but do not need to split their stocks into a NEW and NEY denominated stock. Stock exchanges would decide which currency or currencies they would use to trade debt and equity instruments. This government Euro-NEW and Euro-NEY exchange rate (and the forward curves that can also be derived from the forward NEW-NEY curve) would also provide a reference point for renegotiation of contracts though these contracts would need to be agreed between the relevant parties. As has been discussed above, if they are unable to agree the basis for a renegotiation, these contracts could continue to run with the Euro exchange rate derived from the fixed exchange ratio and the evolving exchange rate between the NEW and the NEY.

48

CHART 14

Sources: Bloomberg; Eurostat

Different monetary policies

Once the separation occurs, the Yolk country would be able to follow different monetary policies and start to restore competitiveness though currency devaluation at a faster pace than through the internal devaluation process. As has already been stated, many emerging markets have shown that currency devaluation is not, on its own, a basis for ensuring ongoing competitiveness. Structural changes are needed to achieve the productivity improvements required for competitiveness, along with potentially resetting wages, entitlement programmes, retirement ages, and cutting government expenditure. The nature of all of these changes are fundamentally painful. So the short term boost to competitiveness that comes from a currency devaluation will allow room to make other changes happen. The Yolk countries can achieve a gradual and signalled devaluation of their currency by running higher nominal interest rates39. If the White countries 3 year true risk free interest rates are around 2%,
39 A rise in interest rates can result in a currency increasing in value on a one off basis as capital is attracted in. But these higher interest rate will have been announced before separation. The forward curve for the currency would include an expected depreciation in the currency reflecting the interest rate differential.
49

0102

enozoruE eht niiii sdnob tnemnrevog raey-01 fo sdlllleiiiiY enozoruE eht n sdnob tnemnrevog raey-01 fo sd e Y enozoruE eht n sdnob tnemnrevog raey-01 fo sd e Y enozoruE eht n sdnob tnemnrevog raey-01 fo sd e Y
Yields on 10-year government bonds, %
53
Greece

Introduction of Euro

Lehman bankruptcy

8002

6002

4002

2002

0002

8991

6991

4991

2991

0991

03 52 02 51 01

Portugal Ireland Italy Spain France Germany 2011

and the Yolk countries true risk free interest rates are around 7%, then the Yolk NEY currency would be expected to devalue around 5% a year relative to the White countries NEW, or 15% over 3 years. These higher interest rates will also provide an additional encouragement to investors to continue to hold the NEY. It is important to remember that this difference needs to be measured on the true risk free rate. Currently interest rates already show a differential that is greater than this see Chart 14 but this differential is because of default risks as the credit default swaps show see Chart 15.
CHART 15

There are two challenges with this gradual devaluation. First it could enter peoples expectations on inflation and so become self defeating. And second the higher interest rate could dampen economic growth, assuming borrowers get hit more than savers. This paper will come back to the latter. On the former, there is a risk that inflation expectations get raised and so salary levels rise offsetting the benefits that come from the devaluation but, as has been discussed above, automatic wage indexation mechanisms will need to be removed, and are anyway not prevalent in many Yolk countries apart from Spain. In addition, with the current levels of unemployment seen in a

1 102 etallll niiii stniiiiop siiiisab 000,6 revo gniiiihcaer eceerG 1 102 eta n stn op s sab 000,6 revo gn hcaer eceerG 1 102 eta n stn op s sab 000,6 revo gn hcaer eceerG 1 102 eta n stn op s sab 000,6 revo gn hcaer eceerG htiiiiw ,slllle vellll detnedecerpnu ot nesiiiir sah spaws tlllluafed tiiiiderC ht w ,s e ve detnedecerpnu ot nes r sah spaws t uafed t derC ht w ,s e ve detnedecerpnu ot nes r sah spaws t uafed t derC ht w ,s e ve detnedecerpnu ot nes r sah spaws t uafed t derC
CDS spreads on 10 year government bonds, basis points
0102 0 005 000,1 005,1 000,2 005,2 000,3 005,3 000,4 005,4 000,5 005,5 000,6 005,6 000,7 005,7
Greece Portugal Ireland Italy Spain

Oct 2011

Sources: Datastream, World Bank DEC Prospects Group;

50

1102

number of the likely exiting countries, this wage inflation risk might be containable.
Implications for private savings, domestic mortgages and international contracts

The nature of the NEWNEY approach is that it allows the automatic redenomination of savings, domestic mortgages and international contracts. There is not a loss in value for savings (as measured in the old Euro) as would have been seen from an Argentina type devaluation.
CHART 16

Individuals will switch their savings and mortgages to their local currencies, over time. But again, because the approach to devaluation relies on higher interest rates, there will not be a shift in the value (as measured in the old Euro) for savings and mortgages if the interest rate is floating for these. For savings and mortgages where the interest rate is fixed, there could be a reduction in the value of Yolk countries savings and mortgages because of the higher inflation. Contracts would have a very small erosion of value as the NEY devalues because the contracts do not receive the benefit of the higher Yolk country interest rate. However with 20% of the
51

s eve tbed d ohesuoh fo nos rapmoC s eve tbed d ohesuoh fo nos rapmoC sllllevellll tbed dllllohesuoh fo nosiiiirapmoC s eve tbed d ohesuoh fo nos rapmoC
Household debt, Q2 2011, % of GDP
0 10 20 30 40 50 60 70 80 90 100 110 105 98 91 87 81 67 60 48 124 94 82 62 45 120 130
Sources: McKinsey Global Institute

modgniK detinU setatS detinU aeroK htuoS ynamreG lagutroP adanaC eceerG ecnarF dnalerI napaJ niapS ylatI

ailartsuA

basket being in NEYs and 15% devaluation over 2 years, this will be very small. As the NEY currency devalues and Yolk salaries (as measured in the old Euro) are reduced in real terms to retain competitiveness, one might expect to see the Yolk savings and domestic mortgages are worth a greater multiple of salaries. This increase in effective debt levels could be a drag on growth. However it does seem that the level of household indebtedness for some of the likely Yolk countries such as Italy and Greece is not that high relative to other countries see Chart 16. In addition given high historic household saving rates relative to investment in a number of Yolk countries, it seems likely that household savings are higher and so income will be boosted by the higher interest rates. For countries such as Ireland, the increase in household debt to GDP will be a constraint on growth. However it is also evident for these countries that the level of household debt level is already a problem and that they are likely to need to follow the path that US has already followed to household deleveraging, probably through greater levels of default.
Implications for government debt

Government debt faces a similar issue to that discussed above for household debt: the devaluation of the Yolk currencies and the higher interest rates will result in Yolk Government debt growing. And this is unlikely to be offset by growth in GDP resulting from a boost in competitiveness, at least in the short term. This problem could be acute for Greece, Italy and Ireland see Chart 15 for current levels of government debt.

52

CHART 17

85 79 71

Sources: McKinsey Global Institute

However there is already a much bigger government debt challenge for the eurozone-crisis countries than the increase that could come from any devaluation of the currency. At the moment, these countries are struggling to refinance their debts at an affordable rate, without support from the indirect ECB. The credit default swaps suggest a significant probability of default. The original benefit these countries received when they joined the eurozone of being able to borrow at the same rate as Germany has now disappeared. And if some of these countries leave the eurozone, they will no longer have the support of the ECB in financing their debt. Any renegotiation of, or default on debt by these countries could also be managed separately and subsequently. Recently Greece has shown how debt restructuring can be managed in a negotiated way. Indeed, as Chart 18 from Reinhart and Rogoff shows, the global economy has a long history of managing these types of debt default or renegotiation. 40

40 Reinhart and Rogoff's This Time is Different

53

231

s eve tbed tnemnrevog fo nos rapmoC s eve tbed tnemnrevog fo nos rapmoC sllllevellll tbed tnemnrevog fo nosiiiirapmoC s eve tbed tnemnrevog fo nos rapmoC
Government debt, Q2 2011, % of GDP
0 20 40 60 80 100 120 140 160 180 200 220 240 226 90 83 81 69 21

111

33

modgniK detinU

aeroK htuoS

ynamreG ailartsuA lagutroP adanaC eceerG dnalerI niapS ylatI

ecnarF

napaJ

CHART 18

1 Sample size includes all countries, out of a total of sixty six, that were independent states in the given year Sources: Lindert and Morton (1989), Macdonald (2003), Purcell and Kaufman (1993), Reinhart, Rogoff, and Savastano (2003), Suter (1992), and Standard and Poors (various years)

The stability of the banking system

Banks in the eurozone face two separate issues: solvency and liquidity. We will discuss each of these in turn, starting with solvency. The NEWNEY approach has been built around the principal of matching. So all banks assets and liabilities will start off matched and so there will no change in solvency of the banks as a result of the change over to the new currencies we will discuss below how the alternative approach of a crash redenomination followed by a devaluation could change the solvency of banks. Clearly those banks in some part of the eurozone such as Spain that are currently suffering solvency issues, will still have issues after separation under NEWNEY. The banking systems solvency could, however, be hit by any renegotiation of debt. But it is unclear how different this would be with or without the exit of one or more country from the eurozone. After all Greece has already renegotiated it debt. Banks in the new Yolk regions will not have the support of the ECB and so will be

0002 0991 0891 0791 0691 0591 0491 0391 0291 0191 0091 0981 0881 0781 0681 0581 0481 0381 0281 0181 0081

no ta togener ro no ta togener ro noiiiitaiiiitogener ro no ta togener ro t uafed tbe d gn ganam fo yrots h gno a sah ymonoce abo g ehT t uafed tbe d gn ganam fo yrots h gno a sah ymonoce abo g ehT tlllluafed tbe d gniiiiganam fo yrotsiiiih gnollll a sah ymonoce llllabollllg ehT t uafed tbe d gn ganam fo yrots h gno a sah ymonoce abo g ehT
Percent of countries in default or restructuring1, %
06 5 0 55 05 54 04 53 03 52 02 51 01

54

reliant on support from their local central bank and institutions such as the IMF. The second issue that banks face is around liquidity. The withdrawal of deposits from the banks might not be caused by concerns on the banks solvency but on the risk that the country might exit the Euro and redenominate and devalue. In fact the current bank jog that is currently seen in some Southern Europe countries is caused by a concern that the country might exit the Euro, more than the solvency of the banks. Investors are exiting government bonds in a similar way. And are buying assets or making deposits in Germany and other core countries, and outside the eurozone entirely, such as London property. 41 The NEWNEY approach is aimed at stopping this speculative outflow.
The NEWNEY with more than 2 regions

The illustrations for the NEWNEY approach, so far, have been around the eurozone splitting into two regions or one country leaving as a single transition. However, the approach could be applied if there were more than one region. For more than one region, the approach would need to be modified so that the basket of currencies that people receive in exchange for a Euro include all the currencies. So if the label Yolk1, Yolk2, are adopted the basket of currencies people would receive in exchange for a Euro would be E1 * NEWs + E2 * NEY1 + E3 * NEY2 + . Where E1, E2, E3, etc are the exchange ratios, and NEY1, NEY2, etc are the new currencies.
Applying NEWNEY with a phased exit or with a small initial exit

The illustrations for the NEWNEY approach, so far, have been around the eurozone splitting as a single transition. But it seems that we might face the scenario of an exit from the Euro of a small
41 Nervous Europeans Snap Up London Property by Andrew Testa, The International Herald Tribune; Foreign interest boosts prime locations, by Tanya Powley
55

country, which for the sake of argument we will call Greece. As was discussed in Chapter 1, if this was achieved though a surprise exit and devaluation, the eurozone could end up at an unstable situation as capital flows out of other countries in anticipation of their subsequent exit. This could result in as other countries getting forced out see the above discussion on the Picking them off gradually scenario. The full NEWNEY approach could be applied to small exit, or even a phased approach to exits, where one country leaves, and then another. However, this is unlikely to be practical as the costs associated with issuing the new currencies will be almost doubled and the politics would be hard to work though. Instead, a different approach, called NEWNEY-Lite, could be used to allow the exit of a small country such as Greece. This approach retains the NEWNEY Principle that every Euro should be treated equally. However, instead of replacing every Euro with a basket of new currencies, a new parallel currency is launched and individuals are given the option of switching their savings, etc over to it. Lets use Deutsche Banks Geuro name for this new parallel currency. 42 Under NEWNEY-lite, Greece would develop the design and target level of their new currency, along with the monetary policy, central bank, etc in exactly the same way as with the full NEWNEY approach described earlier. They would plan to have higher inflation and interest rates in the Geuro, and so would anticipate a devaluation against the Euro over time. The Geuro would be traded on a shadow market prior to switch over day. On switch over day, everyone in Greece (or elsewhere for that matter) would be given the option to switch savings over to the Geuro maybe using some of the inertia or soft compulsion techniques described earlier. As with the full NEWNEY approach, Greek employment contracts would be switched over, as would government welfare and pension payments. Over time, competitiveness will be restored though the devaluation of the Geuro against the Euro, but savers who switched to the Geuro would not suffer as Geuro interest rates would be correspondingly
42 A variety of the parallel currency has idea has been discussed by Gavyn Davies (FT May 24); Tomas Mayer (Deutche Bank); and Huw Pill (Goldman Sachs). However, these cases all have Greece remaining in the Euro. With the NEWNEY-lite this would not be the case eventually.
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higher than in the Euro and so would offset the loss from devaluation. As with the NEWNEY approach, Greece would need to renegotiate its debt levels and other obligations such as those under payment mechanisms such as Target2. Other contracts would be switched over to the Geuro though negotiations the default being that they should be settled in Euros. So for, instance, loans could be switched over subject to potentially a higher rate of interest to reflect the future higher inflation and devaluation of the Geuro currency. The NEWNEY-lite approach would therefore allow an orderly transition of a small country out of the Euro and show commitment to the NEWNEY principle that all Euros are treated equally. As with the NEWNEY approach, NEWNEY-lite does not magically make debt levels disappear, or make a banking system that is insolvent, solvent. However, it allows an orderly transition, and by showing commitment to a very important principle that whatever future changes in composition of the Euro zone, all Euros will be treated equally, reduces the incentive for destabilising capital flows. And as a result other Yolk countries will not face as much risk of speculative outflows of capital that could undermine the Euros very existence.

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4. Winnings and losers, and the politics.

In this chapter, we will explore how the different mechanisms for exit by one country from the Euro will create winners and losers. We also consider the politics of getting the NEWNEY approach to work, as while the Wolfson prize question is focused on the economic processes, the political processes cannot, in the style of the economist on a desert island, just be assumed to work.
Evaluating winners and losers

We will compare two different mechanisms for how a country or group of countries could leave the Euro. The first of these mechanisms is the traditional surprise redenomination and devaluation, perhaps over an extended bank holiday weekend. The second mechanism is the NEWNEY (or NEWNEY-lite). To make the discussion of the specifics more real, we will continue with the example used previously of the Yolk countries or country exiting the eurozone representing around 20% of the eurozone. The key statistics for the new Yolk Zone are set out in the Chart 19.
CHART 19

Illustrative data for Yolk zone exiting the eurozone

DOLLAR BILLIONS

GDP Overseas country liabilities, of which: ECB (LTRO, ELA, etc) Target 2 Government debt help overseas Loans from the IMF
* Some will be via the central bank. *

2,000 1,800 400 500 800 100

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Lets also assume that in the event of the redenomination and devaluation approach, the NEY devalues against the US dollar by 30%, and the NEW appreciates by 10%. How the different players perform under the two approaches will be dependent on negotiations between different parties so for instance can the Yolk Government negotiate with the ECB, IMF and other European governments to redenominate its debt in NEY? How will Target 2 balances be treated? Who will fund a bank bailout for banks with solvency issues as a result of cross border lending? It will also depend on the pace at which the economies recover and the impact on the economies of the shock of the exit. As a result any analysis on winners and losers will be somewhat dependent on assumptions economic growth and negotiations. That being said, it would seem that the redenominate and devalue approach creates more winners and losers than NEWNEY. Lets look at some of them: A less informed Yolk saver. Under the redenomination and devaluation approach, their savings will be worse off by around 30% as measured in dollars. Under NEWNEY their savings will retain their value (roughly) as the basket of currencies will be around the same value as the Euro. For this saver, the redenomination and devaluation approach is very regressive as the richer Yolk savers will have moved their investments overseas. A Yolk borrower. Under the redenomination and devaluation approach, their borrowings will be reduced by around 30%. Under NEWNEY their debt will retain their initial value (roughly) as the basket of currencies will be around the same value as the Euro. A Yolk speculator. The Yolk speculator will have moved their savings offshore perhaps to Germany or outside the eurozone. The speculator might have even taken out additional loans from Yolk country banks. This speculator might be an individual or a corporation. Under the devaluation and redenomination approach, the speculators gain by around 10% as measured in US dollars, or 40% as measured in the new Yolk currency. Under NEWNEY, the
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savings of the speculator retain roughly the same value in US dollars. A Yolk country bank (or one with less Yolk assets than Yolk liabilities). Even with a capital outflow from the Yolk country, the Yolk bank is likely to have a high level of Yolk branch deposits; it will have some assets in the Yolk country but might also have some assets outside the country. It is likely to hold some Yolk Government bonds, though these might have been placed with the ECB in exchange for an ELA loan. We will assume that this bank will treat the currency that it uses to repay the ECB for this repo loan, as the same currency used for the denomination of the government debt. As a result the Yolk bank is likely to have less Yolk assets than Yolk liabilities. Under the redenomination and devaluation scenario, the Yolk bank makes a windfall gain as its assets are biased towards the stronger currency. Under NEWNEY, the value of the assets and liabilities match, so no gain or loss. A White country bank (or one with more Yolk assets than Yolk liabilities). The White country bank is unlikely to have any Yolk based depositors (or at least those that admit to being Yolk country depositors) because it does not have a branch network in the Yolk country. Many of the White country banks will, however, have made loans to Yolk individuals or businesses. As a result it is more likely to have more Yolk assets than Yolk liabilities. Under the redenomination and devaluation scenario, the Yolk bank could make a loss as more of its assets get redenominated into the weaker currency than its liabilities. Under NEWNEY, changes in the value of the assets and liabilities match so no gain or loss. The Yolk government. The Yolk government is likely to redenominate its debt into its new currency. Some of the terms of their debt might be set up so that their debt will remain in Euros but a substantial proposition of their debt will be redenominated. In addition, they are likely to redenominate the liabilities of their central bank to the ECB under Target 2 into their new local currency. As a result they will have up to a
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30% reduction in their debt under the redenominate and devalue process. Under NEWNEY, they would have a small reduction in their liabilities over time as the NEY devalues, assuming that they are able to negotiate a change of their liabilities to NEY on switch over day at the switch over date market rates, but without the corresponding increase in interest rates for their interest bearing debt clearly Target 2 balances are not interest bearing. The ECB. The ECB will be exposed to changes in the Yolk currency though its Target 2 obligations as well as its loans to Yolk country banks, secured against repos on government bonds. Under the redenomination and devaluation approach, it will make a 30% loss on its loans. Under NEWNEY, it might suffer from a gradual loss during the period of devaluation if the Yolk government is able to negotiate a change of their liabilities to NEY on switch over day at market rates but without the corresponding increase in interest rates. The analysis above shows that a redenominate and devalue approach creates major winners and losers. Speculators, Yolk Banks, Yolk borrowers and the Yolk Government, all receive a windfall benefit at the expense of the less advanced Yolk Saver, the White Banks and the ECB. The NEWNEY approach is more neutral in this regard. Now clearly some of the windfall benefits could be offset though a windfall tax, as suggested by Neil Record in his Wolfson entry. But without that, the default and devalue approach creates windfall profits for some.
The politics

There are considerable political challenges in negotiating for any country or countries to leave the Euro. Any open discussion on an exit runs the risk of accelerating capital flight, and so could precipitate the need to exit. However, a unilateral exit by one country can be achieved without all members of the eurozone agreeing, by the exiting country walking away from its treaty obligations. They might end up being
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shut out of global capital markets for years and even outside the European Economic Union, but they can make a unilateral decision to exit. Of course, the economic consequences for the rest of the global economy of this unilateral decision would be severe. The full NEWNEY approach requires all members to agree to the exit and some are passionate about preserving the eurozone and have significant political capital invested. Implementing the NEWNEY approach is therefore particularly challenging in that it requires commitment and agreement from a lot of parties. However, while this is a disadvantage, the reality is that the problems of the eurozone needs to be solved by a broad based discussion and agreement. A Greek exit on its own might resolve some of Greeces problems but would cause a lot of other ones in Portugal, Spain, Germany, etc. The Euro area needs to come up with an agreement on a holistic approach. At the heart of any decision making on this will be France and Germany. Progress towards European integration was driven by France and Germany with the French always conceding a bit more sovereignty than they really wanted and the Germans always paying a bit more than they really wanted. However, neither the political elite nor the electorates were at that time of the introduction of the Euro prepared to go all in towards a full fiscal union with joint and severable liability and the surrender of national fiscal sovereignty. This will be a core part of the ongoing negotiation between France and Germany. So how might an implementation of the NEWNEY approach come about? It seems likely that the first step would be an agreement of the NEWNEY principle that all Euros get treated equally. This might start through a statement made by Germany committing to the NEWNEY principle, perhaps as part of a Euro summit. While the discussions in preparation for this would need to be held in secret, it is a lot less of an explosive discussion than the discussion of a specific country exiting. The agreement to the NEWNEY principle, is likely to be precipitated by one of a number of external events that will trigger a crisis. For instance, an existing member of the eurozone could unilaterally
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decide to exit - for instance this might after the June 17 elections in Greece. Alternatively, the ECB and the eurozone leadership could decide to expel a country because, for instance, they default on their austerity commitments, so no longer are eligible to receive support from the ECB and so are become in default on their debt. Maybe most likely, the crisis will be triggered by a massive capital outflow (the bank jog becoming a bank run) which will be too much for the current firewalls. This would trigger an emergency meeting around increasing them, with German tabloids such as Bild and other papers coming out in opposition to any further German commitment. The negotiations around agreeing to increase the firewall, would struggle, and instead the NEWNEY principle could be agreed to, along with possibly a Euro wide bank insurance scheme. Agreeing to the NEWNEY principle is also easier for the eurozone core than agreeing an exit route because while it does admit that an exit is possible (and so that the Euro is not forever), it does not commit to a country leaving. Indeed, agreeing the NEWNEY principle is potentially, best way of supporting the Euro Zone remaining intact. Once the NEWNEY principle is agreed to, how might all the members of the eurozone all agree to the NEWNEY approach for an exit? If its just one country such as Greece exiting, NEWNEY-lite approach could be achieved with a relatively small bilateral agreement. NEWNEY requires more agreement, so a greater challenge. But its also important that a number of countries make the decision on a permanent basis on whether to stay in or exit the Euro cannot face an ongoing peeling of the onion as countries are picked off. This decision will take some time to make and may even go to a referendum. The benefit of agreeing the NEWNEY principle is that sufficient time can be allowed for this debate and negotiation can be done without the risk of capital flows. Why might the core countries of Germany and France accept NEWNEY? The first argument is that the NEWNEY approach provides greater stability than the crash exit. A crash exit would be a
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greater shock than Lehman and could require most of the eurozones banks to be nationalised as they will be insolvent. This will be particularly applicable it the exit were to be more than just a small country such as Greece. In addition, there is a risk that the exiting country could threaten to walk away from some of its debt obligations, or its obligations to the ECB. The latter might be achieved by the exiting country issuing its own currency, swapping it for Euros, and using the Euros received to repay its debt obligations. This threatened approach could be sufficiently disruptive that all members of the eurozone agree to the NEWNEY managed exit. Finally, it is likely that Germany will have become tired of the ongoing game of political brinksmanship so might welcome a move especially if this is to a slimmed down eurozone. They might remember the German proverb as pointed out by Gideon Rachman: Better an end with horror, than horror without end. 43

43 Time to plan an velvet divorce by Gideon Rachman, Financial Times.

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Conclusions
This document has been written as a contribution to the debate for what might be a Plan B in case one of more countries decided to leave the eurozone. But the approach also acts as a mechanism for the eurozone removing the risk of speculative attacks that could undermine the ongoing existence of the eurozone. The NEWNEY approach provides an alterative to the crash redenomination and devaluation approach. It also does relatively well at meeting the criteria laid out above: 1. Does the approach provide clarity on how Euro denominated contracts, assets, liabilities and sovereign debts are redenominated in the new multi currency regime? These can be derived from the NEW-NEY exchange rate and the initial exchange ratio. Or the contract can be settled with a basket of the new currencies. 2. Does approach result in matched treatment of assets and liabilities (and supply and sales contracts) for corporations, governments and individuals? This is achieved because of the equal treatment of all Euros. 3. How can the migration pace and process be managed so as to provide minimal disruption? The separation of one of more countries from the eurozone will always be a painful process. The NEWNEY approach is more disruptive in that it impacts the whole Union. However it removes the risk of ongoing disruption from speculative cash flows. NEWNEY-lite can operate with less disruption. 4. Does the migration treat individuals roughly evenly? The equal treatment of all Euros achieve this. The approach is not regressive. 5. How doable is the approach politically? There are clearly considerable political challenges to one or more member states leaving the eurozone. The challenge with the NEWNEY approach is that it requires all members to sign up. However, as has been discussed above, agreeing the NEWNEY principle as a first step is more doable.
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6. Impact on macroeconomic effects of exit including inflation, confidence and the effects on debt. The NEWNEY approach prevents the type of shock that could slow the global economy for a decade. It allows the Yolk countries to devalue, though in a more deliberate way. As it does not create winners and losers, it will probably result in fewer bankruptcies. 7. Does the mechanism, and its application, reduce the risk of speculative capital outflows? The NEWNEY principle and approach came from an investor working out how to position a portfolio to benefit from an exit of one or more country. It was designed so as to not allow speculative positions to benefit, hence it should radically reduce the risk of speculative outflows. 8. Does the discussion of an exit approach in governments in itself, result in the destabilising of the Union. As the approach does not provide any benefit to speculative capital flows, the discussion does not destabilise the Union. Even if the eurozone is expected to remain together, policymakers need a Plan B for how one or more countries could leave the eurozone. NEWNEY provides some components that could be included in this plan. But the NEWNEY approach could also support the eurozone remaining together as it reduces the risk of speculative capital flows that could destabilize the Union. So paradoxically, a plan that would allow a member state to leave the eurozone, could allow the Union to remain together. The real power of NEWNEY might come from it never being used.

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Biography, contact details and acknowledgements

Catherine Dobbs

Catherine received a BA in engineering from Oxford University. She subsequently worked in quantitative research at NatWest Investment Management and Gartmore Investment Management, developing investing and trading algorithms. She now divides her time between the South Korea, Thailand and the UK, and is an active personal investor. She can be contacted at catherineldobbs@gmail.com
Acknowledgements

The author would like to acknowledge the input and guidance she received from a number of people in finance, economics, policy and academia, all of whom shared their insights in a personal capacity. While a number will have to remain anonymous, she would like to publicly thank: Martin Baily, a senior fellow at the Brookings Institute and former chairman of the US Council of Economic Advisers during the Clinton administration. Martin has a PhD from MIT and graduated from Christs College, Cambridge with a bachelors degree in economics. Sir David Clementi, the Chairman of Virgin Money and Warden of Winchester College. He is a former Deputy Governor of the Bank of England and was Chairman of Prudential plc. David was educated at Winchester College and Lincoln College, Oxford, where he obtained a degree in Politics, Philosophy and Economics and a blue for athletics. Rick Lacialle, Global Chief Investment Officer of State Street Global Advisors. Rick was previously at Gartmore Investment Management. He has a BSc in Operational Research from Lancaster University and MSc in Econometrics from London
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Guildhall University. He is Chairman of the Board of Inquire (UK) a non-profit body devoted to the research and promotion of quantitative techniques in investment management, a member of the FTSE Policy Committee and he sits on the Asset Management Committee of the Investment Management Association. Hans Peter Maassen, a partner of Argos a Munich-based company that focuses on the acquisition and active management of SMEs, mainly in German speaking countries. Peter has a MBA in Business Administration from Stanford University, a Ph.D. in Chemistry from the Max-PlanckInstitute and a M.Sc. in Chemistry from the University Kaiserslautern. Michael Spence, a senior fellow at Stanford University's Hoover Institution and a faculty member of New York University Stern School of Business. He is the former Dean of the Stanford Graduate School and former Chairman of the Department of Economics at Harvard. Mike studied at Princeton University and Magdalen College, Oxford. In 2001 he was the recipient of the Nobel Memorial Prize in Economic Sciences. The author also benefited from public comments on her earlier submission from a number of academics and journalists, in particular Richard Baldwin (of Vox), Peter Coy (of Bloomberg Business Week), and Hugo Dixon (of Reuters Breaking Views). My thanks to all of them.

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