A guest post by Small Town Man…
Whilst Europe’s eyes have been focussed on the situation in Cyprus, it is interesting that William Hill are now taking bets not on whether the Euro will survive, but who will be the first country to leave. The front runners are Cyprus, Italy, Greece, Spain, Portugal and Ireland.
So what are the implications for a country quitting the Eurozone?
To answer this, we need to understand how exchange rates are determined. There are basically two types of exchanged rate : pegged and floating.
Floating is easiest. In order to buy or sell currency, you have to go through a financial institution set up for the purpose – normally a bank. Like any commodity, there will be a buy and sell spread and the rate you get will depend on the simple rules of supply and demand. If you want it and the supply is limited, then you will have to pay more. But if you want it and no-one else does so that demand is low and the supply is plentiful, then you get it cheaper. Obviously, there are other factors that come into play but that is basically how it works.
Pegged or fixed rates are different. A country will decide to fix its exchange rate against a major or ‘hard’ currency such as Sterling or the US dollar. A government has to work hard to keep their pegged rate stable. Their national bank must hold large reserves of foreign currency to mitigate changes in supply and demand. If a sudden demand for a currency were to drive up the exchange rate, the national bank would have to release enough of that currency into the market to meet the demand. They can also buy up currency if low demand is lowering exchange rates.
So what would happen to a country inside the Euro if it left, presumably because of economic problems?
First, the country would have to print a supply of currency. Once that’s done they would have to issue that currency to it’s residents at whatever rate they decided against the Euro. Following the rules of supply and demand, one would assume that demand for the new currency was low, so you wouldn’t have to pay much to buy it.
As a result the price of your imports becomes considerably higher because nobody wants your low value currency. Perversely, this is good for your exports because they are cheaper.
Typically, you get high inflation. An example would be Argentina where the currency was pegged but then allowed to float after the junta fell. At one point, inflation hit 2000% a month. Turkey had a similar problem with the Lira. Zimbabwe currently has a worthless currency and is actively using the US Dollar instead. Black markets thrive.
To stabilise a floating currency, you need economic stability. This means that any country leaving the Euro would almost certainly have to peg it’s new currency against a hard currency in order to avoid disaster. The real killer for the residents would be hyper inflation which would wipe out savings and salaries overnight. You need to avoid that at all costs, but of course that’s easier said than done because if you weren’t in economic difficulties, you wouldn’t be leaving the Euro in the first place.
Ironically, there is no exit plan for anyone leaving the Euro because it was considered as unsinkable as the Titanic – and look what happened to that? Personally, I find it hard to understand how anyone could have thought that a group of such diverse countries could ever have made it work in the first place.
Ideology over economics and just look where it’s got us!