The topic of euro breakup has slowly been trickling back in the news, especially with the potential for Italy leaving the currency union, a so-called Italexit. In this post I want to explore one of the major conundrums that would-be exiteers must face; the problem of banknotes.
Almost all euro exit scenarios begin with the departing country announcing a shot-gun redenomination of bank deposits into a new currency, in Italy's case the lira. The effort must be sudden—if redenomination is anticipated ahead of time, depositors will preemptively withdraw funds from the exiting country's banking system, say Italy, and put them in the banking systems of the remaining members, say Germany, doing irreparable damage to Italian banks. After all, why risk holding soon-to-be lira when they are likely to be worth far less than euros?
Once the surprise redenomination has been carried out, the next step is to quickly introduce new lira banknotes into the economy. Lira deposits, after all, should probably be convertible into lira cash. This is much tougher than it sounds. Consider the recent Indian debacle. On November 8, 2016 Indian PM Narendra Modi demonetized around 85% of India's banknotes. Ever since then the Reserve Bank of India, the nation's central bank, has been furiously trying to replace the legacy issue with new currency. Because a nation's printing presses will typically only have the capacity to augment the stock of already-existing currency by a few percent each year, a rapid replacement of the entire stock simply isn't possible. India, which has been plagued with a chronic shortage of banknotes since the November announcement, is unlikely to meet its citizens' demand for cash until well into 2017. This in turn has hurt the Indian economy.
Like India, any Italian effort to print enough new lira paper to meet domestic demand could take months to complete. Without sufficient paper lira, existing euro banknotes would have to meet Italians' demand for paper money. Under this scenario, Italians would have to endure a messy mixture of electronic lira circulating with paper euros, reminiscent of the old bimetallic, or silver & gold standards, of yore. I say messy because everything in Italy would have two prices, a lira price and a euro price. In some ways this would be similar to the euro changeover period in 2002 when European shops displayed both euro and legacy currency prices on their shelves (lira, deutschemarks, francs, etc). The difference is that in the 2002 changeover the exchange rate was fixed, so the amount of mental arithmetic devoted to calculating exchange rates was minimal. In the case of Italexit and a new lira, the price of the lira would likely float relative to the euro, so the mental gymnastics required of Italians would be much more onerous.
If the Italian government were to attempt to fix this messiness by forcing retailers to accept euros and lira at a fixed rate, then Gresham's law would probably kick in. Because the government's chosen ratio is likely to overvalue the lira and undervalue the euro, Italians would hoard their paper euros (preferring to use them in Germany and elsewhere) while relying solely on electronic lira to buy things. This hoarding of paper euros, and the ongoing lack of paper lira, would likely lead to a severe banknote shortage, much like the shortages that India and Zimbabwe are currently enduring.
Some readers are probably wondering why Italy wouldn't try printing new banknotes ahead of the redenomination date. That way it could engineer a rapid lira changeover rather than a slow one. The problem here is that if Italian authorities take a preemptive approach, odds are that word will leak out that new lira are being printed, and depositors—spotting an impending redenomination coming down the road—will flee the Italian banking system en masse. So we are right back where we started. A successful Italexit requires that new lira banknotes be printed only after the redenomination has been announced, not before.
One technique that Italy might try in order to get lira paper into circulation as rapidly as possible is to use overstamping (described here). Once redenomination had been announced, Italian authorities quickly produce a large quantity of special stickers or stamps. They would then require Italians to bring in their euro banknotes to banks in order to be stamped, upon which those overstamped euros would no longer be recognized as euros, but lira. The window for getting euros stamped would last a week or two, after which the Italian government would declare that all remaining euro notes are no longer fit to circulate in Italy. Stamped notes would function as Italy's paper currency until the nation's printing presses have had the time to print genuine lira paper currency, at which point Italians would be required to bring stamped notes in for final conversion.
But even here Italy runs into a problem. An Italian with a stash of euro banknotes can either bring this stash in to be overstamped, and eventually converted into lira, or they can break the law and hoard said euros under their mattress. Hoarded euro note will still be valuable because they can be used to buy stuff in Germany, France, and in other remaining eurozone members. An overstamped euro, however, which has effectively been rebranded as lira, will be worth much less than before. Many Italians will therefore avoid getting their money stamped, preferring to get more value for their euro banknotes than less. And this means that Italy is likely to suffer a severe cash crunch, with euros being hoarded and new lira unable to fill the void fast enough, yet another manifestation of Gresham's law.
So any would-be euro exiteer faces several ugly possibilities, including a messy period of multiple prices to massive cash crunches.
It is because of these difficulties (and others) that I see euro exit as an incredibly unlikely proposition. The euro isn't a glove, it's a Chinese finger trap—once you've got it on, it's almost impossible to get out.
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If there is to be an exit, the most likely one will be the euros without the Eurozone approach. Rather than announcing a new lira, Italy simply says that it will officially leave the Eurozone while continuing to use the euro unofficially. This means that Italian banks would continue to denominate deposits in euros and keep euro banknotes in reserve to meet redemption requests. The euro would still be used by Italian merchants to price goods, and euro banknotes would continue circulating across the nation. The difference now would be that the Bank of Italy would no longer have the authority to print euro banknotes. Instead, Italy would have to import banknotes from the rest of Europe, much like how Panama—a dollarized nation—imports U.S. banknotes from the U.S., as do Zimbabwe and Ecuador. By employing this sort of strategy, all the hassles I wrote about in this post (multiple prices & cash crunches) are cleanly avoided while at the same time an exit of sorts is achieved.
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