What if you were sitting in a snug little office looking out at one of Europe’s chillier, northern regions. You might think that the prospects for the summer, and every season beyond, might look warmer without a certain country in your cosy monetary union. A country that has just voted, en masse, to reject the policies that you prescribe.
But how to rid yourself of your recalcitrant friends? Cyprus, accounting for 0.2% of eurozone GDP is essentially irrelevant. Get policy wrong there, and it’s containable. Not like in the big, boot-shaped country you’re really worried about.
In fact, it’s so small that it’s perfect for a little experiment.
You see, if a country wants to negotiate an exit from the eurozone, the biggest challenge will be dealing with its banks. The asset side is easy — just redenominate and which debtors will complain?
The liabilities side is trickier. Redenomination there bears similarities to a haircut. Or a tax. It’ll require special bank holidays and short-term restrictions on transfers. And then there’s a bigger problem, as those you’ve just taxed, haircut or devalued won’t stick around to have it happen again.
Two words spring to mind. Capital and flight. How bad will it be? The doomsday theorists reckon that a country leaving the euro will be irremediably ruined. But what if a central bank is there to provide the liquidity that the banks need?
In Cyprus, there are suggestions that when the banks reopen, the ECB will have to fund almost the entire banking system’s liabilities as depositors yank their funds for something safer than a sovereign promise, like a mattress.
If, as you hope, the system recovers relatively quickly, that central bank liquidity will automatically be withdrawn as the private sector returns (just like it has with that LTRO whizz that you came up with last year).
The same thing could happen in a country leaving the euro. It just needs the ECB to backstop an agreed exchange rate — and to defend it to the hilt. Capital that flows out, and around, the redenomination will quickly return to take advantage of the newly competitive exchange rate.
If a depositor-funded bank recap goes well in Cyprus, then that’s one big step towards removing the fear of redenomination in a far more systemically important country. Exit becomes plausible if far from probable, not just possible.
And if it all goes wrong in Cyprus? Well, what better warning could you send to voters heading to the polls from Parma to Palermo? The sheer panic in the short-term, and misery in the long-term, that result from refusing your prescriptions will surely focus minds.