Get out of the euro but stay in the EU?

Since the introduction of the euro in 1999, support for it among the European population has generally been strong. Nevertheless, from time to time, discussions arise about the possibility of a member state voluntarily leaving the eurozone or expelling a country from it if it does not comply with the policy agreements made.[1] Dutch politicians have also expressed themselves along these lines at times. For example, among others, our former Finance Minister De Jager, following the example of his German colleague Schäuble, proposed removing Greece from the eurozone. With this thoughtless utterance, they managed to further fuel the euro crisis at that time. Today, there are still politicians in the Netherlands who would like to see that a country that does not comply with the policy rules of the Stability and Growth Pact (SGP) can be expelled from the euro. A country should also be able to choose to leave it.

Currently, the European treaties do not provide for the possibility of leaving the eurozone without also leaving the European Union (EU) and thus the single market. It is theoretically possible, however, for a member state to leave the EMU and the EU in order to apply for new EU membership at the same time. But the first question this raises, of course, is whether this is feasible in practice.[2] For example, the United Kingdom's (UK) experience with the Brexit has shown that leaving the EU is a lengthy, painful and costly process. It is unrealistic to assume that it is possible, in parallel with the exit negotiations, to already renegotiate rapid EU accession. So the probability that the exiting country will not be a member of the EU and the single market for some time, perhaps several years, is extremely high. If a country exits from the euro, the cost of a currency conversion comes on top of that.

Therefore, under the current legal framework, it is virtually impossible for a member state to leave the EMU without also having to leave the EU at the same time. This realization has sharply reduced the already low enthusiasm for a possible Nexit in the Netherlands. The price of an exit from the EU for an extremely open, highly EU-oriented economy like the Netherlands is probably significantly higher than that for the UK. But one now occasionally mentioned option is that of leaving the eurozone as a country, but remaining within the EU. Within a Dutch eurosceptic party such as JA21, this option would find support.

In this article, I discuss the financial and economic consequences of such a scenario. Because as far as I know, no one has so far seriously considered the practical consequences of a euro exit, although I cannot rule out the possibility that some member states have already done some homework on this issue behind the scenes during the euro crisis. I first discuss the consequences that would occur for all countries, regardless of whether their new currency is weak or strong after the euro exit. I then provide two scenarios, one for a country with a weak new own currency relative to the euro (Franconia) and one for a country with a relatively strong new own currency (Markenland). Finally, I briefly discuss how to create a stronger euro area. In this case, by "strong" I mean a eurozone with stronger market discipline than is currently present within the eurozone and an elimination of the existing moral hazard created by the fact that policymakers in weaker member states know that if they are in danger of getting into trouble, the European Central Bank (ECB) will ultimately come up with a bailout anyway.

[1] In the remainder of this article, I will assume a voluntary euro exit. At least in theory, it is also conceivable that a country will be expelled from the euro by the other member states because it structurally fails to comply with the policy agreements made. This politically highly relevant difference does not make much difference to the analysis of the financial-economic consequences of a euro exit presented here.

[2] However, such a scenario is fraught with enormous difficulties, such as the negotiation of an exit agreement and parallel decision-making on admission. By definition, this will involve very complicated and thus lengthy negotiations, which in all likelihood will also take place in a context of highly disturbed political relations.

The transition from one currency to another is not an easy process. To begin with, it requires an extensive information campaign, because all prices and rates must be converted from one currency to another. All prices, as well as leaflets, (government) tariff lists and administration must be changed everywhere. The same goes for IT systems, which in many cases must be converted from a mono-currency to a multi-currency system. New coins and banknotes must be produced and distributed. Preparations for this can easily have a lead time of a year or more. In the process, there is always the danger of companies and institutions rounding up their prices when switching from one currency to another, which can lead to temporary additional inflationary pressures.[3]

Furthermore, after the introduction of a new national currency, any cross-border transaction with another euro member country becomes an international transaction. In most cases, it must be settled in a foreign currency, and especially in euros. After all, this has suddenly become a foreign currency for a country that has left the eurozone. The exchange rate risk that thereby arises for an exiting country, and now also arises for trade transactions with the eurozone, will fall overwhelmingly, if not entirely, on its importers and exporters.

Introducing a new currency is a huge project, which, as mentioned above, needs time. Should a country unexpectedly decide (or be forced) to leave the eurozone, there is probably too little time to do so in a controlled manner, without causing chaos.[4] A complicating factor here is that in the scenario where the new currency certainly floats against the euro initially, one cannot determine in advance what the conversion factor (or exchange rate) of the new currency will be at the time of transition.[5] There is a real danger that it will all be rather chaotic. Not to mention the biggest obstacle, which is the question of how a country should handle all contracts with foreign parties. For it is far from clear how all existing contracts will be settled as far as cross-border assets and liabilities are concerned. Here lies the potentially greatest source of conflict, which will lead to legal proceedings that may drag on for years, or even decades. After all, interests vary widely and there is little to no case law to fall back on.[6]

[3] This problem would, of course, be little or no issue if the new currency had the value of one euro from the outset. However, this scenario is extremely unlikely, both in the case of a euro exit by a weak country and by a strong one.

[4] Initially, I work with the assumption that the euro exit occurs unexpectedly and that it takes place without a clear legal framework. Chances are that a country will have to fall back on temporary emergency legislation. Incidentally, this assumption is rather heroic, because the decision for a possible euro-exit (voluntary or forced) will almost certainly be preceded by the necessary political unrest. Also, the time required to get things right is very much at odds with secrecy. This is why I discuss the consequences of abandoning this assumption later in the article.

[5] It is conceivable, that after leaving the eurozone, a country would want to link its new currency tightly to the euro immediately. However, it is to be expected that initially there will be a solid currency turmoil and only after some time a stable peg of the new currency to the euro will be possible.

[6] Note that similar questions arise in the settlement of positions accumulated within the European System of Central Banks (ESCB) between national central banks. Here too, smooth settlement is not a given.

Countries are more intertwined than ever before

Since the euro was introduced in 1999, interstate trade has increased substantially. Furthermore, financial transactions between member states have also grown enormously. In part, this concerns the financial settlement of trade in goods and services, but separately, gross claims between them have increased sharply.[7] As a result, all countries saw both their gross foreign assets and their liabilities to foreign countries grow enormously. Incidentally, this is a global trend that started several decades ago as a result of the liberalization of international capital movements. This is illustrated for a number of countries and the euro area in Figure 1. This figure shows that because of this development, a country's net international debt or asset position today is only the tip of the iceberg of much more extensive gross holdings in or liabilities to foreign countries (see Figure 2).

This trend has also occurred within the euro area. The mutual claims of member states have also increased substantially over the past two decades, although it is difficult to show this trend from the data. Financial flows within the euro area are simply not reflected in the euro area balance of payments, for the simple reason that they are a "domestic" transaction within the euro area. In national balances of payments, it also plays a role that international financial flows are not broken down by region, with the exception of direct investment.

[7] A country's international asset position can be explained in part by balance of payments flows, both current and financial. Furthermore, wealth movements and exchange rate movements play an important role. For a formal analysis for the U.S., see Boonstra (2022).

Normally it is crystal clear in what currency transactions between countries are concluded and in what currency assets and liabilities between them are denominated. Assets of eurozone residents in the US are almost always denominated in US dollars, and conversely, US assets in the eurozone are usually denominated in euros. The exceptions to this rule are rare. Currency risk exists and is factored into the price of a transaction because all parties are aware of it. However, within the eurozone, currency risk between member countries is absent because they all share the same currency: the euro. Similarly, mutual receivables between countries are almost all denominated in euro, as that is the domestic currency of the eurozone.[8] Any exchange rate risk is non-existent within the eurozone. But that changes acutely as soon as a country leaves the eurozone. This is not such a big problem for new transactions, if the parties involved mutually agree on the currency to be used. But for the departing country's existing mutual claims with other member states, it is. These previously "domestic" transactions immediately change in character as a result of the euro exit, as they are suddenly recorded as a cross-border transaction. Whereby the first question that arises after such a step is of course in which currency the existing positions will henceforth be settled: in euro, or in the new national currency of the country that has left EMU?

[8] Exceptions arise when, for example, a Netherlands-based company issues a dollar-denominated bond that is bought by a French investor. However, such transactions are relatively infrequent.

In the following sections, I discuss the consequences of a euro exit of two countries, referred to as Franconia and Markenland. Here I start from the assumption that they succeed in surprising the markets and suddenly manage to achieve a euro exit "out of nowhere”. This is, of course, a heroic assumption, as explained in footnote 2. But this assumption helps to stylize the consequences of such a move. Further on, I discuss what the consequences would be if we abandon this assumption.

Scenario 1: Franconia, the euro exit of a member state with a weak economy

First, I discuss the euro exit of a country with a large economy and a supposedly weak debt position. This is because the country in question, Franconia, has a public debt ratio that is far too high, attracting much international attention. A default of the public sector is feared. Yet it is not a poor country: against Franconia's public debt are large private assets. The country's net international investment position is more or less balanced, but this is the balance of very large gross asset and liability positions. Economic growth is structurally low and the trade balance is in the red.

With a euro exit, Franconia could theoretically restore its competitiveness. However, this will only be the case if the new currency, to be referred to as the New Franc (NF), immediately depreciates against the euro. A second possible benefit of euro exit is that the country regains monetary autonomy. Franconia's central bank can resume its own interest rate policy, which is expected to be less strict than that of the ECB. Also, in theory, the euro exit allows it to evade the ban on monetary financing of public deficits. After all, the central bank can circulate NF, the new legal tender in Franconia, at will. The rate of inflation there will increase initially, due to higher import prices and relatively loose monetary policy. This also means that the initial competitive advantage of the lower exchange rate will soon be (partially) negated.

Unfortunately, these possibilities are at odds with European law, which requires for all EU member states (including those outside the eurozone) that the central bank be independent of politics and that monetary financing of government deficits is not allowed. So in the theoretical scenario where a country leaves EMU but remains a member of the EU, euro exit hardly brings room for a more expansive monetary policy.

If the NF immediately falls in value against the euro after its introduction, as might be expected, Franconia's euro-denominated debt as a percentage of GDP will naturally increase. After euro exit, Franconia will therefore want to pay interest and principal on its public debt in NF. After all, the NF is the new legal tender there. That would mean for the foreign holders of Franconia's public debt that they would have to take a substantial loss on this immediately. It is to be expected that they will not accept this just like that and will demand payment in euro through lawsuits. After all, much of the debt issued is governed by European, or even English, law.

If the government of Franconia is forced to pay the obligations it has incurred in euro, it will see a sharp increase in its debt obligations, as mentioned above, expressed in the national currency NF. And then the Franconian government will run into acute payment problems even faster than if it had simply remained in the eurozone. It is therefore obvious that there will be years of litigation against the Franconian government, and foreign investors will shun new sovereign debt in NF. Separately, any rating agency will view repayment in a currency other than agreed upon as a so-called credit event, resulting in an acute loss of creditworthiness. Franconia's residents will almost certainly lose their access to the capital market. A weak currency and continued monetary financing could lead to structurally excessive inflation.

Incidentally, the problem is not limited to Franconia's public debt. The private sector will also face major challenges. In particular, Franconian-based companies that have financed themselves on the financial markets in euro by issuing negotiable debt securities or with loans taken out with foreign banks may find themselves in trouble. They too face the dilemma of whether to service their debts, such as loans and bonds, in euro or NF after the euro exit. Legal chaos is the likely result.[9] If they opt for the former, their financial position will acutely deteriorate very sharply. After all, their income is largely in NF, and their expenses, expressed in NF, immediately increase sharply. Thus, not only the Franconian government, but also the larger business community, which had no major financial problems before the euro exit, will immediately find themselves in financial trouble. The same is true for Franconian-based banks. Instead, if they choose to service their foreign liabilities in NF, they too can expect mass claims from foreign creditors. This amounts to a massive default of Franconia's residents, resulting in a sharp credit rating downgrade. All in all, not a pleasant prospect.

The residents of Franconia with euro-denominated assets in the other euro area member states are, at first glance, the only ones to benefit from the euro exit. Indeed, expressed in NF, the value of their foreign assets increases. However, they do run the risk that eurozone-based companies and investors will try to seize these assets to compensate for their losses on Franconia. Incidentally, if the Franconians with assets in the eurozone are not the same entities as the Franconians with debts, this will not be easy. But companies that default on their euro-denominated debts are at great risk of having their euro-denominated foreign assets seized.

The only ones who really benefit from a euro exit are the residents of Franconia who hold most of their wealth in euro banknotes. Indeed, the domestic purchasing power of the euro in Franconia increases significantly.

Scenario 2: the euro exit of a member state with a strong economy

This scenario is about Markenland, a country with a strong economy. It has large current account surpluses in its balance of payments, and, over the decades, these have led to a substantial positive international net asset position. As with Franconia in the previous scenario, this net asset position is composed of even larger gross assets and liabilities. Markenland does not want out of the euro to restore competitiveness because it is already strong enough, as evidenced by the large current account surpluses. Markenland wants out of the euro because it no longer feels at home in the eurozone. It feels that too many other member states do not abide by the policy agreements made and it also feels that too often it has to pay for the costs incurred by other countries. Furthermore, it wants to regain its monetary autonomy, because it believes that the ECB's monetary policy is too much at the service of the weak member states and is therefore too lax, according to Markenland.

A euro-exit of a country with such a strong economy is expected to mean that its currency, to be referred to as the new mark (NM), will most likely immediately come under upward pressure and therefore initially appreciate substantially against the euro.[10] This will have an immediate negative impact on the competitiveness of Markenland, although falling import prices and a declining inflation rate may be able to ease the pain somewhat. It will also lead directly to substantial losses on foreign assets. Monetary policy in response to the appreciation and lower inflation of the NM relative to the euro will somewhat paradoxically probably have to be eased to prevent too sharp an appreciation of the NM. To the extent that Markenland's foreign assets are invested by pension funds, they are seeing their funding ratios fall due to the capital losses incurred and lower interest rates.

Even Markenland does not escape legal proceedings. Because to the extent that foreign customers have taken out loans with Markenland-based banks, if these are converted one-to-one into NM denominated in euros, they will see their debts acutely increase sharply. They will not accept that. They will therefore in all likelihood continue to serve their debts neatly in euro, which means that Markenland-based banks will have to take a loss on their loan portfolios.[11] Conversely, foreign creditors of the Markenland-based companies and investors in debt securities and shares issued by the Markenland government and companies based there will, on the contrary, demand that their claims be converted one-to-one into NM just like those of the Markenland residents.

The advantages for a euro exit are also by no means obvious in the case of Markenland.

Turbulence beforehand

The previous scenarios were based on the assumption that policymakers in Franconia and Markenland, respectively, could quietly prepare the euro exit and surprise the outside world with the exit overnight. This assumption, as explained in footnote 3, is very far-reaching and will not hold true in practice. A euro exit requires not only a lengthy and complicated legislative process, but also a long preparation time for the practical issues mentioned above.[12] In any case, the political discussion of a possible euro exit will attract immediate attention long before it is a fact. In a weak country like Franconia, people will convert their bank balances to cash as much as possible, or try to transfer these savings to a bank in another member state, to avoid conversion to NF. An bank run is therefore lurking in Franconia, resulting in a severe liquidity crisis. The only party that can intervene here is the ECB, but it is questionable whether it is willing to do so in this case. Nor is it obvious whether the EU is prepared to come to the aid of Franconian banks that have run into problems because the country wants to leave EMU, for example with the European deposit guarantee scheme.

By contrast, the opposite will occur in Markenland, when people will turn in their cash en masse to ensure that all their euros will be automatically converted into NM in the event of a book-entry conversion. Marken investors will try to repatriate the money they have invested in the rest of the eurozone. We can expect them to incur exchange rate losses in the process. Moreover, residents of other parts of the eurozone may quickly try to invest their savings Markenland to benefit from the expected appreciation. Long before a possible euro exit can be achieved, there will already be great turmoil in the financial markets.

Post-exit policy

When the exit process is then finally completed, the question naturally arises as to what monetary policy the exiting country should adopt. Since both Franconia and Markenland in the scenarios outlined are still members of the EU and the internal market, a peg of their new currency to the euro is an obvious choice. After all, exchange rate stability is conducive to international trade, and for both outgoing countries, the EU is still by far their most important trading partner. Pegging their new currency to the euro is rational policy. So in this respect, the countries are going to adopt similar policies as in the years prior to the introduction of the euro. In those years, all member states tied their national currencies ever more tightly to the Deutschmark. In doing so, they largely gave up their monetary autonomy, because as a result of the currency peg they simply had to follow the policy of the Bundesbank. If Franconia and Markenland link their currencies to the euro after the euro exit, their central banks will still follow the policy of the ECB in Frankfurt, with the main difference from the current situation being that they no longer have a voice in central bank policy.

[9] Note that the aforementioned emergency legislation restricts their freedom of choice. Incidentally, the legal framework is unclear even then, as both the departing country and the EU are likely to come up with emergency legislation. To further complicate matters, chances are that at least some of the bonds issued by Franconia residents will have been issued under English law. Probably most companies will have no choice here and will simply have to continue to meet their obligations in euros. Furthermore, for convenience, I am not mentioning shares issued by Franconia-based companies.

[10] By the way, we also have to take into account to some extent that financial markets will not understand that a country such as Markenland, that is doing so well within the eurozone, wants to leave the eurozone. This could result in markets and rating agencies concluding that policy makers in Markenland are quite confused, which would significantly weaken confidence in the NM.

[11] Again, the legal uncertainty discussed earlier comes into play. It is likely that Markenland banks will incur additional losses on their loan portfolios due to the euro exit.

[12] As a former project manager for the introduction of the euro at Rabobank in the years 1994-1999, I think I have some right to speak here.

The whole idea that a country can leave the eurozone in peace, i.e. without major chaos on the financial markets, is based on a serious fallacy. It is probably better for a weak country with payment problems to "just" default on its debts and enter the ESM, or, if necessary, negotiate a restructuring with the London and Paris Clubs, respectively.[13] For a strong country, it is even more irrational to want to leave the euro. Such a country is better off focusing on policies that make the eurozone stronger, with more market discipline.

Indeed, in the current situation, it is relatively easy for member states to evade market discipline because the ECB intervenes every time it fears that the survival of the euro area is at risk. Inadvertently, the central bank has become the main source of moral hazard in the euro area. By the way, this is emphatically not a reproach to the central bank. It has unintentionally found itself in this position because most member states are poorly complying with the policy agreements made, but at the same time are not taking measures to strengthen the eurozone. Certainly a large member state like Italy, but also Spain, France or Germany, can largely flout the policy agreements of the Stability and Growth Pact (SGP) knowing that the ECB will buy out the country should it run into trouble. A major underlying cause is that the euro area lacks a well-developed capital market. In particular, the absence of a so-called common safe asset has played tricks on the eurozone for decades. When tensions arise in the market and investors flee from Italian paper, for example, they often invest these funds in German government paper. The result of this movement is that interest rates on Italian government paper rise, while those on German paper fall. These movements are quite violent because the market for German government bonds is relatively small. The eurozone is the only major economy in the world in which the central bank must implement its open-market policy without a well-developed, economy-wide market for government paper. That such a market is barely there, even after more than 20 years, is an expensive policy mistake.[14] That the euro still exists in spite of this is at the same time an indication that, when all is said and done, member states do appear to recognize the great strategic importance of the euro. But accidents do happen.

If the ECB can conduct its monetary policy without having to conduct its open market operations in the debt issued by member countries, the situation will soon improve. If the euro area finally gets a good benchmark, like the market for Treasuries in the US, the fragmentation risk of the euro will be gone. As explained earlier, the development of this market is within reach and does not necessarily require further mutualization of member states' sovereign debt (Boonstra & Thomadakis, 2020; Boonstra & Van Geffen, 2022). The ECB can quickly develop this market itself by issuing debt securities , finally providing the capital market with a good benchmark. From then on, it can implement open market policy in its own securities, which is common internationally. If a member state then sees interest rates on its sovereign debt rising too far, the ECB can stay on the sidelines, where it belongs in this case, and let market discipline do its work. Then, if the policymakers of the member state in question cannot or will not adjust in time, the country may, in the extreme, choose to restructure its sovereign debt.[15] That will still be a painful process, but considerably less painful than a euro exit.

[13] The Paris Club is an international body that mediates between lending countries and countries that are unable to repay those loans provided with little or no credit. The club was founded in 1956 by 19 countries with which Argentina was indebted. The London Club is similar to the Paris Club. In the latter, it is exclusively governments on both sides of the table that conduct the negotiations, while in the London Club, banks are the negotiating partner (source: Wikipedia).

[14] The issuance of public debt guaranteed by all member states at the EU level is often wrongly equated in the debate with a prelude to a so-called "transfer union”. This is not justified, as there are several ways to introduce such an instrument, which are in principle independent of whether or not further fiscal integration is needed (Boonstra & Thomadakis, 2020). The realization that the presence of an EMU-wide benchmark is in itself crucial for the stability of the euro area is only very slowly penetrating policymakers.

[15] Of course, even under the European Stability Mechanism (ESM), a member state with payment problems can still turn to the other member states for help. But it is crucial that the ECB no longer play its own role in such negotiations.

Even if a country can leave the eurozone without leaving the EU and thus the single market, it is still a painful and extremely expensive process that comes with considerable financial turbulence and economic damage. That damage is not limited to the exiting member state; it also affects the rest of the EU. The idea that a country can take such a step easily and cheaply is therefore based on a misconception. The discussion of a smooth euro exit of a member state is thus fruitless. It is therefore better to strengthen the eurozone by increasing market discipline within the eurozone and removing moral hazard. An important part of that moral hazard disappears if the ECB can fully implement its open market policy without intervention in the sovereign bond market of member states. To that end, the presence of a well-developed market in common safe assets is imperative, with the ECB able to help develop that market by issuing bonds itself.

Boonstra, W.W. & B. van Geffen (2022), Monetary normalization offers opportunity to substantially strengthen euro area, ESB No. 4812, August 25, 2022, pp. 356 - 359

Boonstra, W.W. & A. Thomadakis (2020), Creating a common safe asset without eurobonds, CEPS ECMI Policy Brief 29, December 2020

Thanks to Bart Bierens, Bas van Geffen and Maartje Wijffelaars for their thoughtful comments on an earlier version of this article.

An earlier version of this article in Dutch appeared in MeJudice on Feb. 7, 2023