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OnTheDesignofaTemporaryExitofInsolventCountriesfromtheEuroZone

By

BeatrizArmendáriz∗

And

AlejandroReynoso∗∗

Abstract

Inspiredbymonetary reforms inLatinAmericaduring the last century, this essayproposesatemporary exit of highly‐indebted‐euro‐zone countries where these can swiftly move fromrecessionanddeflationtogrowthandmoderateinflationwhileavoidingcontagion.Keytoourproposal is a non‐confiscatory principle according to which the redistribution effects of amonetaryreformareminimizedviaasetof toolstobeusedintwowell‐designedinstitutions,namely, EUROFICORCA and EUROUDI. Both institutions are labelled after FICORCA and UDI,whichwere created in Latin America with the principal objective to support the transitionaleffects of altering the exchange rate regime. Moreover, we propose deficit‐reduction policiesunder the umbrella of a forum, which we label European Social Pact (ESP). Our proposalsuggests a transitional passage from recession‐with‐no‐growth to a moderate‐inflation‐with‐growth equilibrium in the periphery where the core European countries credibly committhemselves to support the three growth‐enhancing institutions we propose. In return, eachdepartingeuro‐zone‐countrycommitsitselftoanodefaultclauseviasettingverifiableoutcomesreflecting their commitment to the non‐confiscatory principle.We argue that this equilibriumcanbesustainediftheinstitutionsweproposeworkeffectively.Tothisend,wedeliverabasictoolkit. We further argue that the three institutions should work under a free monetaryconvertibilityenvironmentuntilinsolventeuro‐zone‐exiting‐countriesintheperipherycatchupwiththelivingstandardsoflivinginthecore.

KeyWords:eurozone,contagion,non‐confiscatory,EUROFICORCA,EUROUDI,EuropeanSocialPact.

JELClassifications:E31,E42,E50,E51.

We gratefully acknowledge inspirational support and transmission of knowledge from our PhD supervisor,Rudiger Dornbusch. Without his constant presence in our minds and hearts, this essay could have never beenwritten. The ideas entertained in this proposal are however solely ours, and we very much hope are neithermisinterpretingnorconveyingamisleadingimageofRudi’sgreatmind.Thestandarddisclaimerapplies:theideascontainedinthisproposalareentirelyourown,andnotthoseofHarvardUniversity,UniversityCollegeLondonandProtegoCasadeBolsa.∗HarvardUniversity&UniversityCollegeLondon∗∗ProtegoCasadeBolsa,Mexico____________________________________________________________________________________________________________________________________

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Introduction

Financialcrisisepisodesinmiddle‐incomecountriesabound.1Yet,veryfewhavebeenfollowedby well‐documented monetary reforms. Noticeable exceptions are found in Latin Americathroughoutthe lastquarterof thetwentiethcentury. Duringthisperiod,middle‐incomeLatinAmericaneconomieshavebeenmeticulouslyfollowedbyacademicsworkinginuniversities,andbyresearchersworkingininternationalorganizationsandthinktanks.Itismuchtotheircreditandthatofwell‐trainedpolicymakersthatwenowhaveawealthofinformationonfailedandsuccessfulmonetaryreforms.InthisessaywewillarguethatLatinAmericanmonetaryreformscanshedlightonthecurrenteurozone(EZ)debtcrisis.

BeforedescribingourviewsonpotentiallyreplicableexperiencesfromLatinAmericancountriestothetroubleddebtorsacrosstheAtlantic,letusstartwithsomehistoricalhighlightsregardingthe construction of the European Union (EU), and the architecture of the EZ. The EU hasconsiderablyevolvedsince the1957TreatyofRome.Nowadays, seventeenoutof the twenty‐seven European member states have adopted a fixed exchange rate mechanism, namely, theEuro. The Euro became a legal tender when euro‐denominated bills, coins and all financialtransactions replaced a dozen European national currencies in 2002.2 At this point in time,sovereign countrieswhicharenowconsideredasperipheralnations tobedistinguished fromthe so‐called EZ core,were regarded as qualifying nations for they hadmet the convergencecriteriaasperthe1992Maastrichttreaty.3 Duringtheroaring90sandbeyond,hardlyanyonecould have predicted that a major fixed‐exchange‐rate‐euro‐crisis would violently erupt lessthan tenyears after the launchingof theEuro.A currencywidely acceptedbymore than500millionindividualsfordailytransactions,andusednotonlyasameansofexchangebutalsoasastoreofvalue.

Whilesomewouldarguethattherootsofthecurrentcrunchdatebacktothe2007–2008subprimecrisisandbefore,tomanyobserverstheEZwasnot,isnot,andwillneverbeanoptimal

1 See, for example, Reinhart‐Rogoff (2008) andReinhart‐Rogoff (2009) for an extraordinary account of financialcrisesdatingbacktoEngland’sfourteenth‐centurydefault.2 Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal andSpain. As this article is being written, enlargement of the EZ has created a fixed‐exchange block of seventeencountries.Theinclusionoffiveadditionalcountriestotheblockoccurredatdifferentpointsintime.ThejoiningfivecountriesinalphabeticalorderareCyprus,Estonia,Malta,SlovakiaandSlovenia.3 The EZ peripheral countries are Greece, Ireland, Italy, Portugal and Spain. The EZ‐core is led by Germany andFrance.ItalsoincludesBelgium,theNetherlands,Luxembourg,AustriaandFinland.Relativetotheperiphery,thelattercountriesreviewhigheraverage incomeperhead,and lowerdebt toGrossDomesticProduct (GDP)ratios.With regards to the 1992 Maastricht Treaty. Broadly speaking, the Treaty established five main criteria forcountrieswishingtojointheEZ.First,inflationratescouldnotexceed1.5percentagepointsperyearatthetimeofjoiningtheEZblock.Second,annualgovernmentdeficitscouldnotsurpass3percentofthecountry’sGDPattheendof the preceding fiscal year prior to joining the block. Third, the ratio of gross domestic debt to GDP could notexceed60%ofthecountry’sGDPattheendoftheprecedingfiscalyear;theapplicantcountriesshouldhavejoinedtheEuropeanExchangeRateMechanismunderthenowdefunctEuropeanMonetarySystem,andshouldnothavedevaluedtheircurrenciesfortwoconsecutiveyearspriortojoining.Fifth,thenominallong‐terminterestratecouldnotexceedmorethan2percentagepointsthaninthethreelowestinflationEUmemberstates.

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currencyarea.Theythereforebelievethat the launchingof theEuro in2002wasablundertobeginwith.4Thisdebateishoweverbeyondthescopeofthisproposal.

Instead, we focus on the highly‐indebted‐EZ‐periphery, which currently represents a majorthreattotheglobalfinancialsystem.5Notonlyisincomepercapitaintheperipherylowerthanin the EZ core but also, and most importantly, various peripheral countries have suddenlybecome insolvent in their euro‐denominated obligations vis‐à‐vis domestic and foreigncreditors.Thesedebtscannotberepaidinthenearfuture.Insolvencyintheperiphery,inturnrepresentsa threat to theglobal financial systemasbanksandother financial institutionsareheavilyexposed.PolicymakersintheEZcorehavethusfarfailedtopreventinvestors’fearsofcontagion.6 This has exacerbated the crisis. Money keeps on flowing out of the EZ riskingbanking panics as depositors are losing confidence in the Euro at a rapid pace. A speculativeattackontheEurosimilartothatexperiencedduringtheGreatDepressioninthe1930scannotbe ruled out under the current fixed exchange rate regime. The deflationary trend, rapidcontractionofoutput,andrecordhighunemploymentratesaremoreseverelyfeltinperipheralEZhighly‐indebtednations.

Inspiredbymonetary reforms inLatinAmericaduring the last century, this essayproposesatemporary exit of highly‐indebted‐euro‐zone countries where these can swiftly move fromrecessionanddeflationtogrowthandmoderateinflationwhileavoidingcontagion.Keytoourproposal is a non‐confiscatory principle according to which the redistribution effects of amonetaryreformareminimizedviaasetof toolstobeusedintwowell‐designedinstitutions,namely, EUROFICORCA and EUROUDI. Both institutions are labelled after FICORCA and UDI,whichwere created in Latin America with the principal objective to support the transitionaleffects of altering the exchange rate regime. Moreover, we propose deficit‐reduction policiesunder the umbrella of a forum, which we label European Social Pact (ESP). Our proposalsuggests a transitional passage from recession‐with‐no‐growth to a moderate‐inflation‐with‐growth equilibrium in the periphery where the core European countries credibly committhemselves to support the three growth‐enhancing institutions we propose. In return, eachdepartingeuro‐zone‐countrycommitsitselftoanodefaultclauseviasettingverifiableoutcomesreflecting their commitment to the non‐confiscatory principle.We argue that this equilibriumcanbesustainediftheinstitutionsweproposeworkeffectively.Tothisend,wedeliverabasictoolkit. We further argue that the three institutions should work under a free monetaryconvertibilityenvironmentuntilinsolventeuro‐zone‐exiting‐countriesintheperipherycatchupwiththelivingstandardsoflivinginthecore.

4See, forexample,Krugman,Ofstfeld,andMelitz (2012). In thisbook, the threeauthors inquestiondescribe themeaning of an optimal currency area, and argue that in their own view, theEZdoes not accordwellwith theirdescriptionofwhatanoptimalcurrencyareashouldbe.5Again,asalreadyspelledoutinfootnotethreeabove,werefertotheperipheryasthosefiveEZcountrieswhichdebt to GDP ratios are high relative to the rest. These peripheral countries are viewed as urgently needing tostrengthen their finances and repay their debts for they pose a real threat to the global financial system to theextentthattheyareunabletomeetdebtrepayments.Theperipheralcountrieswearereferringto,inalphabeticalorder,areGreece,Ireland,Italy,PortugalandSpain.6 We refer to the core EZ countries as those founding members European states which debt to GDP ratios arerelatively low when compared to the periphery. These countries are Germany, France, The Netherlands, andBelgium.

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WedistinguishtwoequilibriainthecurrentEZdebtcrisis.First,thestatusquo,whererelativetothe core, highly‐indebted countries in the periphery review more acute deflation rates andoutputcontraction,lackofliquidity,andlatentpoliticalunrest.Weviewthisdeflation‐with‐no‐growth equilibrium as an exceedingly unstable one: it suffices that one country exits in adisorderly fashion for it to provoke a bank run triggering a major crisis in the internationalfinancialsystem.Second,amoderate‐inflation–with‐growthequilibriuminexitingEZmembersintheaftermathofatransitionalperiod.Throughoutthiscriticalperiod,contagioniscontainedviaastrictadherencetoanon‐confiscatoryprinciple.Thisprincipleisrespectedbymeansofatoolkittobeusedinsupportofourthreepillartransitionalinstitutionsnamely,EUROFICORCA,EUROUDI,andESP.

Thisessayelaboratesonthetransitionfromthecurrentequilibriumtothenewone.Basedonhistorical episodes, notably fromMexico, a country that not only is geographically close to amajorcommoncurrencynation,namely,theUnitedStatesofAmerica,butthatalsotradeswithsuchagiganticnationundertheNorthAmericanFreeTradeAgreement(NAFTA),wearguethatintheaftermathofawell‐designedtransitionalphasewhereaninsolventcountryexitstheEZinanorderly fashion,amoderate‐inflation‐withgrowthequilibriumcanbeattained.At thesametime,minimumcontagioneffectscanbeexpectedthroughoutthetransitionalstage.7

Howcanadepartingcountrymanageitseconomyduringandintheaftermathofthetransition?Howcancontagionandconsequentcollapseoftheinternationalfinancialsystembepreventedwhen a highly indebted country leaves the EZ core?How can a departing country implementgrowth‐enhancing structural transformation, return to solvency and eventually rejoin the EZcore?What kind of support international organizations can lend to the periphery during thetransition inorder topreventcontagion?Wedonotclaim tohaveananswer toeachof thesequestions.Wehoweverhopetoshinelightonpossiblevenues.

Thereminderof thisproposal isstructuredas follows. Insectiononewedescribe thecurrentcrisis as we view it. We argue that relative to the status quo, a monetary reform under fullconvertibility in a departing EZ‐member‐state is a superior second‐best scenario for both thecore and the periphery. Inspired by well‐documented evidence and historical experience, insection two we spell out twelve suggestions for a successful monetary reform, two‐thirds ofwhichrelyonour threeconfiscatory‐deterrentpillar institutions. Insection threewedescribethesimpleanalyticsofamonetaryreforminordertoconveyourmainmessage:awell‐designednon‐confiscatory reform should preserve the value of hard‐currency denominated assetsaccumulated in the past and should allow for a smooth transition to a future income streamdenominatedinweakcurrencywithoutalteringthecompositionofeconomicagents’portfolios.In section four we highlight ten main challenges which merit special attention upon an EZdeparting country embarks itself in amonetary reform. In section fivewe finally unleash the

7TheexperienceofMexicoisveryrelevantindeed.Mexicoisthecountryinthathasfounditselfindefaultforthelongest period of time since 1860 up to these days (Reinhart andRogoff (2008)). It is also the country that hassuccessfullymanaged to dealwith crises, built awealth of experience on foreign debt negotiations, and enactedexemplarygrowth‐enhancinginstitutionsthroughoutitsmostdifficultcrisisepisodes.

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modusoperandiofthethreemainpillarinstitutionsinsupportofoursuggestions,andatoolkittoconfrontthetenchallenges.Insectionsixwespelloutafewconcludingremarks.

1. TheEuroZoneCrisisAsWeSeeItWell‐documentedhistoricalprecedentsonthesplinteringofnationsunderacommoncurrencyandinterlinkedassetsandliabilitiesexist in largenumbers.8Anexit fromtheEZbyamemberstate is however unprecedented. To most observers, the magnitude of an eventual exit isenormous.First,becauseofthelargevolumeoftransactionsintheEZinvolvingover500millionindividualswhousetheEuroasalegaltenderandatleast200millionmoreintheEUinvolvedindailyeuro‐denominatedtradeelectronically. Second,becauserelativetomostrecentbreak‐ups in, for example, the former Soviet Union in 1989, EU residents live in an increasinglyglobalizedeconomywheretransactionsdenominatedineurocanbeperformedinstantlyacrosstheentireworld.An eventual collapse of euro‐denominated transactions therefore affects billions of economicagentsincountriesthathavealreadyestablishedfinancialinstitutionsandstockmarketsinthetwentyfirstcenturysuchastheBRICs.9 AdisorderlyexitofaperipheralEZmemberstatecanthus have disruptive consequences in theworld financial system and daily lives of billions ofpeopleacrosstheglobe.An orderly departure, on the other hand, could have myriad and immediate effects in thedepartingnation(s)andintheremainingones.Wewillhoweverarguethatintheeventofaneventualdeparture,providedthisiswellthoughtout,thecatastrophicconsequencespredictedbyavastmajorityofobserversthusfarcanbeavoidedatbest,minimizedatworse.Suchanexitcanonlybe an imaginativeone if onlybecauseof the lackof legallybindingprovisions inEUtreaties,whichdonotcontemplateEZexits.Eveniftherewereabenchmark,legalorotherwise,historyhastaughtusthatthereisnoequivalentofChapter11bankruptcyproceduresgoverninginternationaldebtcontracts,inclusiveofcaseswheresuchcontractsareprivate.10IfwewereabletoanticipatesomeoftheconsequencesofanEZcountryexiting,whatwouldourforecast be from the standpoint of the departing country? Irrespectively of whether thedeparture is sudden and disorganized, one should expect the establishment of a local centralbank,adevaluationof the localcurrency, inflation,acompletereorganizationof thedepartingcountry’spaymentsystem,andan imminentnecessity todealwithdebt: agreedrescheduling8Thesplinteringofamodernnationfollowedbytheintroductionoflocalcurrenciesineachsuccessornation,andsubsequentsharingofassetsexternaldebtobligationsisnotnewindeed.Theearliestcaseconcernswhatusedtobeknown as Great Colombia in 1829. More recent historical examples include the break‐up of Austro‐ HungarianEmpire in 1918, the dissolution of the Ottoman Empire after World War I, the divorce of the Central AfricanFederationin1953,andthedisintegrationoftheformerSovietUnionin1989.See,notably,Armendáriz‐Williamson(1993),andGarber(1994)formoredetaileddescriptionandinsights.9TheacronymstandsforBrazil,Russia,India,andChina.RelativetotheUnitedStatesandEurope,thesearefast‐growingeconomies,whicharerapidlybecomingimportantplayersinfinancialmarketsworldwide.10Undertheprevailingso‐calledChapter11legalprovisionsintheUnitedStates,forexample,aenterprisethatisunabletomeetrepaymentobligationshassomeremainingassets,whichareeitherservedtorepaythecreditorsofthetroubledenterpriseorbecomeunderdirectcontrolbythebankruptenterprise’screditors.

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andwrite‐downsofexistingliabilitiesinonescenario,outrightdefaultisanother.Moreover,thedepartingcountry’sresidentswillinevitablyexperiencevariousmonetaryshocks,notablythoseofindividualsundercreditandlabourcontracts,andinvestorsinstockandmoneymarkets,tomentionafew.Therapidcascadeofeventscaneasilyspiraloutofcontrolinwhichcasewemayexpectstagflation,thatis,zeroornegativegrowthalongsidehyperinflation.Ourmainfocusherewould therefore be on the effects in the departing country, which can inevitably have acontagioneffectonothereconomies.Inourview,widespreadinsolvenciesinexitingEZmembersandchaoticscenarioselsewherearerooted in confiscatory redistribution. When economic agents fear that their assets will beconfiscated as a result of a EZ exit by amember state, confiscation of assets in the departingcountryandbeyondrepresentamajorthreat.FromthestandpointoftheEZcore,EUmembers,andbeyond,thefearsofaconfiscatoryreformtakingplaceintheEZexitingmemberstateimplyassetconfiscationintheEZandelsewhere.Thosefearsmayprovokeachainofbankruns,whichcan in turn trigger a collapse of the fixed exchange rate system in the entire EZ, an eventualdisintegrationof theEU,whichmember states can reinstate tradebarriers, freemovementofcapital,andobstaclestolabourmobilityacrossEUborders.Asdramaticastheabovescenariosmightappear,thetruthisthatonecannotruleanyout.Itistherefore legitimate to explore venues for an orderly exit of one or various peripheral EZmembers inanattempt tominimizeunavoidablecostsduringacritical transitionalstage. Wewillarguethatorderlyexitscanonlytakeplaceaftertheenactmentandconsolidationofstableinstitutions in the entireEZ, not only as away to containEZ andEUdisintegration, butmustimportantly, toreignitegrowthandprosperity.Wearehenceforth takingaclearstand:wedonot embrace the idea that, relative to an orderly and well design exit, a disorderly one canbenefitanyone.Underanorderlyexit,thatis,underanwell‐designedmonetaryreform(MR)aswecontemplateit,thedetailsofwhichwillbedeferredtosectionfivebelow,anEZmemberconsideringtobreakaway,albeittemporarily,shouldprioritizeaninstitutionalizeddebt‐reschedulingoftheinternalandexternalobligationsviaawellthoughtoutmechanism.NotethatdepartingfromtheEZandMRsareusedinterchangeablythroughoutthisproposal.Ourconjectureonanorderlydeparturebeingpreferredoveradisorderlyoneprioritizingdebtis inspired by successful monetary reforms in Latin America. By way of an example let usassumeforamomentthatasovereignmemberoftheEZexitsinanorderlyfashion.Whatdowemeanby orderly?Thedeparting country states from the start that its ultimate objective is totakea“sabbatical”,thatis,atemporarilyleaveofabsencefromtheEZfixed‐exchange‐ratecoreinordertomoreeasilygeneratehardcurrencytomeetitseuro‐denominatedobligationsontheonehand,andtobrightenitsgrowthprospectsontheother.11

11 An alternative scenariowould be that of a disorderly exitwhere the EZmember defaults. Based on historicalexamplesfromthe1980sinLatinAmerica,weknowthatthestandardreactionbytheindebtedcountry’screditorsacting ina concertedaction fashion is expected tobeharsh ifonlybecause creditorsmaybe tempted to send “asignal”whichcanpotentiallydeterfuturedefaults.(Formoreonthissee,forexample,Armendáriz(1999a)).

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Notethatwhatwearesuggesting isnotanunreasonablestrategybecausetheexitingEZstatecanpotentiallygeneratecurrentaccount(CA)surplusesmorequicklyunderaflexibleexchangerateregimeasopposedtorelyingonthelong‐termdeflationaryeffectsunderafixedexchangerate. To generate a CA surplus, however, the departing EZ member will inevitably have tointroduceitsownlocalcurrencyviaitsownandresurrectedcentralbank.ThesenewbillswillbeworthlessthantheEuro(henceforth:thehardcurrency).Inotherwords,adepartingcountryshouldexpectadevaluationofitsowncurrencyandanipsofactoinflationaryspiral.Moreover,the departing EZ nation should also expect capital flight and, possibly, more severe politicalunrest relative to the already existing one. In what follows we will argue that, from thestandpointofaninsolventEZ‐memberintheperiphery,anddespitetheincommensurablecosts,exitingtheEZinanorderlyfashionParetodominatesthestatusquo.Followingtheintroductionofthelocalandweakercurrency,fightinginflationismostlikelytorepresent a major challenge. In parallel to enacting EUROFICORCA to deal with debt, thedepartingcountrymustthereforekeepinflationundercontrolifonlybecauseitwouldwishtoavoidtheriskofhyperinflationandconsequentcosts.12Tothisend,ourproposalwillthereforeinvolve the launching of EURODI, an institution designed to facilitate a continuous re‐benchmarkingofpricede‐indexationinaninflationaryenvironmentwhereeconomicagentsriskconfiscation.EURODIshouldinturnbesupportedbycontext‐specificESPstoproperlycontainthe risks of over‐indexation and hyperinflation in the labour market. The details on how toestablish such inflation‐deterrent and growth‐enhancing institutions will be spelled out insectionfivebelow.Ourideasofarisanythingbutnew.EversinceDornbusch’sseminalcontributiondatingbacktothe mid‐1970s, it has been widely recognized that the static effects of a deflation and adevaluation of a local currencymight be in principle the same in the long run, but that theirdynamic effects in the short and long run are quite different.13 Specifically, because of pricestickiness,adeflationisreflectedslowlyintheCAunlikeadepreciation,whichhasanimmediateshortruneffect.AdepreciationviaaMRmightthereforebepreferredatthiscriticaljunctureintheEZperiphery.14 A real depreciation induces economic growthwithin a shorter time framerelativetoadeflation.15Suchgrowth‐enhancingeffectworksthroughtheCA.Andwhatwewillbearguinginthisproposalisthatgrowth‐enhancingCAsurplusescanonlybereinforcedwhen

12Evenifhighinflationisanticipated,hyperinflationcreatesinefficienciessuchasmenucostsandshoeleathercostswhich countries in South America, notably Brazil and Argentina, are quite familiar with following unsuccessfulmonetaryreforms in thesecountries,especiallyduring themonetaryreformswhich tookplaceduring the1980sdebtcrisis.13See,notably,Dornbusch(1976),andRogoff(2002).14Asthismanuscriptisbeingwritten,atleastoneexamplemayillustratetheimmediateneedofhardcurrencytoavert a disorderly default on foreign obligations by a euro zonememberwithinweeks. Greece, in particular, isunder intense pressure to repay 14.4 billion euro of its outstanding debt to bondholders by March 2012 (TheFinancialTimes,January14/152012).Onasomewhatlargerscale,similarpressuresarebeingfeltbyItaly,Spain,Portugal,andIreland,whichriskofdefault,asreflectedbytheirbondyields,aresoaring.15 This has been widely acknowledged and proven to be empirically true in various countries including Brazil,Colombia,Greece,India,Israel,Malaysia,thePhilippines,SriLanka,Thailand,SouthAfrica,andformerYugoslavia.See,forexample,Edwards(1986).

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accompanied by the above‐mentioned transitional institutions so as to permanently improvecompetitiveness.16Oneshouldexpectthatarealdepreciationofalocalandnewlycreatedcurrency(henceforth:theweak currency), assuming away transaction and switching costs for the moment, to be asuperioroptiontothatofthedeflationaryvenuecurrentlypromotedonbycoreEZleaders.Thequestionagainiswhatexactlydowemeanbywell‐designedtransitionalinstitutions.InadditiontomutuallyreinforcingEUROFICORCAandEUROUDI,andaswealreadymentionedabove,weadvocate context‐specific ESPs to avoid the temptation of over‐indexation and to controlinflation in a concerted manner among key economic players in the departing peripheralcountry.Moreover,wesuggestthecreationofaESPacrosstheentireEZcountries.Weaskourreaderstobepatientwithregardstothedetailsandlogisticsinvolvedinthecreationandmodusoperandiofthesekeyinstitutions.Let us focus for themoment on the critical transitional stage. This passage is so exceedinglydelicate that only by clearly understanding it, can we possibly justify the creation of threeinstitutions in lieuofor inadditiontothosethattheEUmembershavealreadyinvestedin. Inour view, EZ peripheral countries are already going through a transitional stage. The currentscenario in those countries is one of recession, deflation and associated costs. The costs ofstayinginfortheperipheryaregradual.Mostnotoriously,thesecostsarereflectedinchangingeconomic agents’ relative incomes and wealth levels. In particular, income distributiondistortionshavealreadysurfacedviahighlevelsofunemploymentandafallinrealwages.Inthelong run, however, as in the case of Argentina during the 1990s, a prolonged deflation in acountryreviewingdebt togrossdomesticproduct(GDP)ratiosseeminglymanageableexantecanleadtoexpostinsolvencyandaneventualcollapseofthefixedexchangerateregime.17Nowletuscomparetheabove‐mentionedstatusquo,toanscenariowhereaEZmemberdecidesto exit in an orderly fashion. Associated costs for the departing country are unavoidable too.Again,theideaisnotnew.KrugmanandTaylor’simportantcontributionsinthe1970sdeliveredmaininsights.Transitionalcostscanindeedbehigy,particularlywhenrelativepricevolatilityisintense. These must be expected in economies with dysfunctional payment systems, weakbankingsectors,andlowaveragehouseholdwealthlevels.18Ourpointupuntilnow is that,having takenastandonanorderlydeparturebasedon theoryand,most importantly,onexperiencefromsuccessfulmonetaryreforms,wearewellawareofthepotentialconsequencesofintroducingaMR.Inanutshell,aMRfollowedbyadepreciationoftheweak currencymay have considerable effects onwealth distribution because of debt andinflationand,inmostinstances,thetransitionaladjustmentsmayhaveaconfiscatorydimension.16NotethatthekeyassumptionwearemakinghereforthecaseofasplinteringEZstateundertakingamonetaryreform is that theMarshall‐Lerner condition holds, that is, that ceteris paribus, a real depreciation improves thecurrent account, which usually happens if imports and exports are sufficiently elastic with respect to the realexchangerate.Forgreaterdetailsonthis,see,forexample,Davison(2009).17 For adeeperunderstandingof theArgentine crisis in the1990s and at the turnof the tenty‐first century, seeHausmann‐Velasco(2002)18 See,Krugman andTaylor (1978), andReynoso (1989) for an in‐depth analysis on an array of potential costsassociatedwithmonetaryreforms.

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Itisimportanttonotethatwhenweusetheterm“confiscation”here,wearenotreferringtoalegalappropriationofprivateproperty.Rather,weassociatethetermconfiscationtothosecaseswhere policy makers take critical decisions, and where those decisions can drasticallydeterioratethevalueofeconomicagents’financialassets.InsectiontwobelowweborrowfromawealthofexperienceonMRsinLatinAmericatomoreclearlyseehowtheconfiscatoryeffectsofMRscanbepotentiallyminimized.Why worry about confiscation? Fears of confiscation of assets can exacerbate panics andcrashes,whichtheEZcoreisrightlyconcernedabout.Investorsknowthatuponbreakingapart,EZ policymakers’ decision in the departing state can severely affect incomedistribution, andthatassetsbothinthecoreandtheperipherymayend‐upbeingconfiscated.KeyactorsintheEZdepartingstateandinothercountrieslinkedtoitareexpectedtoreactdefensivelyagainstanykindofconfiscationassociatedwiththevalueof their financialassets.This isparticularly truewhen the government of the departing country introduces capital controls and/or imposesmultiple exchange rate regimes,whichhavebeenwidely enduredby, for example,millionsofLatinAmericans followingwidespreaddefaults in the1930sand1980s.19Taxationof financialtransactionsoftenreferredtoasTobintaxes,mightalsobeperceivedashavingaconfiscatorydimension. The confiscatory effects of a MR by a departing EZ member can therefore bemultidimensional,andareoftenpoorlyunderstood.LetusattempttoshedlightonthemeaningofconfiscatoryMRs.Ourfocusforthemomentwillbe on just creditors, debtors, and depositors whose transactions take place via financialintermediaries(henceforth:banks)locatedinadepartingEZcountry.PriortotheMR,thebanks’assetsandliabilitiesaredenominatedinEuros(henceforth:thehardcurrency).Ourthreeactorsin thisexamplewill ask/speculateonwhatwillhappen to theirassets in theaftermathof thereform.Oneoptionthatthelocalgovernmenthasistolabelallassetsandliabilitiesintheweakcurrency.Inthiscasecreditorswouldworseoffbecausetheown,whichareanassetfromtheirstandpoint,wouldbeworthless.Likewise,debtorswillbebetteroffbecause thevalueof theirliabilitiesvis‐à‐vistheircreditorswilldecreaseastheirpastliabilitiesinhardcurrencycanonlybepaidoutoftheircurrentincomedenominatedintheweakcurrency.Howaboutdepositors?They will be clearly worse off too because their hard‐currency denominated savings wouldsuddenlyhavelostvalueduetotheMR.Weviewthisasanundesirablescenarioifonlybecausedepositorswouldattempttotaketheirassets out of the country, potentially triggering a chain of bank bankruptcies. Evenwhen thegovernmentof theexitingEZnationmanages to takedepositorsbysurprise,capital flightwillaffectboth,thecountrywheretheMRtakesplaceandotherstatesinthecoreandelsewhere.Hitby a massive inflow of capital may prompt other national authorities to intervene, as suchinflows can create inflation. The European Central Bank (ECB), for example, which has aninflation‐targeting mandate might have to intervene. Also the Federal Reserve Bank in caseEurosflowoutoftheEZ.

19ForadetailedaccountofLatinAmerica’ssovereigndefaultsinthe1930sand1980s,seeArmendáriz(1990),andfortheoneinthe1980sseeSachs(1982)andSachs–Cohen(1992).Cardoso–Helwege(1992)deliveraexcellentoverview on how unnecessary distortion such as multiple exchange rate regimes and capital controls can becounterproductive,alsointhecontextoftheLatinAmericancrisesafterWorldWarII.

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The situation can be even worse for creditors and banks that are reluctant to grant debtrestructurings.Thisisbecausedebtorscandefault,inwhichcase,theirassetswillbecompletelyconfiscated.Eventemporaryconfiscationwillbeharmful.Creditorsandbankswouldliketoberepaid on the day repayments are due, if not before, in an attempt to minimize loses.Confiscation in this case, in instances where the government declares that all assets in theaftermathoftheMRwillbedenominatedintheweakcurrency,willneedtobeenduredlocalandforeigncreditors,banks,anddepositors.Now,letssupposeanalternativescenario,whichiscloserinspirittowhatweadvocateinthisproposal.Assumethatcreditors,banks,anddepositorsinthecountrywhichisonthevergeofengagingitselfinaMR,aregovernedbypolicymakerswhocrediblyrecognizeallexistingassetsin the strong currency. Specifically, by decree, policy makers declare that all assets held bycreditors, banks, and depositorswill be fully convertible into local currency at the prevailingmarketexchangerate.Transactioncostsaside,creditorsarenotaffectedbythereform.Bankswillnotbeaffectedneitherandnorwill depositors.The threeactorsunder this scenario canfullyconvert their local‐currencyassets intohardcurrency, andkeep themsafelyanywheretheywish.Under this new scenario, debtors are relatively worse off when compared to their creditors,becausetheirobligationsinweakcurrencyattheprevailingmarketratescannotberepaidoutoftheircurrentincome.Unlikethepreviousscenario,creditorsandbanksarerelativelybetteroff,while debtors are worse off. Debtors’ insolvency is clearly due to the potentially huge andinvoluntaryhike in theirdebtobligations relative to their current cash flows.Aren’t creditorsand banks hit by debtors’ insolvencies? Of course they are. But relative to debtors’ outrightdefaults,creditorsandbankswouldbebetteroffiftheyagreetograntdebtrestructuringsinanorderlyandinstitutionalizedfashionviaEUROFICORCA.On a bright note, it is important to point out that debtors’ insolvency problems – be thissovereignorprivate‐namely,thatofgeneratingincomeintheweakcurrencyinorderrepayinhardcurrencyistransitional.Thereasonbeingthatoneshouldexpectthatinaneconomywherethere is a local currency issued by the country’s central bank, growth prospects are brighter.Thissolvesdebtors’insolvencyprobleminthelongrun.Theproblem, inourview, isoneof insolvency in theshort runor throughout the transitionalstage.Quitesimply,thedifferencebetweencashflowsinlocalcurrencyanddebtsdenominatedin hard currency, albeit at convertible exchange rates determined by the market when debtobligationshavetoberepaid,can leadtoachainofdebtors’bankruptcies.This isalwaystruewhen debtors, be these private or public, in a country launching a MR do not meet theirobligations, and banks and other creditors refuse to grant debt rescheduling. Failure to grantdebtreschedulingcan in turn leadtoachainofbankruptcies ifandwhendepositors fear thatbankrupt banks are no longer solvent and therefore are no longer perceived as trustworthyguardiansoftheirdeposits.Whatwe have just described attempts to display our understanding of the current EZ crisis.First,andquiteindependentlyoftherootsofthecrisis,anorderlydeparturebyEZmembersisa

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second‐best scenario. To be precise, it is the best possible scenario at this particular point intime.OnceEZmemberstatesintheperipherypubliclyrecognizethatMRsarethewayoutfromtheirinsolvencyandpoliticalproblems,theymustalsodistinguishquiteclearly,anddeclareit:whatwill exactlyhappenwithpast assets and liabilities.Moreover, they should also spell outquiteclearlywhatwillbedoneinthefuture.Thatis,post‐reformscenario.Onceaclearviewiscrediblyconveyedregardingwhatthefaithofmedianvoters’previousassetsandliabilitiesarewithaneyeonthefuture,policymakersshouldcrediblyconveythatvisionandmakeitpublic.Webelievethatwithastrongendorsementof“that”visionbytheEZcoreandinternationalaidagencies,thetransitionalstagecanhaveminimumcontagioneffects.Thepolicymakers’visioninthedepartingEZstate,priortoaconvenedsplinteringfromEZcore,mustbeonthearchitectureofthenewfinancialsystem.First,andpriortotheMR,policymakersintheEZexitingperipherymustchosebetweenafreeconvertibilitysystemandanotheronewithconvertibilityrestrictions.Undertheformer,whichistheoneweadvocate,banks,enterprises,andindividuals’balancesheetscanbeaccountedforinmorethanonecurrency.Tobeprecise,inEuros,inthecountry‐specificweakcurrency,andincountry‐specificEUROUDIs.20Second,fromthestandpointofremainingEZcorememberstates,andwithoutunderestimatingthesunkcostsincurredinthearchitectureoftheEZ,weadvocateare‐examinationbythecoreofkeepingtheEZperipheryin.AdevaluatedEurothesedaysislargelyperceivedasbeingrootedintheEZperiphery’sdefaultrisk andpotential contagion‐related costs. Paradoxically, thepeculiar typeof contagionunderthestatusquoisbeneficialtotheEZmembers.It isnotdeliberate,butisneverthelesspositivebecause by keeping the peripherywithin, the core enjoys the benefits of a depreciated euro,whichisinturnbeneficial,particularlytothecoreEZmembers’CAs.NotethatwearereferringtoarealdepreciationintheEZcore,whichmightbequitesubstantialindeed,ifonlybecauseofthemandateoftheECB,namely,thatofbeinganinflationtargetinginstitution.Webelievethat,politicalconsiderationsaside,thepeculiartypeofcontagionwearereferringtounderthestatusquoislargelyoffsetbythecostsofdisorderlyandpossiblyunavoidableperipheraldepartures.Ontheotherhand,therearemeasurablefinancialcostsofkeepingtheperipherywithintheEZ.An obvious one is the contribution by the core EZmembers to bailouts under the EuropeanFinancialStabilityFund(EFSF).21Furthercontributionstothisfundmightbeneededtobailoutperipheral countries threatening to leave for the sake of avoidingwidespreadbank runs. Theidea of establishing a Banking Act similar to the one launched in the United States in theaftermath of the Great Depression, which was approved and signed by President Roosevelt,might also be a necessary cost that the EZ coremust have to consider soon, if only becausecontagionderived from insolvenciesand followupbankruptcies ismitigatedwhendepositors

20NotethatweareusingthewordEUROUDIinterchangeablywhenreferringbothtoaninstitutionandacurrency.This may be potentially misleading. To be perfectly clear, EUROUDI here is used in connection with inflation‐adjusted units of account, often used in financial markets going through an emerging market phase. Clarifyingdetailsarefullyexplainedinsectionfivebelow.21TheEFSFhasalreadycommitted780billionEurostotemporarylendover400billiontotheperipheryinordertoavertdefaults.Subsequentcontributionsareexpectedas thecrisisunfolds.See, TheCouncilofEuropeanReport(2011)tobefoundinhttp://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/123979.pdf

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are insured across all EZ member states. Additional intangible costs are incommensurable.Downgradesbyinternationalratingagenciesandtheireffectsmostbefactoredin.Onamoretheoreticalnote,theCoasetheoremwouldsuggestthatthereareefficiencylossesinthepresenceoftransactioncostsemergingfromongoingnegotiationsamongthecorestatesandbetweenthecoreandtheperipheralEZmembers.Inasimilarvein,Pigouviantaxationmustalsobe considered because perceived positive externalities generated by the core lead tounderinvestmentincontagion.Thisisduetothefactthatsuchexternalitiesarenotinternalizedbytheperiphery.22UnderinvestmentincontagionisinturnaddingtensionsamongEUmemberstates.Arecentcase inpoint is thedividebetween theUnitedKingdomand themainEZcoreleaders,namely,GermanyandFrance.Moreover, EZmember states aredemocratically electedpoliticians, andvoters’ dissatisfactionmightfurtherexacerbatepolitical‐economygeneratedturmoilandassociatedcosts.Hence,ouranswertothequestionastowhetherthetangibleandintangiblecostsofkeepingtheEZblockasit is outweighed by the benefits of allowing an orderly monetary reform in the periphery iscautiously a positive one. To close this section we hereby take a clear stand on this too: anorderlymonetaryreformin theperipheralEZmemberscanhaveapositive impactongrowthandaspeedypassagefrominsolvencytosolvencywithminimumcontagioneffectsifandonlyifallEZmembersintheperipheryconsideringasuccessfulmonetaryreformadheretoournon‐confiscatoryprincipleviathethreeinstitutionstobespelledoutinsectionfivebelow.2. TwelveprinciplesforaneffectiveNon­ConfiscatoryMonetaryReform.Asstatedfromtheonset,wecannotthinkofabetterbenchmarkfortheEZcrisistoassessMRsthan the one offered to us via an extraordinarywealth of experience on this very subject bymiddle‐incomeLatinAmericaneconomies. Inourownexperienceandreviewofthe literature,LatinAmericaexhibitsmultiplewaysoflaunchingMRs,buthardlyanyofthosefocusesonournon‐confiscatory principle. Quite simply: We view this as a constraint on EZ departinggovernments.Also, andperhapsmore importantly, asaprecondition forminimizingandevenavoidingthenegativecontagioneffects,whicharealreadylooming.While fullyrecognizingthatminimalisticconfiscatoryeffectsdrawnfromLatinAmericanMRs,whichweencapsulateintwelvecriticalpoints,mightnotbereplicabletotheEZhighly‐indebtedstates,weneverthelesspointthemoutinhopethatatleastasubsetofthosemightdeliverusefulinsights.Thisbeingsaid,webelievefirst,thatbyfocusinginpriorityontheknowhowandthelogisticsviaspellingoutwhatseemstousverycommonindeedcanbehelpfulatthisparticularjuncture, and, second, that the EZ peripheral countries considering to abandon the EZ fixedexchangerateregimemightbenefitconsiderablybythefollowingpracticalsuggestions:

22See,Coase(1960)andPigou(1920).Asthisessayisbeingwritten,however,theEFSFhasbeendowngradedbygrading agencies, which hinders euro zone leaders to increase core members’ and other international agenciescontributions to the bail‐out fund. The greatest fear is that the current bail‐out strategy aimed at keeping theperiphery within the euro zone is simply not working. Greece’s external debt obligations alone amount toapproximately 350 billion euro, that is, nearly half of euro zone core commitments to the EFSF. (InternationalHeraldTribune,January18,2012)

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1. Introduce State­ContingentMechanisms ofDebtRestructuringWith Creditors as an

integral part of the Monetary Reform. Uncertainty can have a positive value added.Unlikethecurrentcostofdeflation‐with‐no‐growthintheperiphery,whicharecertainandeven quantifiable, these costs are low relative to contingent transitional costs underuncertainty. Specifically, relative to certainty under the status quo, incurring contingentcosts in an uncertain world is a preferred strategy for all parties involved. Contingentrepayments by otherwise solvent debtors prior to the reform are possible under flexiblemechanisms thatallow forautomatic state‐contingentdebt rescheduling, like theMexicanFICORCA,whichde‐tropicaliseunderthelabelEUROFICORCA.Inanutshell,andanalogousthe latter, the former institution has proved to be efficient in that debt restructuring isgrantedselectivelytoasubsetofotherwisesolventdebtors.Inprinciple,thesedebtorsareallowedtomakerepaymentscontingentonobservables,suchasinflation,growthrates,andreal wages. Debtors’ ability to meet full and timely repayments without the need ofautomaticrestructuringcriticallydependsonhowquicklyeconomicgrowthisreignited.

2. AvoidOver­indexation.Exitingafixedorsemi‐fixedexchangerateregimeisequivalenttodevaluingthelocalcurrencyinthecountrythatundertakesaMR.Adevaluationofthelocalcurrency can, in turn, improve solvency because of its swift and direct effect on thecountry’s CA.We view this as the onlyway to return to positive and sustained economicgrowth.Wehoweveracknowledgetheobvious:devaluationsareinflationary.Andinflationhasaconfiscatoryelement.Itaffectsincomedistributioninawaythatisbiasedinfavourofwealthier local actors who can more easily hedge against devaluation and inflation. Theconfiscatoryeffectsofadevaluationandfollowup inflation,even ithasnothappenedyet,areinevitable.IntheparticularcaseoftheEZ,wealthierindividualsarealreadytakingtheirhard‐currencydenominateddepositsoutofpotentiallydepartingEZperipheral countries.The confiscatory effects of inflation, however, can beminimized if and only if efforts aremadetokeepinflationundercontrolviamutuallyreinforcingEUROFICORCAandEUROUDI,supportedbycountry‐specificESPs.

3. KeepBudgetDeficitsUnderControl.Confiscatoryeffectsrootedindevaluations,inflationasidemomentarily, other transitional costsof aMRare inevitable. Suchcosts canbehighindeed. These include transaction costs, switching costs, and political costs, tomention afew. Awell‐designed reform can considerably lower these costs. Howeverminimal thesecosts might be, we believe that such costs should be in a first instance absorbed by thegovernment.We recognize that these costs will ultimately have to be shouldered by thedeparting country’s taxpayers. We advocate the introduction of a fair taxation system.Specifically,fully‐enforcedprogressiveincometaxationasopposedtovalueaddedtaxesandobscuredistortions,typicallybiasedagainstthepoorcankeepconfiscationatitsminimumif only because political‐economy considerations can be exceedingly destabilising andhindereconomicgrowthandprosperity.23InthecontextofaEZstateundertakingaMR,and

23 See, for example, Alesina‐Perotti (1996)whose empiricalwork suggests that the effects of increasing incomeinequalities can have a negative impact on growth via lowering investment. In the same vein we argue that a

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totheextentthatlargedeficitscontributetohighinflation,andthathighinflationcanerodethe budget itself, we further emphasize the inflation‐deterrent role of a state contingentmechanism for debt restructuring, an adequate benchmarking for de‐indexation, and theintroduction of a convening platform to conduct income policies, via EUROFICORCA,EUROUDIandESP.Theseinstitutionsmustbeputtoworkinconjunctionwitharevampedand independent central bank, the treasury department, and the judicial system in thedepartingEZmember.Wecannotemphasizeenoughthekeyroleofbudgetdeficitreductionpoliciesperse.Thesepoliciesshouldbeviewedasanecessaryconditionintheirownrightforensuringmacroeconomicstabilityandmicroeconomicefficiency.24Well‐designedbudgetdeficitreductionpoliciescanfurtherminimizetheconfiscatoryeffectsofareform.

4. FleeFromAnySlantthatmayignitePanics,BankRunsandContagion.Onalargerscale,

the costs of amonetary reformmay be a by‐product of panics, bank runs, and contagioneffects.Thesecanbemitigatedoravoidedonceeconomicagentsarepersuadedthatanon‐confiscatory principle will be institutionalized before and after the reform. And in thecontextof theEZ,viaour threepillar institutions.Creditorsshouldbere‐assured that thevalueoftheirassetswillbepreserved,eventhoughrepaymentswillnecessarilyhavetobewritten down and/or delayed via debt‐restructurings in departing EZ states. We alsorecognize that this has a confiscatory dimension because of the following three reasons.First,becausewrite‐downsareclearlycostlytothecreditors.Second,becauserepaymentsviadebtreschedulingwillbemadetolocalcreditorsinlocalcurrency,whichinvestorsmaywish to convert into hard currency involving transaction costs. Third, because delayedrepayments lower the value of financial institutions’ assets given that proceeds fromotherwisetimelyrepaymentshavealternativeuses.Thatis,rescheduleddebtcaninvestedinmoreattractiveprojectsyieldinghigherreturns.Wealsorecognize thatdepositorswillhavetobeinsured,andthatdepositinsuranceinvolvescosts,whichultimatelywillbeborneby taxpayers. Avoiding these confiscatory costs is impossible, minimizing them is. Theearlier economic growth kicks off with the supporting above‐mentioned pillars,EUROFICORCA,EUROUDI,andcountry‐specificESPs,thelowerthecostsofpotentialpanicsandcrashes,andthelowertheconfiscatoryelementofamonetaryreform.

5. Embrace Free Convertibility. Avoiding unnecessary distortions is a key element of a

successful monetary reform. Imposition of currency denomination of bank holdings,exchange rate controls, dual or multiple exchange rates, Tobin taxes, among others areconfiscatory. Without a priori value judgement on any such type of interventions, westrongly adhere to a free convertibility regime and property rights protection of alreadyacquiredassetsbyalleconomicagentspriortotheMR.Wefullyacknowledgethatcreditors’lackofcautionpriortothe2007–2008subprimecrisisisnotunprecedentedandthattheir

monetaryreformcanworsenincomedistributionandthattotheextentthatlowgrowthisbiasedagainstthepoor,theconfiscatoryeffectsaremoresevereasthepoorsuffermostrelativetowealthierindividuals.24SeeCórdoba(1992)foralucidexpositionoftheMexicanexperienceonbudget‐deficitreductionpoliciesduringthedebtcrisisofthe1980s,andtheirpotentialreplicationtothecaseoftransitionaleconomiesinEasternEuropeintheaftermathofthefalloftheBerlinWall.

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investments in theperipheryweremadewithin the context of a growingworld economywhichcametoahaltratherlatedue,partially,tofinancialengineering.Wehoweverbelievethat keeping creditors confiscation at a strict minimum, namely, via state‐contingenteconomy‐widereschedulingfacilitiesundertheumbrellaofEUROFICORCAistheonlywaytomoveforward.

6. EnsureInternationalCooperation.Anyreasonableproposalofamonetaryreformhasan

inter‐temporal dimension.We have emphasized its dynamic effects when comparing thepotentialbenefitsofamonetaryreformrelativetothoseofadeflationunderthestatusquo.The missing piece of this seemingly complicated set of suggestions thus far is that thepotential benefits of a MR can only be reaped with the support of internationalorganizations’assistance,bothfinancialandtechnical.Onlywiththeendorsementofawell‐design monetary reform by international organizations can investors be reassured onminimalistic confiscatory effects triggered by EZ departures. When viewed this way,cooperation between the periphery and international organizations ismutually beneficialforcooperationistheonlywaytoavoidamajorcrisis.InsectionfivebelowweexplainhowcooperationcanmoreeasilybeachievedviaaEZ‐wideaEUROFICORCAandaEU‐wideESP.

7. Make Debt Redemptions in Local Currency. Indeed, we strongly believe that financial

transactionscontractedinhardcurrencypriortotheMRshouldberespectedaccordingtothetermsandconditionsspecifiedineachandeverycontract.Debtrepaymentstoforeigncreditors via EUROFICORCA should be made in weak currency by a multiplicity of localdebtors, but outlays from EUROFICORCA to foreign creditors should be made in hardcurrency.However, ifandwhen foreigncreditorsrefuse tograntdebtreschedulingunderalreadynegotiatedagreementswithEUROFICORCA,debt redemptionsaccruing to foreigncreditors should be made in local currency. All debt contracted with local financialintermediariesshouldalwaysberepaidandredeemedinlocalcurrency.25Notethatincomefromdebtrepaymentsandredemptionsaccruingtolocalcreditorsinweakcurrencycanbefullyconvertedintohardcurrencyattheprevailingmarketrate.Werecognizethatthishasa confiscatory element in favour of partially insolvent debtors.We however believe thatsuch confiscatory effects can be kept to aminimum in comparisonwith outright defaultsandifawelldesignedmonetaryreformisclearlyannounced,understood,moreimportantly,negotiated andacceptedby all creditors leading to the establishmentof a comprehensiveMRviaEUROFICORCA.

8. IssueNewDebtinLocalCurrencyOnly.Afterthemonetaryreformhastakenplace,newly

contracteddebtwithintheboundariesofthedepartingcountryshouldbedenominatedinlocalcurrency.Newdebtwithexternalcreditors,ontheotherhand,shouldbecontractedinEuromarkets,andbegovernedby theexternalcreditors’ rulesandregulations inexternalcreditors’ countries of residency. Confiscation in this case is negligible because local

25 Note that this might be partially violating our non‐confiscatory principle because there are undeniabletransactioncosts.Specifically,debtorsarerepaidinlocalcurrency,whichtheymosteitherspendinthedepartingEZstateorexchangeforhardcurrency.Avoidingtransactioncostsisimpossible,however.Insectionfiveweexplainefficiencygainsemergingfrommakingrepaymentstolocalcreditors‐whocanfreelyconvertthoserepaymentsintohardcurrency–inlocalcurrencyinlieofmakingthoserepaymentsinhardcurrencydirectly.Ourconjectureisthatsuchefficiencygainslargelyoffsettransactioncosts.

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currencydenominatedobligations canbe converted intohard currencyobligations at netpresent value prices, and because the return to Euromarkets by the periphery in theforeseeable future isunrealisticunless,of course,departingcountriesarewilling topayahighriskpremium,whichwedonotanticipateittobepostreformscenarioverydifferentfromthecurrentone.Further,weanticipatethatcountriesinthecorewillbeabletobelesscreditconstraint,andthatthevalueoftheEFSFwillbeupgradedenablingthecoretolendmore in support ofwell‐designMRs in the periphery.Using theEUROFICORCAvenue fornewly contracted debt will be useful if and when unforeseen contingencies emerge andnewlycontracteddebtneeds toberestructuredagain.Ourconjecture,basedonhistoricalevidence, is that EUROFICORCA will also help to relax credit constraints in a post MRscenario.

9. ObtainIMFEndorsementandSupport.Adepartingcountry’scentralbankcanonlyissue

localcurrency. It shouldhoweverenjoyaccess tohard‐currencydenominateddebt,whichwillberedeemedinhardcurrency.Noticethatthiscouldhaveaconfiscatoryingredient iftaxpayerswere forced topay for enjoying thebenefits of bailouts suchas contagionwithuncertainreturns.ButthiscanbeavoidedviaStandbyagreementswiththeInternationalMonetaryFund(IMF).Weview the IMFasakey international institution tominimize theconfiscatory dimension of a successful monetary reform if only because the IMF hasaccumulated a wealth of experience in extending loans to countries going throughtransitionalbalanceofpaymentcrises.Whilesomeoftheseexperiencecanbetransmittedto other institutions such as the European Bank for Reconstruction and Development(EBRD), it has taken the IMFa greatdeal of trial‐and‐error fine tuning tomake sure thatcountries, particularly those in middle‐income Latin America, to ensure compliance witheconomic policies that make sense. These policies are required in those EZ departingcountries inorder fordepartingEZcountris tohave theirsolvencystatusreinstated. TheroleoftheIMFpotentiallyworkingintandemwiththeEBRDisindeedexceedinglyvaluableindealingwith the currentEZ crisis.At currentmarket rates, concessionary loansdonotinvolve a high cost on taxpayers while their return in terms of technical assistance totroubleddebtorsintheperipheryarehighandofcrucialimportancetothestabilityoftheglobalfinancialsystem.

10. Maintain theOption toRevert to theCore. A departing country can revert to the corecountries’ currency if andwhenboth the core and thedeparting country find itmutuallyconvenient.We should note thatwhile a forced exitmight have a very large confiscatorycomponent in the aggregate, particularly on the periphery, what we advocate here is avoluntaryexit.WecouldunderstandthatcoreEZmembersmightbetemptedtopenalizeEZcountries in the periphery as a signalling device to other nations in the periphery. Thisstrategyisunreasonable,however,becausesignallingviasmallstatesintheperipheryisnotcredible by large insolvent countries.26 More importantly, political instability andconsequent effects on growth is unwarranted under forced exits. If well designed, avoluntary, transparent, andmutually agreed upon exit has minimum confiscatory effectsrelative to forced departures. It is also the onlyway to guarantee amutually convenient

26Armendáriz(1999a)elaboratesonthisfortheparticularcaseofBoliviavis‐à‐vislargercountriesinLatinAmericasuchasBrazilandArgentinainthecontextofthe1980sLatinAmericandebtcrisis.

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return of EZ peripheral countries, which investors might factor in when evaluating theconfiscatorydimensionofthereform.Wethereforeinsistonanegotiatedsabbaticalduringwhich the EZ peripherywill dowhat is needed to return, in exchange of conditional andcrediblesupportbytheEZcore.

11. Tolerate Dual Currency Transactions. The departing country must tolerate free

circulationofboth,hardandweakcurrencies,attheprevailingexchangeratedeterminedbythemarket.27Banningfreeconvertibilityandcirculationofhardcurrencybythedepartingcountryexacerbatesdistortions,rangingfromunder‐invoicingandover‐invoicingofexportsandimportstotheemergenceofblackmarketsforhardcurrency,whichcanfurthererodethe departing country’s ability to remain solvent in hard currency. Confiscation in theabsence of free circulation and convertibility is therefore biased against the country’streasurydepartmentsandultimatelyagainstthetaxpayers.

12. DelegateTheIntroductionofNewBillsOntoaThirdParty.Asinanymonetaryreform

we knowof, there are transaction and switching costs associatedwithwithdrawing hardcurrency to be converted into local currency for daily transactions. We endorse a cost‐effectivetransition,which iscountry‐specific. Insome instancestheover‐stampingofbillsmightbetheacosteffectivesolution,asitwasthecaseduringthewell‐documentedAustro‐Hungarian empire monetary collapse. Whichever venue the departing country wishes totake, cost effectiveness should take into account the new reality. Dismantling an entirenetworkofelectroniccashdispensersdoesnotseemtobeacost‐effectivestrategy.Addingatechnologicaldevisetoexistingcashdispensersseemsmorerealistic.Thischallengeshouldbetakenonboardbycountriesinthecore,wherehighskilllabourisrelativelyabundant.Asfortheissuingofnewbills,mostefficientmoneyprintingbillscanbefoundelsewhere.28Wethereforeadvocatecosteffectivedelegationofbothcashtillsandnewbillsontocountriesthataremostefficientsoastoavoidforgery,andkeeptransactionandswitchingcostatastrictminimum,therebyloweringtheconfiscatoryeffectsofthereform.

Note that our endorsement of policies (1) – (8) above aimed at minimizing confiscationcriticallyreliesonourthreepillartransitionalinstitutions.Thequestionremainsofcourseastowhatexactlyarethose?Again,wepostponethisquestiontosectionfivefurtherbelow.

27 This is already happening in a considerable volume of electronic transactionswhere costumers are given thechoicetoselectthecurrencytheywishtopaywithwhenusingacreditordebitcard.Forexample,priortomakingapaymentatastoreinFranceaUKresidentinsertshercardintoamachine,whichdisplaysamenutochosefrom,namely,apaymentinEurosorSterlingPounds.Onceachoiceismadebythecostumer,sheisrequestedtoenterherpersonal identification number (PIN) and the transaction takes place provided, of course, that the costumer inquestionhasenoughfundsinthecaseofadebitcardorhasnotexceededhercreditceilingincaseshechoosestomakethepaymentusinghercreditcard.Wesuggestsomethingsimilarforthecaseofcashpaymentsinthecountrythathasundertakenamonetaryreform.Sheshouldbeabletopayinhardorlocalcurrency.Transactioncostsarelowrelativetoconsolidationofresidents’expectationsonpolicymakershonouringfreeconvertibilityatalltimes.Theonlydifferenceinthecaseofcashtransactionsisthatlocalbillsandcoinswillnotbeacceptedasamediumofexchangeinacountrybelongingtotheeurozonecore.28NewZealand is a case in point.Not only it has a proven record of cost effectivemoney printing, but the newmoney in circulation has proven to be anti‐forgery and environmentally friendly. New Zealand’s technology atproducingbillsfordailytransactionsincashhasbeenrecentlyreplicatedinAustralia.

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3. TheSimpleAnalyticsofaNon­ConfiscatoryMonetaryReformA major advantage of a monetary reform as outlined so far is that prioritizes EU residents’expectations. Indeed, the non‐confiscatory principle cemented by the three pillar institutionsoutlined insection fivebelow,willguarantee that thevalueofbankdeposits inhardcurrencywill be preserved. As for the value of bills and coins in circulation, full convertibility andtransferabilityofdeposits,billsandcoinswill limitthescopefordepositorstotaketheirweakcurrencyoutoftheEZperiphery,whichinturnpreventspanics,bankrunsandcrashes.Inotherwords, local policy makers in the departing country should guarantee full recognition ofpreviously contracted hard currency denominated debts before the reform, with priorendorsement of the EZ core and international agencies. We therefore see no reason why acountry’sresidents intheEZperipherylaunchingamonetaryreformsunderfullconvertibilitywould have an incentive to change the composition of their portfolios and/or to locate theirfinancialassetselsewhere.Post‐reform scenario and from the standpoint of, say, a single resident of a country that hasundertakenamonetaryreform,herexperienceindailytransactionsshouldnotdifferfromthatofchangingherresidencytoaperipheralcountrywhereaweakcurrency isusedasmeansofexchangeandfuturestoreofvalue.Tobetterillustratethesimpleanalyticsbehindourview,letustaketheexampleofasinglemigrantwhohasresidedinahardcurrencycountry,hasearnedincome, consumed and saved part of that income in hard currency. Upon migrating to hercountryoforiginwherethecurrencyincirculationistheweakcurrency,herpastwillcontinuetobedenominatedinhardcurrency.Butinherfuture,shewillearn,consume,andsaveintheweakcurrency.What thisexampleshows is thatmigratingdoesnotalter thedenominationofthisparticularmigrant’spast.Theonlythingthatchangesisthecurrencydenominationofherfuture.Theaboveexample,however trivial itmayseem, isexperiencedbymillionsofmigrantseveryyear.AndthisisexactlywhatwouldhappentoanEZcountryintheperipherythatundertakesaMR. Itspast remains inhardcurrencyand its future inweakcurrency. It is important tonotethatourexampledoesnotapply toreturningmigrantsonly. In thecaseof theEU, free labourmobilityfacilitatesunemployedindividualsinthecoretomigratetotheperipherywherewagesarelowerbutalsothecostoflivingislower.Theperipherymightbeperceivedbyhigh‐skilledunemployed individuals in the core as a placewhere skilled labourwages are relativelywellpaid because inherent scarcity of skilled labour in the periphery prior to joining theEZ, andbecauseacquiredon‐the‐job skills in the coreareenshrinedalongsidehighpurchasingpowerduetorelativelylowercostoflivingintheperiphery.Moregenerally,movingbacktoacountrythatundertakes aMRwill enablemigrants tomove forward, save, andaccumulatewealth forfinancing a comfortable retirement.When viewed thisway,MRs should not distortmigrants’smoothconsumptionandsavingpatternsassuggestedbythestandardlife‐cyclehypothesis.29

29Accordingtothelife‐cyclehypothesisarepresentativeconsumerplansherconsumptionandsavingspatternatearlystagesinherworkinglifesoassmoothherlevelofconsumptionthroughoutherentirelife.(See,Modigliani(1966)).

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Onamuchlargerscale,wecanthinkofmillionsofmigrantsalreadyresidinginaweakcurrencycountry, which splinters at once. Leaving aside for the moment the above‐mentionedtransitional stage practicalities, one can assume that soon after their divorce from the hard‐currencycore,enterprises, individuals,policymakersand thegovernmentofabreaking‐awaynationwillstandinapositionwhereassetsandliabilitieswillbedenominatedinboth,theweakandthehardcurrencies.Checkinganddepositaccountswillbedenominatedinbothcurrencieswhilecurrentincomeandexpendituresinnon‐tradablecommoditieswilltakeplaceintheweakcurrency.How canone replicate in the aggregatewhat at an individual level seems relativelytrivial?Theanswertothisquestion isat theheartofourproposal. Wearguethatbyadheringtothenon‐confiscationprinciple,propertyrightsofeconomicagents’pastassetsdenominatedinhardcurrency must be honoured in hard currency to eliminate the risk that investors in hardcurrencyincur.Somewhatparadoxically,areforminvolvingfullconvertibilityandpreservationofinvestors’propertyrightssimplifiestheproblem.Itpointsoutonevenue,namely,debt,andthe restructuring of it at all levels. Unavoidably, debt‐restructuringmust bemutually agreedupon ex ante, that is, prior the a MR, by all participants. Just as in the case of a migrant.Postponingrepaymentsinhardcurrencymustbenegotiatedwithherbankinthehard‐currencycountry prior to moving to the country where her income will be denominated in the weakcurrency.At the levelofa country,debt restructuringexantemustbenegotiatedwith theEZcoreandinternationalaidagenciespriortotakingoff.In reality, insolvencies in the peripheral EZ countries predate potential monetary reforms.However,becauseweareassumingthatunderaflexibleexchangerateregimetheprobabilityofrepaying by a debtor country and its residents is higher than under a deflationary scenariounderafixedexchangerateregime,thenetpresentvalueoffutureobligationsbydomesticandforeign debtors is higher under a MR. However, in the aftermath of the reform, the suddenadjustment of the exchange rate when external debt obligations are denominated in hardcurrencycantriggerdebtors’defaultwhendebtrestructuringandautomaticreschedulingisnotcontemplatedpriortoanyMR.Thisproposal focusesonpartialdebt reschedulingofobligations that cannotbe repaidoutofcurrent income by residents of a country who earn current income in the weak currency. Itdeliberately leaves aside exchange rate controls, multiple exchange rates, and relatedbureaucracy,whichmake thepictureobscureatbest, canbe counterproductiveatworse.Forthesakeofclarity,wehavechosento focusonasingle issue,namely, thatofgeneralizeddebtrestructuringandcumdepreciationofthelocalcurrency,whichwehavebeenreferringtoasamonetaryreformoraMR.Debt restructuring can be difficult in practice, however, if only because it involves an entirecountryalreadyentangledindifferenttypesofdebtsanddealingwithamultiplicityofcreditorsatonce.Itshouldbenoted,however,thatourunderstandingofthesituationintheEZislargelybased on proven MR experiences in Latin America. And that it is on the basis of theseexperiences that we will be addressing directly the way Latin America has approached theproblem of automatic debt restructuring institutionally, which by and large simplifies theproblem.

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4.FacingTenMainChallengesToMakeThisProposalViableTheviabilityofourproposalheavilyreliesonhowthedepartingEZmember, theEZcoreandinternationalaidagenciesrespondtothefollowingtenchallenges:

1. Theproblemoflocaldebtorsvis­à­visbanksestablishedwithintheboundariesofthe country where the monetary reform takes place. This is a relatively minorproblem when applied to the case of enterprises engaged in short term tradabletransactions, but is a gigantic challenge in thenon tradable financial sector. Long termdebtsuchasmortgages, forexample,meritspecialattention.Adevaluationpersedoesnot trigger debtors’ insolvency in this case. Instead, a devaluation enables economicagentstomoreclearlydistinguishthetruepricesoftheircashflowsontheonehand,andthecollateralvalueoftheirdebtobligationsontheother.Bothareobscurerelativetoanon‐reform scenario. Post reform scenario the departing country will face a majorliquidity problem because there is an inevitable amismatch between debtors’ currentincome in theweak currency and debtors’ long term obligations denominated in hardcurrency.Anilliquidpositiontakestheformofacontractionarydevaluationintheshortrun.WesuggestthatEUROFICORCAlendssupporttoilliquiddebtorsexperiencingsuchamismatchasavenueforotherwisesolventdebtorstopreservetheircreditstandingvis‐à‐vistheircreditorsduringthetransition.Inthelongrundebtorsshouldbeabletomeettheir obligations as the short term mismatch following a sudden devaluation willdisappear.

2. Theproblemoflocaldebtorsvis­à­visbanksestablishedoutsidetheboundariesofthecountry thatundertakes themonetaryreform. A somewhat similar scenario totheonewe justdescribedemergesvis‐à‐vis foreigncreditors.Underanon‐confiscatoryreform both domestic and foreign creditors are repaid but domestic creditors mustaccept repayments in the weak currency which they can convert into hard currency.Foreigncreditorsontheotherhandmustberepaidinhardcurrency.Becauseduringthetransitionthesupplyofhardcurrencycannotbecontrolledbythelocalgovernment,andthisconstraintislikelytobetight.EUROFICORCAwillneedinternationalaidagenciestoaddress the hard andweak currencymismatch. Binding hard currency constraints canonly be relaxed with international cooperation throughout the transition. Again, postreform scenario, and in the long run, the shortage of hard currency constraintwill nolonger be binding and solvent debtors at this point can pay their hard currencyobligationswithoutthesupportthatforeignagencies.

3. Theadverseselectionproblem.Inthepreviousparagraphweemphasizedtheneedtograntdebtrestructuringtodebtorswhoweresolventpriortothereform.Thishighlightsakeyissue,namelythatoftheeffectsofadevaluationonotherwisesolventdebtors.Afterthereform,solventdebtorsbecomeinsolventinhardcurrencybecausetheircurrentcashflowsaredenominatedintheweakcurrency.Intheaftermathofthereformwethereforeface a typical adverse selection problem à Stiglitz‐Weiss in that creditors cannotdistinguishex‐antebetweeninsolventandsolventdebtorsleadingtoanundesirableexit

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ofotherwisesolventdebtors.30Bothtypesareexperiencingdebtrepaymentdifficultiesinhard currency, and there is an informational asymmetry in that creditors cannot tearapart whose debtors are solvent and are therefore relatively less risky post reformscenario.Onewaytocircumventthisproblemisviagrantingdebtrestructuringonlytothosedebtorswhoweresolventpriortothereform.31Thisdoesnotdifferfromatypicaladverseselectionscenario increditmarketswhereonly solventdebtorswill self‐selectthemselves intodebt reschedulingagreements,with theaddedbonus thatmanywouldself‐select in knowing that only in a post‐reform scenario they stand a chance ofbecoming solvent via EUROFICORCA. Likewise, debtors who perceive themselves asinsolventdebtorspriorandpostreformwillself‐selectthemselvesout.Whencomparedto a situation where widespread debt restructuring is granted to both solvent andinsolventdebtorsbeforeandafterthereform,grantingdebtreschedulingtothesolventonesonly–whichiswhatFICORCAdidinthecaseofMexico,whilewritingoffthedebtsofthose individuals/firms/governments who self‐select themselves out is efficient.Otherwisestated, thisdoesnotdiffermuch fromAkerlof’smarket for lemonsscenarioswhere one group of economic agents know their own types while the other does notleading to a market collapse.32 In the international finance arena, a collapse issynonymoustooutrightandunilateraldefaults.Wearguethattherewillnotbeacollapsebecause granting debt restructuring to ex ante and ex post solvent debtors is a waycircumventingadverseselectioninefficiencies.Itisinthusinthecreditors’owninterest,both domestic an foreign, to have a well‐designed institution like EUROFICORCA toaddresstheissueofshortterminsolvencies.Internationalcooperationisthereforenotagift that will benefit debtors only. Instead, EUROFICORCA should be viewed as aninstitutionalisedvenuethatreinforcesincentivecompatibledebtcontractsforitisinthecreditors’owninteresttorescheduledebtors’obligationstopreservetheiroptionvalue.Likewise,itisinsolventdebtors’owninteresttopreserveagoodcreditstandingvis‐à‐vistheir creditors.Moreover, it is also in the departing government’s own interest not topromoteacultureofnon‐repayment.Creditors,bothdomesticandforeign,expectthatalargeportionofoutstandingobligationsowedtothembyexantesolventdebtorswillberepaidinthelongrun.ItishoweverimportanttoemphasizethatforeigncreditorsoptionvalueduringthetransitioncanonlybepreservedifEUROFICORCAobtainssupportfromforeign agencies to honour hard currency obligations which should be repaid in hardcurrencyviaEUROFICORCA.

30See,StiglitzandWeiss(1981).InanadverseselectionmodelalaStiglitz‐Weiss(1981),andundertheassumptionthatdebtorsdonotknoweachothers’types,say,riskyorsafe,Armendariz–Gollier(2000)demonstratethatcross‐subsidizationmightbeattractivetosafeandriskydebtorsduetothefactthatcrosssubsidizationactsascollateraleffectvis‐à‐visthecreditors,andthisreducesinterestrates.Negotiatingdebtrepaymentsasablock,bothsolventand insolventdebtorsmightstrikeabetterdeal, theArmendariz–Gollierarticlewouldsuggest.Butconfiscatoryeffectsareboundtobelargerrelativetonegotiatingdebtrepaymentswithrisklessdebtorsonly.31Alternatively,wecanthinkofanoutcomealaBester(1985)whereperfectsortingbetweensolventandinsolventcreditorscantakeplaceifandwhendebtorshavesufficientcollateral.See,alsoGoodhart(1989).Ourproblemhereis thathaving sufficient collateral value isnot feasible for alldebtor in the short run, that it, immediately after adevaluation.Anditisintheshortrunwhenthedecisionovergrantingdebtrestructuringtotroubleddebtorsmustbetakenbyforeigncreditors.32 Akerlof,George(1970), “TheMarket for“Lemons”:QualityUncertaintyandtheMarketMechanism”,QuarterlyJournalofEconomics,Vol.84,No.3.

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4. Thelackofliquidityproblem.LocalbankswillneedtoberecapitalizedfollowingaMR.

Thereasonsarethreefold.First,localbanksalreadyowedebtstoforeigncreditors.Thosedebts have been contracted prior to the reform, and our non‐confiscatoryMR dictatesthatthosedebtsmustberepaid.Theshiftfromthehardtotheweakcurrencycanonlyexacerbate banks’ liquidity problems. Second, themere fact that post reform scenariofuture income of local debtors is labelled in local currency generates a disconnectedbetween past obligations denominated in the hard currency and current obligationsdenominatedintheweakcurrency.Andsuchadisconnectwillfurthererodethequalityof localbanks’portfolios.Third,post‐reformscenario,thebanks’balancesheetsinbothhardandlocalcurrenciesinvolveexchangeraterisk,whichismagnifiedbyexchangeratevolatility.Typically,bankscannotaffordtobearexchangerateriskintheaftermathofthereform. In section five belowwe spell out theway to dealwith exchange rate risk viaEUROFICORCA in order to sustain a local banking system, which will find itselfoverexposed to sudden and abrupt exchange rate fluctuations. EUROFICORCA canpotentially mitigate the effects of lack of liquidity ranging from further contraction ofoutputtowidespreadbankbankruptcies,panicsandcrashes.

5. Theproblemfacedbylocalbanksinneedofhard­currencyholdings.Ourattention

nowturnstotheshortageofhardcurrencythatlocalbankswillunavoidablyexperiencepost‐reform scenario. Banks operate in a global financial system, and their dailytransactionsbeyondtheirlocalboundariesaredenominatedinhardcurrency.Moreover,banks have outstanding external debts, whichmust be repaid in hard currency. Localbankscontinuedinvolvementintheforeignexchangemarketcruciallydependsontheirholdingsofhardcurrency.Lackofaccesstohardcurrencybylocalbankscanbeutterlydisruptive to thedeparting country’s financial system. We therefore emphasize in thisproposal the crucial importance of a post reform scenario where local banks haveunlimited access to local currency via their newly created central bank, becausebanksliabilities vis‐à‐vis their depositors, and because at any point in time depositors andbanksshouldbeable to fullyconvert theirholdingsdenominated in theweakcurrencyinto hard currency at the prevailingmarket rate.History shows thatwhen aMR takesplace in the midst of a global financial crisis, it closes access to international capitalmarkets to the governments of the country undertaking the reform, the country’scorporationsandthe localbanks. This isoneofthemostseriouschallengesthatanEZdeparting country is bound to face. We therefore once more reiterate the need for ainternationally endorsed EUROFICORCA. Lack of support to this institution in need ofhardcurrencycanleadtohyperinflationandstagflationintheEZexitingcountry,whichcanonlybecounterproductive.Bearing inmindthatunilateraloutrightdefaultscannotberuledoutandthatthesewouldinevitablyleadtoacompletecollapseoftheexitingEZstates payment system, similar effects should be expected if EUROFICORCA is notsupportedby internationalagencies.With theirsupport, costeffectivenon‐confiscatoryreformsinperipheralcountriesaremutuallybeneficialtobothdebtor intheperiphery,creditors in thecore, theEUandbeyond.Astepping‐stone togrowthandprosperity inthe periphery is that of maintaining an efficient payments system with internationalsupport. Once the EZ core and international agencies have understood this, ourconjectureisthatcomparedtoaEFSFdesignedforbailoutsofalldebtincludingthatof

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insolvent private sector enterprises and private banks, it will be more efficient todisaggregate.Thatis,toleavetheEFSFtodealwithexanteandexpostinsolventdebtorswhilekeepingexantesolventdebtorsundertheumbrellaofEUROFICORCA.

6. The problem of debts contracted outside the banking system. With regards to allotherdebts,analogoustoleasecontracts,amonglocalagentsoutsidethebankingsystem,we advocate that such debts be settled in theweak currency even though these debtshavebeenoriginallycontractedinthehardcurrency.Notethatfullconvertibilityensuresthat creditors arenot expropriated. Inparticular, and in linewith thenon‐confiscatoryprinciple at the heart of this proposal, such creditors will be able to transform localcurrencydebtrepaymentsintohardcurrency.Inpracticeweshouldencountertheexactsameproblemastheonewehavealreadydiscussedwhenreferringtodebtsthatinvolvethe local banking system. Specifically, the reform will trigger a disconnect betweendebtors’ hard‐ currency denominated obligations in their past, and the departingcountry’s residents current cash flows denominated in the weak currency. A simpleexamplecanhelpusclarifytheproblem.AssumeaworkerintheexitingEZstatehastopayherrentbytheendofthemonthintheaftermathofadevaluation.Hersalarytodayisdenominated in the weak currency while her outstanding monthly rent in the strongcurrency. The contract that ex ante reflected market conditions, is now completelydisjointed. Itwillneedtoberenegotiated. Inan inflationaryenvironment,however, thehighfrequencyofthoserenegotiationsmightbenotfeasibleatbest,inefficientatworse.ItisinresponsetoscenariosliketheonewejustportrayedbymeansofourexamplethatwesuggestaEUROUDIinstitution.Aswewillargueinsectionfive,theroleofEUROUDIisenhancedby thedebtcontractsdenominated inEUROUDIs,whichcaneasily takeplaceunder theumbrella of EUROFICORCA.EUROUDI contracts can in turn relax thebudgetconstraints the departing country faces in the hard currency. This way the country inquestionwillneedlesssupportfrominternationalagencies.

7. The problem of wages in labour contracts and other prices. Based on historical

experience from monetary reforms in Latin America, we strongly advocate partialindexation,especially inmerchandiseandserviceswherepricesmustbelabelledintheweakcurrency.Merchandises,servicesandwagesmusthoweverbenumericallyidenticaltothoseprevailingpriortothereform.Theonlydifferenceisthatpricesmustbelabelledin theweak,not in thehardcurrency.Forexample, awage labelled in fiveunitsof thehard currencyprior to the reform should beworth five units in local currency. This isunavoidable and seemingly violates our non‐confiscation principle. However, a partialindexation should be compared with a full indexation scenario. Under the former weexpect moderate inflation, and under the latter hyperinflation which costs andconfiscatoryeffectsarefargreater.33Hyperinflationandfollow‐upcontractionarypoliciesin weak currency countries can lead to stagflation thereby severely hindering theexpected benefits of a monetary reform, which principal objective is to accelerate thepaceofeconomicgrowth.How toavoid tensionsbetween labourandemployersunder

33Brazil inthe1980s,forexample,sufferedfrominflationratesofovertwo‐hundredpercentperannum.Byandlarge,andaccordingtoCardoso‐Helwege(1992),acontributingfactorwasfullindexationofwages,bonds,andtheexchangerate.

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partial indexation? This is yet another important question, whichwe again address insectionfivebelow.Inparticular,wewillbearguingthatpartialindexationisonlyfeasibleviacountry‐specificEuropeanSocialPacts(ESPs).34

8. Theproblemoftaxation.Anotherproblemingrainedinanymonetaryreformweknowof since World War II is that of a sovereign debt, internal and external. While thisproblemhasalreadybeendealtwithabove for thecaseofprivatedebtwhichwehavearguedmustbehonouredinhardcurrencybythedepartingEZnation.Inparticularwehave suggested that such debtmust be honoured by solvent local debtors in the hardcurrencyviaEUROFICORCAto foreigncreditors.And in theweakcurrency todomesticcreditors,alsoviaEUROFICORCA.Themainprobleminthecaseofsovereigndebtisthattaxes are collected in the weak currency, which under moderate inflation can beconvertedintohardcurrencytorepayforeigncreditorswhiledomesticcreditorswillberepaidintheweakcurrency.Themainproblemhereisinflation.Timeagainweinsistontheneed tokeepmoderate levelsof inflation for theriskofadevaluationand inflationspinningoutofcontrolwilldelaythebenefitsofthereformatbest,willtotallycounteractthematworse.35Ouremphasishere isonreversecausality:while largerbudgetdeficitsare inflationary, inflationarypressures in turnhinder thegovernment’sability to lowerits deficit. Keeping inflation under control using EUROUDI and context‐specific ESPsvenuesisthereforeofoutmostimportance.

9. Theproblemofhard­ currency reservesneededby the centralbank. The focusof

ouranalysisunderthisheadernowturnstoongoingconcernsby localcentralbanks inperipheral departing nations and their ability to accumulate hard currency reserves.While the post‐reform scenario is rather standard in that a local central bank in theperiphery enjoys thebenefits of extending credit in local currency, theproblem is thatthis bankwill need foreign reserves to support the payments system. Specifically, thecentralbankduringthetransitionwillneedforeigncurrencyreservesforsupplyinghardcurrency to guarantee full convertibility on the one hand, and tomake timely foreignexchangeinterventionstostabilizethevalueoftheweakcurrencyontheother.Letusbeperfectlyclearhere.ThisproposalneitherendorsesapostMRfixedexchangerateregimenoranyformofcrawlingpegandinterventionistdirtyfloatingofanykind.Wehowevercontemplatescenarioswhereintenseanddestabilizingspeculationnecessitatesthelocalcentral bank intervention. Theneed of international reserves in the context of a freelyfloating exchange rate is twofold. First, as we have already argued, to support thepaymentsystem.Inparticular,ifthelocalbankslackaccesstoforeigninterbanklendingasweexpecttheywill,thenthelocalcentralbankcanusepartofitsforeignreservestomaintain the flowof interbank transactions. Second, andmore to thepoint, tomitigatedestabilizingspeculation,foreignreservescanplayacrucialrolebuttheseshouldnotbeusedtoanchortheexchangerateinanyway,shapeorform.Moreover,weadvocatethat

34Inasimilarvein,weshouldalsocontemplatewhichcontractsshouldalsobelabelledinlocalcurrencyfollowingthereform.Therelevantquestionhereiswhetheranominalanchorcanbefoundsothat longtermcontractsaremadeconsistentwithconstantpricechangeswithinthejurisdictionwheretheMRtakesplace.35NotethattaxcollectionissuesareexacerbatedbytheOlivera–Tanzieffect.Specifically,whiledebtrepaymentsmustbemadewithina tight time‐frame, taxcollection isgenerallycollectedwitha lag,which furthererodes thevalueofgovernmentrevenuesinaninflationaryenvironment.See,Tanzi(1977),andDornbusch‐Simonsen(1987).

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these foreign exchange interventions to fight excessive speculation should be theprerogative of a fully independent central bank.We have already established that thesuccess of a MR crucially depends on a market‐determined exchange rate, which canfreelyfluctuate,andonthedesignofamechanismthatwillguaranteefullconvertibilitybetween the hard and theweak currency.We have alsowarned that this is a delicateissueforfullindexationand/orexcessivemoneyprintingaretemptingpoliticalvenuesindemocraticallyelectedregimesintheperiphery.Becauseweshouldexpectashortageofforeignreservesduringthecriticaltransitionperiod,thecentralbankwillfaceaproblemof hard‐currency binding constraints, which can only be relaxed with the support ofinternational agencies. We need to insist on this. The question then is how to gathersupportfrominternationalorganizationssuchastheEuropeanCentralBank(ECB)thathassofarresistedtheideaofabreak‐upoftheperipheryfromthecore?Wedonothaveananswertothisquestion.OuronlyhopeisthatourproposalwillbeviewedthroughthelensofeconomicreasoningandlogicbehindMRsthathavealreadysucceededelsewhere,and not from a purely political perspective.Whilewe fully respect the historical rootswhichareclosetotheheartoftheconstructionoftheEZcommoncurrencyareabythosewho designed them and their predecessors, we stand firmly by our three pillarinstitutions as venues thatmake sense from an economic standpoint. Endorsement ofthese institutions by the core and the periphery under a fully flexible exchange rateregimeisofparamountimportancetoeconomicgrowthandprosperity.

10. Theproblemofbillsandcoinsincirculationbeingacceptedasameansofexchangeandcapital flight.Lastbutnot least, themonetaryreformwillneed to issuenewbillsandcoinstograduallyreplacehardcurrency incirculation.Towithdrawhardcurrencyandintroducelocalcurrency,albeitatasmallscaleduetothelargevolumeofelectronictransactions, is easier said than done. To some observers, hard currency holders havealreadytakeneuro‐denominateddepositsoutoftheperipheryandinmanyinstancesoutoftheentireEZ.Lookingforward,though,itisconceivablethatholdersofhardcurrencypost reform scenariowouldbe reluctant to surrender their hard currencyholdings fortheyrepresentastoreofvalue.Gradually,however,alleconomicagentsinthedepartingcountrywouldneedtodrawfromthosesavingsinhardcurrency,andconvertthemintolocal currency for daily transactions. Historical examples to circumvent such type oflogisticalproblemsabound.36Areversiontolocalcurrencyprintinginanimprovedandmore efficient manner, via delegation onto another country, for example, has alreadybeendiscussed.37Itisneverthelessacostlychallengenottobeunderestimated.

36MostwidelycitedexamplesincludesuccessfuldissolutionoftheAustro‐HungariancommoncurrencyafterWorldWarIwhenbillsinsuccessorstateswerestampedtodevaluethem.Over‐stampingofaformerlycommoncurrencyalongsidetheimpositionofcapitalcontrolscanlimitthescopeforbankruns(Aldcroft‐Rodger(2010)).Wehavespentagreatdealoftimestudyingthisscenario,andhavecometotheconclusionthatitcanonlybereplicatedifcapitalcontrolsareputinplace.Sinceweviewthoseasconfiscatory,areplicationofsuchanover‐stampingschemedoesnotappealtousinthecurrentcontextofanincreasinglyglobalizedfinancialsector.37 New Zealand, in particular efficient at producing polymer bills, which are environmentally friendly, andconsiderablylesspronetoforgery.

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5. MakingtheReformviable:EUROFICORCA,EUROUDI&ESP.

Inanutshell,thechallengingquestionsspelledoutintheprevioussectioncanbesummarizedasfollows.First,thesplinteringEZnationwillneedtoundertakeageneralizeddebtrestructuringofexternalandinternalliabilities.Ourobjectiveherewillbetofindaninstitutionalwaytodealwith debt restructuring in order to postpone repayments until the departing country debtorsreturntoasolvencyposition.Second,theexitingEZcountrywillexperienceadevaluationofitsnewly created currencyandan ipso factoproblemof inflation. This couldeasily spiraloutofcontrolmostlybecauseofthetemptationoffullindexation.Inparalleltodebtrestructuring,ourtargetherewillthereforebethatofdetectinganinstitutionalizedwaytocontinuouslyde‐indexprices.Third,thedepartingEZcountrywillbefacingashortageofhardcurrency.Itwillneedthehard currency to honour external debt obligations and to launch its fully convertible weakcurrency. To be able to have access to hard currency at all times, the country’s resurrectedcentral bankwill need full cooperation from theEZ core and international agencies. Our lastgoal in this sectionwould thereforebe thatof suggestingaway for theEZperipheralnationswishing to leave to gather international support throughout the entire duration of theirsabbatical.Inthissectionweborrowideasfromawealthofreforms,mostnotablyfromLatinAmerica,inanattemptassembleaninventoryofkeytoolsthatwillhelpusaddresstheabovechallenges.Insodoing we are fully aware that each monetary reform is context‐specific, and that drawingconclusionsfromwhathasworkedinotherregionscangiveasenseofdirectionatbest,canbemisleadingatworse.EUROFICORCALet us startwith the issue of rescheduling the private‐sector debt.38Wehave stated from theonset that for the reformnot tobe confiscatory, all hard‐currency‐denominateddebtmustbehonoured in full. Theway of settling these obligationswill however differ depending on thecreditors’ identity. Debt repayments to foreign creditorsmust bemade in the hard currency,whiledebt repayments to local creditorswill bemade in the fully convertibleweak currency.This is easier said thandone.Letusnot forget that theexiting countrywillneed todealwithdebt restructuring of tens of thousands different debt contracts. Doing it in a transparent,expeditiousandstandardizedfashionisagiganticundertaking.InwhatfollowsweborrowfromtheexperienceofMexicowithregardstoreschedulingofitsprivate‐sectordebtinthe1980sand1990s.Mexicosuccessfullyrestructured itsprivate‐sectorsectorobligationsowedbyamultiplicityofdebtorsviaaninstitutionestablishedalmostthirtyyearsago.ThisinstitutiongoesbythenameFICORCA.39 Created just after amassive devaluation in 1983, itsmain objectivewas to assist

38WeassumethatthesovereigndebtcomponentisaddressedthroughthemechanismsalreadyestablishedbythecountriesoftheEurozone.39 FICORCA stands for “Fideicomiso de Cobertura de Riesgo Cambiario” (Exchange Rate Risk Trust). It wasestablishedinMexicoin1983,thatis,shortlyafterMexicodefaultedonitsexternaldebtandtheMexicanPesowassharplydevalued.(See,ZedilloPoncedeLeón(1985),andInformeAnualdelBancodeMéxico(1983))

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Mexicancorporationsthathadtopayhard‐currencydenominateddebtsinaglobalenvironmentwhere the local government and private sector enterprises had virtually no access tointernationalsourcesoffunding.FICORCAwasincorporatedasaTrust. ItsSettlorwastheFederalGovernment,anditsTrusteewas theCentralBankofMexico. TheTrust acted as an automatic refinancing facility for localdebtors and their foreign creditors. It would collect debt repayment contributions in localcurrency from localdebtorsand thenactasapaymentagency to foreigncreditors requestingrepaymentsinhardcurrency.Under a FICORCA agreement between a single debtor and the Trust, at each pre‐establishedperiod,thedebtorwouldpayapredeterminedPesoamounttotheTrust.Atthesametime,theTrust would pay in full and in the hard currency the due obligations of the debtors to theirforeign creditors. There were instances where by the end of a given loan cycle, there was ashortfall against the Trust, which reflected the difference between the pre‐determined PesorepaymentsmadebythelocaldebtortotheTrustandtheoutlaysinhardcurrencymadebytheTrusttotheforeigncreditors.Thisshortfallwasautomaticallycapitalizedandrescheduled,thatis, itwasrepaidata laterdaterelativetothatspecifiedintheoriginal loancontract.Fromthedebtor’sstandpoint,paymentsinMexicanPesoswerefixedwhilethematurityoftheloanwasflexible.ThismechanismofautomaticrestructuringwasknownasAFICORCAMIENTO(fromtheverbAFICORCAR).Under the FICORCA by‐laws, the only eligible debtors were those who were meeting theiroriginaldebtobligationsand/orthosewhohadsuccessfullyrestructuredtheir loansandweremaking repayments on their alreadywritten‐down obligations. To remain in thewarship ofFICORCA,debtorshadto fulfilMexicanPesodenominatedobligations inatimely fashion. TheFICORCAcontractsweredesignedinsuchawaythattherepaymentsinMexicanPesosbylocaldebtors and the hard currency outlays from FICORCA to the debtors’ foreign creditors wereequivalentinpresentvalueterms.Inpractice,however,FICORCAcontractshadanupperboundtenure. Therefore, therewas a residual risk to be borne by the Federal Government in caseswheretheimpliedmaturityoftheloanexceededthestatutorymaximum.Exante,andtotheextentthattheprogramwaspartofasuccessfulstabilizationstrategy,onewouldexpectthatafuturerevaluationoftheexchangeratewouldtranslateitselfintoaforeignexchangegainaccruingtotheTrust.InthecaseoftheMexicanexperience,thisisexactlywhathappened. By the time the last FICORCA loanwas repaid in September of 1991, this facilityreportedacumulativenetprofitofUS$1billionoveratotalofUS$11billionparticipatingloans.The concept of AFICORCAMIENTO as an insurance against unforeseen contingencies whichprevented a debtor from honouring in full its hard‐currency denominated debts vis‐à‐vis herforeigncreditorsaccordingtoapre‐specifiedrepaymentcalendar,andthefollow‐upautomaticreschedulingof theshortfallbecamepartof the jargonof financiers in theirdailyparlanceupuntil these days. At present, awide range of contracts, from commercial loans tomortgages,have AFICORCAMIENTO clauses, and are a pretty standard practice in the Mexican financialsystem.

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AnessentialcomponentofourproposalforanorderlyandtemporaryexitofacountryfromtheEZcoreistheenactmentofaninstitution,whichwouldresembletoFICORCAand,thus,wegiveit the generic nameof “EUROFICORCA”.40Weneed to remindour readers that EUROFICORCAwouldbean institutionalizedfacilitator.Asortofgo‐between,whichwouldbeputtogethertoaddress the fact that a devaluation temporarily weakens local debtors’ income generatingability to honour their past obligations in full, with eventual shortfalls to be rescheduled.EUROFICORCAcanencompassprivatesectorandlocalgovernmentdebts.Itshouldthereforebeviewed as carefully‐designed venue to bridge the transitional gap between the temporarilydisjointed income, which is currently labelled in the weak currency and out of which pastobligations in thehard currencymustbehonoured. Inotherwords,EUROFICORCAshouldbeviewedasatemporaryfacilitythatmitigatestheshortruneffectsofadevaluationandagrowthspurttakeoffleadingtofullrecoverywithaneventualreturnoptiontotheEZcore.Wemustbeextremelyclearatthispoint.Bydesign,EUROFICORCAisverydifferentfrommoral‐hazard‐baseddebt‐reliefschemesàlaKrugman.41Laraisond’êtreofFICORCAisthatotherwisesolventdebtors residing in theEZexitingperipheryare temporarily illiquid inhard currency.These debtors are experiencing a disconnect due to the devaluation of their countries’currencies.TheirsituationisrootedintheeffectsoftheMRontheexchangerate,andno‐whereelse.42Let us now turn to the issue of foreign versus local debt. In line with our non‐confiscatoryprinciple, foreigndebt outlays accruing to foreign creditorsmost bedenominated in thehardcurrency.Localdebtoutlaysaccruingto localdebtorswillbedenominated in fullyconvertiblelocalcurrency.Inwhatfollowswefirstanalyzetheissueofsettlinglocaldebtors’obligationsinthe hard currency. For the sake of argument we will henceforth refer to such facility asEUROFICORCA‐1.Ideally,theSettlorofEUROFICORCA‐1canbetheEU,andtheTrusteetheECB.In this case we see EUROFICORCA‐1 as a facility that can address the refinancing needsencompassingbothsovereignandprivatedebt.We must at this point warn our readers that as this proposal is being written, we remainconvinced that the sovereigndebt componentof theperipheralEZ troubledcountrieshasnotbeenresolved.ThetransitionalburdenofaMRmaycomplicateourscheme.WebelievethataEUROFICORCA‐1 encompassing sovereign and private‐sector debt is desirable. We howeverunderstand, that therearenascent institutions,whichareclose to theheartsofpolicymakerswhohavealreadylaunchedthem.Tosimplifyouranalysis,wethereforethinkitwouldbebesttoputpoliticsasideforthemomentsothatouridealversionofaEUROFICORCA‐1becomesviablebyincludingasubsetofstakeholdersonly.

40ThewordsFICORCAandEUROFICORCAshouldnotbeusedinterchangeably.Theyhavedifferentmeaningsandarestronglyattachedtothecontrastingstateandnatureofthedebtcrisesinmiddle‐incomeeconomiesatdifferentpointsintime,anddifferentinenvironmentsacrossthetwosidesoftheAtlantic.41 Krugman (1988) and Krugman (1989) puts forward numerous debt‐relief schemes which rationale is easilyshowndiagrammaticallyviawhathereferstoasadebt‐reliefLaffercurve.Thoseschemesfacilitatetheeliminationofa“debtoverhang”.See,also,Armendáriz(1999b) forasynthesizedexposition, inventory,andrationalebehindsuchschemes.42SeetheAppendixforanillustrationofthepotentialbenefitsaccruingtoboththedebtorsandtheircreditorswhenaninstitutionlikeFICORCAexitsinthemidstofaMR.

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Tothisend,andunderalessthananidealscenario,EUROFICORCA‐1wouldconsiderexclusivelythenon‐sovereigndebtcomponentofobligationswhichmustbehonouredbyamultiplicityofprivate‐sector debtors. Here the roles of the Settlor and the Trustee, respectively, could bedelegatedtothelocalgovernmentandthelocalcentralbankrespectively.However,itshouldbenoticed that for this to be viable, there is an unavoidable need of substantial amounts ofinternationalreserves,andthereforesomesupportwillhavetocomefromthecountriesintheEZcoreand/orfromtheEuropeanCentralBankandotherinternationalagencies.Namely,eveninthisless‐than‐idealformat,EUROFICORCA‐1willneedtobecapitalizedinthehardcurrency,and may also need to borrow in hard currency. The equity component will require foreigncurrencyfundingfromthelocalgovernment,andtheborrowingnecessitatestheparticipationofthecentralbankrequiring funding inhardcurrency fromtheECB. Inanyevent,enactmentofEUROFICORCA‐1 is unthinkablewithout the participation of the rest of the EZ countries. Thewaysuchcooperationcantakeplacewillbediscussedlaterinthissection.The main mandate of EUROFICORCA‐1 would be to disburse variable hard currency debtrepaymentstoforeigncreditorsinexchangeoflocal‐currencydenominatedinflationindexed(oranalogous)fixedpaymentsmadebysolventlocaldebtorsinthepostreformscenario.NotethatthisparticularTrustreceivesrepaymentintheweakcurrency,whichshouldfirstbeconvertedintohardcurrency.ByaddingtothishardcurrencydenominatedamountaportionoftheTrustcapital, EUROFICORCA‐1 can then repay in full foreign creditors’ claimson local debtors. Wehenceforth call any contract between a local private debtor and EUROFICORCA‐1 aEUROAFICORCADO‐1contract.We should expect that at early stages in the MR, local debtors’ income is worth very littlebecause of the sharp devaluation of their newly created weak currency and because growthwouldnothavebeenreignitedyet.43Hence,whenconvertinglocalcurrencyintohardcurrency,theearlystages’shortfallswehavealreadyalludedtoearlieronareexpectedtobe large.Therole of EUROFORCA‐1, however, is neither to bail out insolvent and/or debtors that areunwillingtorepaynortocoverex‐anteanypermanentshortfall.Instead,itsroleisdualinthatitmust accept the local currency and exchange it at market prices for hard currency to makerepaymentstoforeigncreditorsontheonehand,andtoensurethattheshortfallisautomaticallyrescheduled according to a pre‐specified rule agreed upon between EUROFICORCA‐1 and thelocaldebtors.WebelievethatEUROFICORCA‐1canpotentiallymitigatecontagionbecauseasitplaysthemuchneeded go‐between role between amultiplicity of local debtors and their foreign creditors inadherencetoournon‐confiscatoryprinciple.OurpredictionisthatifEUROFICORCA‐1ineachcountry commits itself to accept local currency, and designs an automatic reschedulingmechanism,abankingcrisisinthecorecanbelargelyaverted.

43 The growth rate in Greece alone is expected to decrease by as much as six percentage points in 2012(InternationalHeraldTribune, January18,2012).To revert this trendmight take some time, and this iswhywerefer toEUROFICORCAas an institution for a full return to a solvencypositionmight take a long time indeed incaseslikethis.

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Thereasonissimple.Non‐negligiblelevelsofperipheraldebtwilltypicallyappearinthebalancesheetsofbanksheadquarteredinthecore,andfromaprudentialsupervisionstandpoint,capitalrequirements are being met via debt rescheduling. Moreover, the debt that is beingautomaticallyrescheduledisthatofdebtorswhoaresolventand/orwillingtopay,thatis“good”debtors.Thebadexternalitygeneratedby“bad”debtorsdisappears.CreditagencieswillfactorthisinwhenassessingthequalityoftheportfolioofbanksintheEZcore.Thecoremustbetonprivatedebtors in thedepartingcountrynotwishingtocut tieswith foreigncreditors,andonsovereigndebtors in thedeparting countrywishing to return to the core if onlybecause theywish tocatchupquickly,enjoy thestandardsof livingofcoreeurozonecountries,andpleasemedianvoterswhodislikeinflation.These reasons should suffice to convince the core that investing in the creation ofEUROFICORCA‐1isabetworthtaking.Ourproposalthusfarisbestillustratedinfigures1and2below.

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Wenowturntoallthosedebtsdenominatedinhardcurrency,repayableintheweakbutfullyconvertible currency at the prevailingmarket rate. These debts are owed to local banks andmust be repaid, again, by local debtors in the weak currency. The facility in charge ofrestructuring these loans will be labelled EUROFICORCA‐2. Its Settlor can be the localGovernment of the departing country, and its Trustee the resurrected central bank.EUROFICORCA‐2will function inasimilar fashion toEUROFICORCA‐1,except that itwillhavefarmore flexibilitybecauseweexpect that the local centralbankwouldbeable to lendweakcurrencydenominatedamountstotheTrust.ThemandateofEUROFICORCA‐2wouldthereforebetogatherthedebtservicepaymentsfromborrowersand topay in full to the localbanks theobligationsdenominated inhard‐currency,althoughthesettlementwillbemadeintheweakcurrencyatthemarketclearingexchangerate.EUROFICORCA‐2will also have the capacity to carry out the automatic debt rescheduling onpotentialshortfalls,coveringtheshortfallswiththeequityprovidedbythegovernmentandthepotentialloansitcanobtainfromthelocalandindependentcentralbank.WeshouldinsistthatrelativetoEUROFICORCA‐1,EUROFICORCA‐2willnotneedtogetholdofhardcurrencyinordertohonourlocaldebtors’obligations.It is important to note that the reason for settling local loans using theweak currency, eventhough suchpayments are equivalent ‐at theprevailingmarket exchange rate‐ to the originalcontractdenominated inhard currency is twofold.On theonehand,weexpect that theweak

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currencywillobtainpublicrecognitioninthesettlinglocalcontracts,payingwages,andinmostretailandservicerelatedtransactions.Itisthenreasonabletoanticipatethatwhenlocallendersare repaid, they will only convert a fraction of their income into the hard currency. Thisobviously contributes to the stabilization of the exchange rate and relaxes foreign reservesconstraints.Second,bymakingrepaymentsusingtheweakcurrencytolocallenders,thecentralbankcanmoreeasily lend to theTrust.Bearing inmind that thecentralbank is independent,thoseloanswillbeextendedifandwhenthecentralbankcanassist.Thecentralbankcanthusmoreeasily dealwithtransitoryexchangerateor inflationvolatility,anddebtsimultaneouslyandinacentralizedmanner.EUROFICORCA‐2by‐lawsdictatethatpayments in localcurrencymustbedefinedrelativetoabenchmark that approximately reflectsdebtors’ ability to repay.Onepossiblebenchmark thatnaturallycomestomindwouldbeaEUROAFICORCAMIENTOrulethatwouldofferlocaldebtorsthepossibilityofmakingfixedrepaymentusingtheConsumerPriceIndex(CPI)asabenchmark.Wewillreturntothisissuefurtherbelow.EUROFICORCA‐2 should be perceived as a powerful venue to mitigate the potential lossesincurredby localbanks. Itwouldbeanexceedinglyuseful institution, ifonlybecause itwouldhelptosmoothoutthetransition,anddosoinaverytransparentfashion.Itcouldprovidethemuchneededrecapitalizationrequiredby local financial institutions,helpingthemsurvivethetransitionperiodintheaftermathofthereform.EUROFICORCA‐2,likeEUROFICORCA‐1,shouldalsobeviewedaspartofastrategytoachieveasuccessfulstabilization.Totheextentthatstabilizationtranslatesintoagradualappreciationoftherealexchangerateafteritsinitialovershooting,itcanalsoprovetobeaprofitableventureforthegovernmentinthelongrun.(IntheAppendixwedeliveranexample).WeshouldnotethatEUROFICORCA‐2canbeparticularlyeffectivewhenappliedtorestructuringlong‐term debt in general and, in particular, mortgages.44 Since mortgages represent a largeportionofassetsheldbylocalbanks,automaticreschedulingpreservesbanks’equity,whichwealsoexpecttoincreaseinvalueoncetheMRhastakenhold.TheinflationaryrisktheEZexitingcountrywouldtakebyallowingitscentralbanktolendtotheTrustwouldthereforebegreatlyabatedifandwhentheeconomybootstrapstowardsthegoodequilibrium.Thatis,oncetheEZdeparting nation returns to a situation where long term solvency and financial stability isachieved.Note that from a purely logistical standpoint, the multiplicity of debt contracts that willpotentially be under the umbrella of EUROFICORCA‐2 calls for a benchmarkEUROAFICORCAMIENTOintheweakcurrency.4544Thishappened inMexico (See, Sánchez–Arrollo (1995)).Themagnitudeand the consequencesof the2007–2008 sub prime crises are far greater, however, and thus the necessity of institutionalizing an automaticreschedulingmechanismunderEUROFICORCA‐1assoonaspossible.45 Also, as a practical question, individual borrowers would not deal directly with EUROFICORCA‐2. A logicalprocedurewouldconsistonhavingdebtorsrestructuring(AFICORCAMIENTOandUDIZATION)directlywiththeirbanks;thenbankswouldpackageandinscribetheseloansintheEUROFICORCA‐2program.

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EUROUDIInacontextofaneconomy‐widedebtrestructuring,notalldebtswouldhavebeencontractedviafinancialintermediaries.Wehavealreadyalludedtothisproblemearlieron.Specifically,ourstartingpointinthissubsectionishowtodealwithdebtscontractedoutsidethebankingsector.WefoundtwoexperiencesinLatinAmericathatcanbeveryrelevanthere.Thefirstonecomesfrom Argentina during one of its monetary reforms in the mid‐1980s. This was coined “theAustral Plan” throughout which a price benchmark called “Tablas de Desagio” or markdowntableswasused.These tablesmade inflationbenchmarkspublic.Theywereusedbycreditorsanddebtorstocalibratedebtcontracts,ifandwhenabruptandunexpectedchangesininflationtookplace.Themarkdowntableswereshort‐lived,andthereasonwhytheydidnotliveuptoexpectationsremains a subject of heated debate. Our conjecture is that on the one hand the Argentineanmarkdown tables were often perceived as exceedingly complex and confusing. On the otherhand,theywereintroducedinthemidstofafailedandalsoshort‐livedmonetaryreform,whichconsisted of replacing the Argentinean Peso for the Argentinean Austral with the principalobjective of getting rid of the inflationary inertia, which is not the objective of aMR in a EZexitingcase.

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In contrast, Chile and Mexico introduced an alternative and more transparent system,respectively, the “UnidaddeFomento”orUF, and the “Unidadde InversiónorUDI.Theseareunits of account, which are published daily and aremade available to the general public viaprinted and electronic media. Such benchmarks are dithered consumer price indices. Theyshouldbeviewedasanofficialestimateofthedailyconsumerpriceindex(CPI).TheUDIsandUFsarecalculatedbyextrapolatingadailyvaluefortheCPI,basedonthemostrecentlymonthly(Chile)orbi‐weekly(Mexico)inflationnumbers.UDIs andUFs (henceforth:UDIs) are reliablebenchmarkswith a conspicuouspresence in theeconomy:taxrulesoftenincludeUDIZATIONclauses,thereisavastmarketforgovernmentandcorporatebondsdenominatedinUDIs,therearefuturesandover‐the‐counter(OTC)derivativesinUDIs, and,moregenerally, all sortsof credit and service contracts arealsodenominated inUDIs.Drawing from the Chilean and Mexican experience, we firmly believe that having a generalbenchmark like the UDI to be used by exiting EZmembers is absolutely essential. The pricebenchmarkwehaveinmindshouldbeconsideredasabasictoolforeffectivedebtrestructuringinanenvironmentofexcessivepriceand/orexchangeratevolatility. Itgreatlysimplifies theissuingofallsortsofcontractswithinasettingwherescaleisoftheessence.In thecontextofEUROFICORCA‐1and2,weshouldthereforehopetowitness twoconcurrentingredients inmost contracts inanEZdeparting country,namely,EUROFICORCAMIENTOandEURODIZATION.46 Specifically, the repayment schedule for any eligible loan contract underEUROFICORCA‐1by‐lawswouldbe expressed in fixedorquasi‐fixed amountofEUROUDIs. Inaddition,theloancontractwillhaveavariablematuritydependingontime‐variableexchange‐raterisk.47Ona larger scale, theadvantagesofhavingEUROUDIsare twofold.First,distributional effectsarisingfromunexpectedinflationareminimized.And,second,buyers’purchasingpoweracrossthe board (inclusive of future markets in financial services) is guaranteed. Ideally, a non‐confiscatoryMRintheEZdepartingmemberswouldbesupportedbythecreationofthesetwoinstitutions, namely EUROFICORCA and EUROUDI. This should help peripheral departing EZmembers in their transition fromdeflationandrecession tosolvencyandeconomicgrowth. Itshould also help the EZ core creditors to the extent that the choice of the right benchmarkincreasestheprobabilityofsuccessofEUROFICORCA,therebyreassuringalldebtorsinthecore

46Themostrelevantexperiencehereisthe“PuntoFinal”programestablishedinMexicoafterthe1994devaluationwhichfacilitatedmassiverestructuringofloanportfoliosoftheentirebankingsystem.Keytotheserestructuringsunder such program was the concurrent inclusion of two components, namely, UDIZATION ANDAFICORCAMIENTO.See,the1995BankofMexicoAnnualReportforfurtherdetails.47Clearly,oneeasywaytogetaroundthisproblemwouldbe ifpost‐reformcontractsweredenominated inhardcurrencyandrepaidinlocalcurrency,butthisdoesnoteliminatethemismatchbetweencurrentnominal incomeandpayments to debtors in real income.While the redistributionproblem for smoothoperationof thepaymentsystemnecessitatesFICORCAandUDI‐stylecontracts,weshouldnotethattheseinstitutionalvenueshaveemergedbecauseof the inability tocontractdebtabroadanddomesticallybycountriesholdingontoweakcurrenciesandthathaveahistoryofdevaluationand inflation.Thisproblemisoftenreferred toas the“OriginalSinProblem”.(See,Eichengreen–Hausmann‐Panizza(2002)).

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thatthevalueoftheirclaimswillbepreserved.Thiscaninturnavertacascadeofbankrunsandconsequent financial crash.Wedonot see anyotherwayof reassuring investors’ fears that apotentialexitfromtheEZwouldleadtoaconfiscationoftheirassets.We have to bear in mind that the EUROUDIs are not just an effective tool to reassure non‐confiscationofassetsonalreadycontracteddebtingeneral.TherearemyriadofcontractsintheeconomyofanexitingEZstate,whichwemustthinkof.Themostnoticeableonesarelong‐termlease contracts. Immediately after the MR, all lease contracts are denominated in the hardcurrency. The imminentdevaluationof theweak currencymakes it impossible for lessees tohonour hard‐currency denominated contracts. What we suggest by means of this particularexample is that bilateral restructuring of such type of contracts be denominated in country‐specificEUROUDIs.ContractsdenominatedinEUROUDIsalsobenefitfromstandardizationandfinancial innovation. Specifically, and in the particular example of long term lease contractsdenominated in EUROUDIs, real estate developers might wish to borrow in EUROUDIS, andextendleasesinEUROUDIs.RealestatedevelopersshouldbeabletofinancetheirinvestmentswithfundsdenominatedinEUROUDIs,andinvestorsshouldbeabletohedgetheirbalancesinEUROUDIs as the derivatives market develops. We should expect this phenomenon to occurwithin a short‐time frame. In theparticular caseofMexico in the aftermathof the1994Pesocrisis, forexample,all leasecontractswhichweretypicallydenominated inUSdollarspriortothe crisis,werequickly renegotiated inUDIsaffecting theentire real estate sector.Thus, onalarger scale, we should expect that economy‐wide contracts denominated in EUROUDIs willrelaxhardcurrencybudgetconstraints.We now return to our non‐confiscatory principle which is embedded in self‐reinforcingEUROFICORCAandEUROUDIinstitutionswithregardstothelegalsystem.AMRundertakenbyadepartingEZ state isnoexcuse toendorsedelinquencyand fraud.Withoutunderestimatingtheshockthatalleconomicagentsmayhavetoendurefollowingasuddendevaluation,theriskof a poorly designed MR is that of promoting a culture of non‐repayment. We hope that bydescribing the major guidelines and modus operandi of our twin institutions, to haveconvincingly argued that that risk is close to zero. The enactment of EUROFICORCA andEUROUDI sustains a solid legal framework for a continuous dissemination of contractenforcementandpropertyrightsprotection.Lastbutnotleast,wehavealreadywarnedtheEZmemberstatesconsideringtopartawayfromtheperilsofafixedexchangeratesystem,thattheyshouldexpectashortageofhardcurrency.Euros will be scarce during the transition for at least two obvious reasons. Firstly, the localcentralbankcannotprintthem.Secondly,acountryintheperipherythatishighlyindebtedinhardcurrencyisalreadyexperiencingalimitedaccesstotheinternationaldebtmarkets,andthesituationcanonlyworsenintheaftermathofaMR.HowcanoneensurethatEUROFICORCA‐1has,directlyorindirectly,increasedaccesstothehardcurrency?DrawingfromawealthofexperienceonsuddendevaluationsinLatinAmerica,theexitingstatesshould be warned on their continuous need to rely on international organizations. For ourproposaltowork,anyperipheralcountryconsideringtoleavetheEZwillneedstructuralloansfrommultilateralinstitutionstofundatleastpartofEUROFICORCA.Moreover,thelocalcentralbank must have an increased access to hard currency, which can only be obtained from

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European institutionssuchas theECBandthe IMF. Stabilityandgrowth in the longrunwillhowever ensure that the central bank can again be in the position to build foreign currencyreserves.Butthisbynomeanscanhappeninthetransitionalstage.Politicalissuesaside,themainquestionhereis:whatincentivesdointernationalagencieshaveinhelping theperiphery toundertakeamonetaryreform like theone thatwe justdescribed?Thestandardanswertothisquestionthusfar isthefearofcontagionandtheconsequentandincommensurableworldfinancialcrisisincaseofdisorderlyexits.However,cooperationinthisproposalsuggeststhatavoidingdisorderlydefaultscanbewelfareimprovingforbothcreditorsanddebtors.Theideaintheinternationalfinanceliteraturefromimplicitcontracttheoryisnotnew.48Thisisalsotruehistorically.Anditisonthisbasisthatweproposeagrowthenhancingmonetary reform,whichwillminimize the riskof contagionunderourbasicnon‐confiscatoryprinciple. At the same time, the MRwe propose will revert the insolvency trend. This trendunderthestatusquoisalreadyproventobedetrimentaltoeconomicgrowthintheEZ.Our proposal does not underestimate the historical roots of the euro zone and sunk costsincurred thus far. This iswhywepropose a temporarydeparture, a sort of sabbaticalwhichlengthiscriticallydependentontheextentofsupportthattheperipherywillreceivefromtheEZcoreandinternationalaidagencies.Letusassumeforthemomentthatitisindeedpossibletopersuadetheinternationalagenciesthat financial support must be granted, and that a departing country’s central bank in theperipheryobtainssufficienthardcurrencyduringthetransition.Itthenbecomespossibleforthecentralbanktoopenatemporarydiscountwindowinhardcurrencytosustainthedesignofastablebankingsystem.49We insistonthewordtemporary for in the longrun, thepostreformscenariowillreviewwell‐capitalizedlocalbanks,andthedepartingcountrywillenjoyrenewedaccesstoloansininternationalfinancialmarkets.In addition to the process through which the local Central Bank will build its internationalreserves, some regulatorymeasures on foreign exchange transactions –which do not involvecapitalcontrolsbyanymeans‐gearedtowardsinternalizingtheliquidityriskinhardcurrency,could be drawn from the prudential regulation in Mexico in the aftermath of the 1994 Pesocrisis.50In 1995, the central bank of Mexico launched two important initiatives. First, it suggested a“liquiditycoefficient”wherebyprivatebankswereforcedtoaccumulatetheirownhardcurrencyreserves for making timely repayments on their newly‐contracted foreign currencydenominated liabilities. Hence, in the event of illiquidity due to either a global or anidiosyncratic shock, domestic banks would not be affected at best, mildly affected at worse.Second, it launchedan initiativecalled“admissionof liabilities”whichboilsdowntorequiring48See,notably,Crawford(1987)whoshowsthatinarepeatedPrisoner’sdilemmaset‐up,cooperationbetweendebtorsandcreditorsParetodominatesastrategywherebothpartiesplayanon‐cooperativestrategy.Armendáriz(1999a)conveysCrawford’smainideabymeansofasimplePrisoners’dilemma‐typeexample.49Furtherdetailsonthelogisticsandsuccessofatemporarydiscountwindowliketheonewehaveinmindcanbefoundinthe“InformeAnualdelBancodeMéxico(1995)”.50Forfurtherdetailsonthe1994Pesocrisis,alsoreferredtoasthe“TequilaCrisis”,seeEdwards(1997)

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banks tomatch their hard currency denominated assets and liabilities adjusted for exchangeraterisk,creditriskandmaturity.Thebenefitsofdiscountwindowsandadmissionofliabilitiesareobvious.EUROPEANSOCIALPACT(ESP)Letusnowturntothethirdpillarofasuccessfultransition,namely, theESP(EuropeanSocialPact). We have so far emphasized that the success of a non‐confiscatory monetary reformcritically depends on the way creditors and debtors approach the problem of internal andexternalindebtednessinadepartingcountry.Inwhatfollowswearguethatthisisanecessarybutnotasufficientcondition.Tocompletethepicture,thedepartingcountrycanonlyguaranteesuccessinthedesignofaMRinanenvironmentwhereunitlabourcostsaredecreasingsteadilythoughthetransitionalstage.In the long runwe should expect an increase in productivity and a gradual recovery of unitlabourcosts.Dealingwiththeshort‐runfallinrealwagesrepresentsamajorchallengeinnon‐repressiveregimessuchasthoseintheEZdemocracies.Sincewehavespentquiteabitoftimein this section describing the merits of indexation in the financial sector, and a toolkit(includingthediscountwindowandadmissionof liabilities)toadheretoournon‐confiscatoryprinciple, this proposalmight seemingly underscore non‐confiscation in the labour sector bystatingtheinevitablefallinrealwagesintheaftermathofthereform.Inwhatfollowswewillattempt to persuade our readers that we are fully aware of the confiscatory yet transitionaldimension of a MR, which is shouldered by the labour force, but that this is a second‐bestscenario forEZdemocraciesrelative to thestatusquo.Moreover,wewillprovidea toolkit forexiting EZ member states to deal with this transitional and potentially explosive political‐economyproblem.History,has taughtus thatmanymonetary reformshavenot succeededbecause their leadershave failed to persuade workers that transitional low real wages are conducive to futureprosperity. Time and again we have seen that when partial indexation gives its way to fullindexation, thenextstopishyperinflationandchaos.51This isbyfar themajorchallenge wemustfaceunderinthisproposalfromapolitical‐economystandpoint.CrucialtoourproposalisthatanexitingEZmemberstatemusthaveinstitutionalsupportfromoutside,mostlybecauseofthemuchneededaccesstohardcurrencyinordertomoderatethemagnitudeandpotentialexcessvolatilityofthesuddendevaluation,anitseffectsinthefinancialsector.Itisnowtimetoaddresstheequallyneededcooperationoflabour,withintheboundariesof the departing EZ country. Specifically, we are addressing here the gigantic issue of wagecontention in support of structural reforms. Ironically, the former enables the country tosupport indexation cum restructuring in the financial sector, whereas the latter is all aboutpreventingfullindexationinthelocallabourmarket.

51NotethatwehavebeenentertainingtheideaofmultipleequilibriaalaBlanchard(2011).Itisthroughthelensofthiskindofsetupwherewemustmakesurethattheeconomydoesnotendina“bad”equilibrium(i.e.,nogrowthandhyperinflation).

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Implementing this rather contradictory approach to indexationmay sound close to politicallyimpossible,butthefactofthematteristhatthismonumentalpassagefromeconomicpolicytopolitical‐economyconsiderationshasbeensuccessfullybridged in, forexample,Spain,Mexico,andColombia,underthenameof“PactosSociales”orSocialPacts.52Priortospellingoutthedetailsofthispacts,weshouldspareafewwordsonthetruemeaningofsocial pacts as we view them. Social pacts are neither purely cosmetic, nor an expression ofgenerous good‐will by democratically elected politicians and their constituencies. If well‐designed,socialpactstaketheformofrealinstitutionalizedplatformsconstructedonthebasisof four fundamental principles. First, social pacts are inclusive of every relevant governmentagency and economic and social sector. All sectors should convene and participate and havetheirwordatregularencountersonanequalfooting.SuchencountersareallabouttheissuanceofpolicyguidelinesoninitiativeslaunchedbyMRgovernments.Pactsaretypicallyheadedbyanexecutivecommissionofbusiness,governmentandsocialleaders;haveclearrulesforconsensusgathering, and governance. Second, social pacts do not directly include political parties orlegislators. This is indeed why they are labelled as social pacts, and not because of puresemantics. In fact, these pacts represent a concerted policy response which will later on bepresentedtotherespectivelegislatureswiththebackingofastrongmandatefrom,byandlarge,all sectors of society. Third, social pacts manifest themselves as continuous peer monitoringdevices across key sectors, with each sector ready to adjust if necessary. In fact, it is notuncommontoseethattheexecutivecommitteeofatypicalsocialpactmeetsatleastonceaweekintimesofstressandthatboardmembersfindsupportfromoutsideagenciesthatmonitortheeconomyusingand/orgeneratinghigh‐frequencydataonleadingandunbiasedindicatorsinatimelyfashion.Socialpactsshouldbeabletodeliverpro‐activeandswiftreactionstounforeseencontingencies and to adjustmembers’ reactions on the basis of past performance, unbiasedforward‐looking outlook and context. Fourth, and most important, social pacts are all aboutsolidarityandfairness.Theireffectivenesscruciallyreliesoneveryonerepresentingaparticularsectoratthemeetingsputssomethingonthetable.Quitesimply,socialpactsareneitheraninstitutionalizedvenueforloweringwagesatallcostsnoravenueforinflictinglosesoncorporations.Instead,socialpactsincarnateanaturalforumfor discussing structural change reforms, encompassing taxation, potential subsidies, andpotential by‐laws to improve competitiveness and efficiency. And last but not least, to put inplace theneeded social safetynets to ensure theviabilityof reforms in context‐specific socialfabrics.Whenviewedthisway,socialpactsareclosest inspirit tocontinuousreferendumsonkeyissuesthroughacriticaltransitionalperiod.Weverymuchhopethatatthispointourreaderswillunderstandthereasonswhywesuggestthat all tools in our two pillar institutions supporting non‐confiscatory MRs in the financialsectorbeplacedunderapolitical‐economyscaffoldingof anESPwith twobranches.The first

52Typically,anorthodoxanti‐inflationpackageheavilyreliesonbudgetdeficitreduction.Whatwearearguinghereis that efforts to reduce the deficit while unobservable by nature, full accountability vis‐à‐vis enterprises andworkers via full disclosure of accounts (revenues and expenditures) is necessary for enterprises andworkers tocooperate. Enterprises will not increase prices and workers will not request higher wages if the treasurydepartmentpersuadesbothsectorsthatbudgetdeficitreductiontargetsarebeingmet.(See,Parker(2011)).

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branch, henceforth ESP‐1, will relate to a pact between the exiting EZ member state policymakersandkeyrepresentativesofallEZ institutions.ESP‐2wouldhenceforthbeasocialpactamongstthelocalsocialstakeholderswithintheboundariesoftheexitingEZstate.TheunderlingrationaleforsuggestingthecreationofESP‐1isbestunderstoodthroughthelensof the foreign aid format EZ exiting states will be needing in lieu of complementary to thecurrentbailouts.Wehavealreadyreferredto financialsupport inhardcurrencyandtechnicalassistanceviainternationalinstitutionssuchastheIFM.Inreturn,internationalsupportshouldbemadeconditionalfinancialaccessandknow‐howtotheexitingcountry’scomplianceinlinewiththenon‐confiscatoryprinciple.Weexpectduringitssabbaticalperiod,theexitingcountryandtheremainingEZcorememberswouldfindamutuallyconvenientreturntothefixedexchangeratemechanism,whicheverformit takes at the time the exiting country is strong enough and ready to return to full EZreintegration.Inotherwords,itwouldnotbeintheinterestoftheEZtopaveawayoutwithanoreturnoptionbecauseitmighttemptmanyothermemberstoexittherebyself‐inflictingitsown dissolution. Instead, it is in the interest of the EZ core to strengthen over time theeconomiesofcountriesinitsperipheryandtoexpandinthelongruntheeconomicimpactofthemonetaryunion.ESP‐1shouldbethecornerstoneforrallyingtheconsensusoftheEZmembersandinstitutionsaround the exiting country while imposing conditionality, which contemplates a maximumduration for the sabbatical, on a case‐by‐case basis. Onewould expect that the country on asabbaticalwouldreceivethesupportfromtheEZcoreinfavourableterms,subjecttoconditionsandexplicitguaranteeswithsomeheftyhaircuts.Ifthecountrysuccessfullyrejoinstheunion,suchguaranteeswouldbehandedback.However,ifthecountryfailstoreturntotheEZ,eitherby notmeeting the performance standards of themonetary union or because such a countrydecides to stay out of it indefinitely, then this country should be charged a pre‐specifiedmonetaryamountplusapenalty forexercisingrights thathavebeenexceedinglycostly to theEZ‐coreatthisparticularjuncture.Figure4deliversasnapshotofouridea.

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ESP‐2isabouttheinternalnegotiations.Inthefirststageseffortsshouldbeplacedonloweringunemployment rates, building the road to recovery and preventing full and non consensualindexationofwagesinthelabourmarket.Onewouldexpectlabourunionstointernalizepartoftheadjustmentcostsinexchangefortransitionalsocialprogramstohelpthoseingreatestneed.Likewise,afairself‐restraintonthesideoftheprofitmarginsoftheprivatesectorenterprisesisunavoidable.Inaddition,corporationsshouldacceptacompletedismantlingofindustry‐specificprivilegesandtaxloopholes.Both,workersandcorporationsshouldagreewiththegovernmentonshortand long termstepsofa fiscal reformwithaneyeonasocial safetynet.Only thenadeparting EZ government and policymakers can put in place the toolkit we have alluded toundertheumbrellaofaEUROFICORCAandEUROUDISinstitutions.Moreover,andunderawell‐designedESP‐2, thegovernmentofadepartingEZstatecanestablishadditionalprograms forfinancialreliefacrosstheeconomy.InthesamespiritofESP‐1,therecommendationsofESP‐2will be sent to the country’s ownparliament, for approval, once a social consensushasbeenreached.

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Lastbutnotleast,webelievethattheexecutiveinstancesofESP‐1andESP2mustcommunicateon a regular basis, to share information and exchange viewpoints so that the distinguishingfeaturesofasocialpact,namely,flexibility,inclusivenessandfairnessarepreservedacrosstheboardandacrossthetwopolitical‐economyinstitutions.6.Conclusion

Acooperativeequilibriuminwhichaheavily indebtednationcantemporarilyexit theEZ isattheheartofthisproposal.Wehavearguedthatduringitssabbatical,theexitingEZcanengageitself in a well‐designed monetary reform. This will be conducive to high rates of economicgrowth. The reform we have proposed is unprecedented in that the departing nationinternalizes thepotential impactonotherEZ states.Thesewouldalso internalize thebenefitsthatsuchatemporarydeparturewouldbringtothesplinteringstate.As we have described the architecture of this reform, it would minimize contagion, and thenegative effects emerging from high nominal and relative price volatility during a criticaltransitionalstage.Thedepartingnationwouldseektopromotegrowth‐enhancingpoliciesviaadevaluationof itscurrency,andattempttopreservetheintegrityofthefinancialandpaymentsystem.Ourproposalisbasedonanon‐confiscatoryprincipleaccordingtowhichallassetsdenominatedinhardcurrencybyinternalandexternalcreditorswouldbehonoured.Thevenuestofacilitate

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debt restructuringofboth internalandexternaldebtshavebeenspelledout.Wehavearguedthat such venues adhere as much as they possibly can to our fundamental non‐confiscatoryprinciple.We have highlighted that some degree of indexation in the financial sectorwas necessary toimplementdebtrestructuringunderadevaluation‐inflationspiral.Andthatpreventingasimilardegree of indexation in the labourmarketwas of the essence. In exchange, profitmargins byprivate sector enterprises would be cut so as to prevent price hikes in the typical context‐specificbasketofgoodsofaveragehouseholds.Weconcludedbysuggestingtheenactmentofasocialpact to facilitate access to amoderate‐inflation‐withgrowthequilibrium.Bydesign, thesocial pact is a unanimously and consensual venue inclusive of all key economic and socialactors. It should achieve an orderly adjustment of relative prices within the EZ exiting stateborders.Wesuggestedaparallelsocialpacttoworkinconjunction.Thiswouldbeconsensual‐basedacrosstheEZcoreandbetweentheEZcoreandperiphery.ReferencesAldcroft, Derek, and Richard Rodger (1920) “The disintegration of the Austro‐HungarianCurrency”,TheEconomicJournal,Vol.30,No.117Alesina, Alberto and Roberto Perotti (1996), “Income Distribution, Political Instability, andInvestment”,EuropeanEconomicReview,Vol.40:1203–1228.Armendáriz, Beatriz (1989), “Foreign Debt settlements with Several Creditors”, InformaciónComercialEspañola,Vol.43.Armendáriz, Beatriz (1990), Foreign Debt Renegotiations; An Historical and TheoreticalAnalysis, PhD Dissertation, Paris, France: Ecole des Hautes Etudes en Sciences Sociales, andCambridge,MA:MIT.Armendáriz,Beatriz,andJohnWilliamson(1993),TheG‐7’sJointandSeveralBlunder,PrincetonUniversityPress:EssaysinInternationalFinanceNo.189(April).Armendáriz, Beatriz (1999a), “International Debt: An explanation of the Commercial Banks’LendingBehaviorAfter1992”,JournalofInternationalEconomics,Vol28(February)Armendáriz, Beatriz (1999b), “Analytical Issues onLDCDebt:A Survey”, TheWorldEconomy(July–August)Armendáriz, Beatriz, andFrancisco Ferreira (1999), “TheWorldBank and theAnalysis of theInternational Debt Crisis”, in J. Harris, J. Hunter, and C. Lewis (eds.), The New InstitutionalEconomicsandThirdWorldDevelopment,NewYork:Routledge.Armendáriz, Beatriz, and Christian Gollier (2000), “Peer Group Formation In an AdverseSelectionModel”,TheEconomicJournal,Vol.110,No.465:632–643.

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Aspe,Pedro(1992),EconomicTransformation:TheMexicanWay,Cambridge,MA:MITPress.

Bester,Helmut(1985),“ScreeningvsRationinginCreditMarketswithImperfectInformation”,AmericanEconomicReview,Vo.75:850–855.Blanchard,Olivier(2011).“2011inreview:fourhardtruths”.IMFDirect,December21

Bolzico,Javier,YiraMascaro,andPaolaGranada(2007).“Practicalguidelinesforeffectivebankresolution”,WorldBankPolicyResearch,Workingpaper#4389(November)

Cardoso, Eliana, and Ann Helwege (1992), Latin America’s Economy: Diversity, Trends, andConflicts,Cambridge,MA:MITPress.Cavanese, A. J. andDaniel Heyman (1992), “Fiscal lags and the high inflation trap”, QuarterlyJournalofEconomicsandFinance,Vol.32,No.2(Summer).Coase,RonaldH.(1960),“TheProblemofSocialCost”,JournalofLawandEconomics,Vol.3:1‐44.Córdoba, José (1992), “Ten Lessons FromMexico’s Economic Reform”, typescript. This paperwaswrittenfortheEuropeanBankofReconstructionandDevelopment(EBRD),London,UK.Crawford, Vincent P. (1987), International Lending, Long‐Term Credit Relationships andDynamic Contract Theory, Princeton Studies in International Finance No 59, Princeton, NJ:PrincetonUniversityDePablo, JuanCarlos(1999), “EconomistandtheEconomy:Argentinasince1958”, typescript,UniversidaddeSanAndrés,Argentina.Davidson,Paul(2009),TheKeynesSolution:ThePathtoGlobalEconomicProsperity,NewYork:PalgraveMacmillan,p.125.Dornbusch, Rudiger (1976). "Expectations and Exchange Rate Dynamics". Journal of PoliticalEconomy84(6):1161–1176.Dornbusch,Rudiger,andMárioHenriqueSimonsen(1987).Inflationstabilizationwithincomespolicysupport:areviewoftheexperienceinArgentina,Brazil,andIsrael.NewYork:GroupofThirty,Ohio:OhioCollegeLibraryCenter.Edwards, Sebastian (1986). “Are devaluations contractionary?”. Review of Economics andStatistics,Vol.86,#3,August.Edwards, Sebastian (1997), “TheMexicanPesoCrisis:HowMuchdidweknow?Whendidweknowit?”,NBERWorkingPaperNo7233,Cambridge,MA:NBER.

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Edwards, Sebastian (1989), “Structural adjustment policies in highly indebted countries” inJeffrey Sachs, Developing country debt and the world economy, Chicago, IL: University ofChicagoPress,pp.249‐262

Eichengreen,Barry,RicardoHausmann,andUgoPanizza(2002),“TheOriginalSin:ThePain,theMysteryandtheRoadtoRedemption”,PaperpresentedataconferenceonCurrencyandMaturityMatchmaking:RedeemingDebtfromOriginalSin,Washington,D.C.21‐22November:TheInter‐AmericanDevelopmentBank.Eichengreen,Barry (2010) “Latin lessons for theEurozone”,UniversityofCaliforniaBerkeley(January).

Fisher, Irving(1933). “TheDebt‐Recession theoryofGreatDepressions”,Econometrica,Vol.1,No.4:337‐357.

Garber,PeterandMichaelG.Spencer(1994),ThedissolutionoftheAustro‐HungarianEmpire:Lessons for Currency Reform, Essays in International Finance, Princeton, NJ: PrincetonUniversityPress,FebruaryHausmann,RicardoandAndrésVelasco(2002)“Hardmoney´ssoftUnderbelly:understandingtheArgentinecrisis”,BrookingsTradeForum,pp.59‐104

Federal ReserveBank ofNewZealand (2011), Explaining Currency:NewZealandBankNotesandCoins,Wellington:ReserveBankofNewZealand.Goodhart,CharlesE.(1989),Money,InformationandUncertainty,London:Macmillan.Krugman, Paul. y Lance Taylor (1978). “Contractionary Effects of Devaluations”, Journal ofInternationalEconomics,Vol.8,issue3:445‐456(August).Krugman,Paul(1988),“FinancingvsForgivingaDebtOverhang:SomeAnalyticalNotes”,JournalofDevelopmentEconomics,Vol.29Krugman, Paul (1989), “Market‐basedDebt‐Reduction Schemes”, inMichael Dooley, Jeffrey A.Frenkel, and PeterWickman (eds.), Analytical Issues in Debt,Washington, D.C.: InternationalMonetaryFund.InternationalHeraldTribune,January18,2012.Krugman,Paul (1988), “FinancingversusForgivingaDebtOverhang:SomeAnalyticalNotes”,JournalofDevelopmentEconomics,29.

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Nelson,Rebecca,DickK.Nanto,JonathanSanford,andAndrewWise(2012),“FrequentlyAskedQuestions about IMF Involvement in the EurozoneDebt Crisis”, Congressional Report ServicePaperNo.7‐5700,Washington,D.C.Packer, George (2011) “The broken contract. Inequality and the American decline”. Features,ForeignAffairs,Nov/DecPigou,ArthurC.(1912),WealthandWelfare,London:MacmillanReinhart,Carmenand KennethS.Rogoff (2008).“Thistimeisdifferent:apanoramicviewofeightcenturiesoffinancialcrisis”,NBERworkingpapers13882,March.

Reinhart, Carmen and Kenneth S. Rogoff (2009), This Time Is Different: Eight Centuries ofFinancialFolly,Princeton,NJ:PrincetonUniversityPress.

Reynoso, Alejandro (1989), Essays on theMacroeconomic Effects ofMonetary Reforms, PriceControlsandFinancialRepression,PhDDissertation,Cambridge,MA:MIT

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Rogoff, Kenneth S. (2002), “Dornbusch’s Overshooting Model After Twenty‐Five Years”,Washington,DC:IMFStaffPapersVol.49,SpecialIssue.Sánchez Arroyo, Abdón (1995), “Esquemas de reestructuración de pasivos ante diversosescenariosde tasade interése inflación”,BancodeMéxico,Documentode Investigación9503(July).

Stiglitz, Joseph E, and Andrew Weiss (1981), “Credit Rationing in Markets with AsymmetricInformation”,AmericanEconomicReview,Vol.71:393–410.Tanzi,Vito(1977),“InflationLagsinCollectionandtheRealValueofTaxRevenue”,Washington,D.C:IMFStaffPapers,vol.24:154‐167,March.Taylor,Lance(1983),StructuralistMacroeconomics:AppliedModelsfortheThirdWorld”,NewYork,NY:BasicBooks.

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APPENDIX.ExampleofaloanwithAFICORCAMIENTO

Letsconsideraloancontractoriginallydenominatedinthehardcurrencybetweenaborroweranda lender.Supposethefacevalueoftheloanis100units labeledinthehardcurrency.Theloancycle is10years,withexactsamerepaymentsperyear.Theinterestratechargedonthisloanis5percentperannum.Assumethelenderobtainsfundingtofinancethisloanat150bpsbelowthe lendingrate.Thedebtorenjoysa (constant)yearly incomeof100units in thehardcurrency through the entire duration of the loan. In the absence of a monetary reform, thishypotheticaltheprofileofthishypotheticalloanis:PerformanceoftheloanbeforetheMonetaryReform(inunitsofthestrongcurrency)

!"#$%&'

#$&(&)%*+%, !"#-&+.)&+#% /%&0-0(& 1#&)2'3)4"0%&(

5#--#60-7('

+%8#"0

1#&)2'

3)4"0%&9/%8#"0

: :;; :; <=;''''''''''''''''''''' :<=;''''''''''''''''''' :;; :<=;>

? @; :; A=<''''''''''''''''''''' :A=<''''''''''''''''''' :;; :A=<>

B C; :; A=;''''''''''''''''''''' :A=;''''''''''''''''''' :;; :A=;>

A D; :; B=<''''''''''''''''''''' :B=<''''''''''''''''''' :;; :B=<>

< E; :; B=;''''''''''''''''''''' :B=;''''''''''''''''''' :;; :B=;>

E <; :; ?=<''''''''''''''''''''' :?=<''''''''''''''''''' :;; :?=<>

D A; :; ?=;''''''''''''''''''''' :?=;''''''''''''''''''' :;; :?=;>

C B; :; :=<''''''''''''''''''''' ::=<''''''''''''''''''' :;; ::=<>

@ ?; :; :=;''''''''''''''''''''' ::=;''''''''''''''''''' :;; ::=;>

:; :; :; ;=<''''''''''''''''''''' :;=<''''''''''''''''''' :;; :;=<>

!"#$%&"'"(#$)*+,"$-($./$0"*&' 1./234.

Nowassume that there is amonetary reform.Asa result the local currency loosesvalue.Thedevaluationmakesthecurrent incomeof theborrowertodropby30percentagepointswhenher income ismeasured in the strong currency. Suppose the loan contract remainsunaltered.Nowassumethatthedevaluationimprovesthecountry’scurrentaccountandaggregateoutput.Thisgrowthspurtwillbenefittheborrowerinthatherincomewillincreaseata5.5percentagepointsperyear.Herincomeisnowlabeledinthelocal/weakcurrency.Assumethatasofyearseven, this particular borrower’s income returns to its pre‐reform level in the hard currency.Undertheseassumptions,theprofileoftheloanwouldnowbe:

Armendáriz‐Reynoso

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PerformanceoftheloanaftertheMonetaryReform(inunitsofthestrongcurrency)

!"#$%&'

#$&(&)%*+%, !"#-&+.)&+#% /%&0-0(& 1#&)2'3)4"0%&(

5#--#60-7('

+%8#"0

1#&)2'

3)4"0%&9/%8#"0

: :;; :; <=;''''''''''''''''''''' :<=;''''''''''''''''''' >;=;;'''''''''''''''''' ?:=@A

? B; :; @=<''''''''''''''''''''' :@=<''''''''''''''''''' >C=D<'''''''''''''''''' :B=EA

C D; :; @=;''''''''''''''''''''' :@=;''''''''''''''''''' >>=B:'''''''''''''''''' :D=;A

@ >; :; C=<''''''''''''''''''''' :C=<''''''''''''''''''' D?=?;'''''''''''''''''' :E=@A

< E; :; C=;''''''''''''''''''''' :C=;''''''''''''''''''' DE=>?'''''''''''''''''' :<=;A

E <; :; ?=<''''''''''''''''''''' :?=<''''''''''''''''''' B:=@B'''''''''''''''''' :C=>A

> @; :; ?=;''''''''''''''''''''' :?=;''''''''''''''''''' BE=<?'''''''''''''''''' :?=@A

D C; :; :=<''''''''''''''''''''' ::=<''''''''''''''''''' :;:=DC'''''''''''''''' ::=CA

B ?; :; :=;''''''''''''''''''''' ::=;''''''''''''''''''' :;>=@C'''''''''''''''' :;=?A

:; :; :; ;=<''''''''''''''''''''' :;=<''''''''''''''''''' ::C=C@'''''''''''''''' B=CA

Notethatthedevaluationincreasesthedebtburdenconsiderablyduringthefirstyears.Thisisdetrimentaltothequalityoftheloan.Thereasonwhytheborrowerexperiencesaheavyburdenduringthefirstyeasisthatthedevaluationhasdecreasedhiscurrentincome,nowdenominatedintheweakcurrency.Anditisoutofcurrentincomethatshemustmakerepaymentsinthehardcurrency.Thedebtburdengappriorandpostreformscenariosisshowninthediagrambelow.Byassumption,thelender’sincomegrowthintheweakcurrencyclosesthegapinthelongrun,whichtakesplaceasofyearsevenafterthereformhastakenplace.

NowsupposethelenderdecidestoAFICORCARherloanimmediatelyafterthereformhastakenplace. As a result, the debt burden will be fixed to pre‐reform levels. Her repayments willthereforebe lowerrelative to thepreviousscenario.That is, thedebtburdenwillbe lowered.Theshortfallbetweentheoriginalrepaymentandwhattheborrowerispayingisautomatically

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rescheduled. In otherwords, the loan is nowAFICORCADO. The profile of this loan is nowdifferentfromthepreviouspost‐reformscenario.WeshowtheAFICORCADOloanprofileinthefollowingtablePerformanceoftheloanAFICORCADA(inunitsofthestrongcurrency)

!"#$%&'

#$&(&)%*+%, !"#-&+.)&+#% /%&0-0(& 1#&)2'3)4"0%&(

5#--#60-7('

+%8#"0

1#&)2'

3)4"0%&9/%8#"0

: :;;<; =<=''''''''''''''''''''' =<;''''''''''''''''''''' :;<=''''''''''''''''''' >;<;;'''''''''''''''''' :=<;?

@ AB<= C<;''''''''''''''''''''' B<>''''''''''''''''''''' :;<>''''''''''''''''''' >D<E='''''''''''''''''' :B<=?

D EE<= C<=''''''''''''''''''''' B<B''''''''''''''''''''' :;<A''''''''''''''''''' >><A:'''''''''''''''''' :B<;?

B E@<; ><;''''''''''''''''''''' B<:''''''''''''''''''''' ::<:''''''''''''''''''' E@<@;'''''''''''''''''' :D<=?

= >=<; ><=''''''''''''''''''''' D<E''''''''''''''''''''' ::<D''''''''''''''''''' EC<>@'''''''''''''''''' :D<;?

C C><= E<:''''''''''''''''''''' D<B''''''''''''''''''''' ::<B''''''''''''''''''' A:<BA'''''''''''''''''' :@<=?

> =A<= E<C''''''''''''''''''''' D<;''''''''''''''''''''' ::<C''''''''''''''''''' AC<=@'''''''''''''''''' :@<;?

E =;<E A<@''''''''''''''''''''' @<=''''''''''''''''''''' ::<>''''''''''''''''''' :;:<ED'''''''''''''''' ::<=?

A B:<> A<>''''''''''''''''''''' @<:''''''''''''''''''''' ::<E''''''''''''''''''' :;><BD'''''''''''''''' ::<;?

:; D:<A :;<D''''''''''''''''''' :<C''''''''''''''''''''' ::<A''''''''''''''''''' ::D<DB'''''''''''''''' :;<=?

:: @:<C ::<=''''''''''''''''''' :<:''''''''''''''''''''' :@<C''''''''''''''''''' ::A<=>'''''''''''''''' :;<=?

:@ :;<@ :@<>''''''''''''''''''' ;<=''''''''''''''''''''' :D<@''''''''''''''''''' :@C<:='''''''''''''''' :;<=?

!"#$%&"'"(#$)*+,"$-($./$0"*&' 123455

!"#$%&"'"(#$)*+,"$-($..$0"*&' 1./64.5

!"#$%&"'"(#$)*+,"$-($.6$0"*&' 1../42. Whatthistableshowsis,first,AFICORCAMIENTOboilsdowntoextendingtheloanmaturity.Inourhypotheticalexample,theborrowernowhastwelveyearsinsteadof10torepayherdebt.Second,insteadofrelativelyhighdebtrepayments,whichwillreducethefacevalueoftheloan,debt repayments will now be lower. In our hypothetical example, this particular borrowerreducedthefacevalueofherloanby10unitspriortothereform.Shenowreducedthevalueofitsloanby5.5units.Theremaining4.5unitswouldhavebeencapitalized.And,third,fromthelender’sstandpoint,grantinganextensionofthematurityofthisparticularhypotheticalloanbytwoyearsyieldsacapitalgainequivalentto3.45%.