The indecent propsal (made here, elsewhere and elsewhere) to split up the Euro into two currencies through the departure of Germany, Austria, Finland and the Netherlands, followed by recapitalization of banks as necessary, appears to be gathering more supporters.

Once the current lunacy (“no bank bondholder left behind”) runs its course, ending the careers of a few Eurozone periphery presidents and prime ministers along the way, a new crop of European leaders may finally be left with no option other than to do the right thing.

Hans Olaf-Henkel’s support for the policy in an FT editorial piece appears to have caught the attention of widely read bloggers such as Mike (Mish) Shedlock and Michael Pettis. Please see their explanation why Germany can/should leave the Euro, but Spain cannot/should not in Eurozone Breakup Logistics posted yesterday on Mish’s blog. An extract follows here.

It always works the same way when a country with a lot of external debt devalues its currency. As the peseta devalues, Spain’s external debt will rise in tandem since it is denominated in the appreciating currency. Since Spain is already believed to be overly indebted, as the debt rises relative to domestic assets, Spanish credibility will decline quickly and financial distress costs will rise.

But of course as credibility declines and defaults rise, the peseta will drop even more as investors flee the currency and as domestic borrowers with euro-denominated debt try to hedge the currency risk. This will go on in a self-reinforcing way until the currency has been crushed. In the end, for Spain to leave the euro would probably cause its external debt to more than double – perhaps even triple – as the peseta falls. Of course it will be forced into default within days or weeks.


This is why I think Henkel’s proposal makes sense. Rather than have Spain leave the euro, Germany can leave the euro. The new German currency would automatically appreciate and the euro would depreciate, but without the terrible debt dynamics, the adjustment in the currency value would be much closer to the theoretically correct adjustment. The relative adjustment would probably be in the 20% range rather than in the 50% range.

Of course German banks would still have a problem. Their deposits would be in the form of the new German currency, and a lot of their loans – all those to Spain, for example – would be in the depreciating euro, and so they would take large losses. But at least the losses will be less – and more importantly the process will be more orderly – than if Spain simply leaves the euro and defaults.

One way or the other Germany is going to take a pretty big hit. It is a complete waste of time trying to figure out how to avoid it. It would be far more constructive to resolve the problem as quickly as possible in as orderly a manner as possible, and as any good Minskyite would tell you, that means we have to pay special attention to the balance sheet dynamics. That’s why I think Henkel’s proposal is an interesting one.

It increasingly appears that inept, ill-advised and spineless leaders will continue to torture the Eurozone economies with nothing to show for it in the end. Deflation, depression and the departure of one or some of the PIIGS from the Euro will all likely be allowed to rear their head before a sensible indecent proposal is adopted. Only the separation of the single Eurozone into two or more suitable currency zones will restore monetary and currency value flexibility to the ailing European periphery and thus set the right foundations for recovery.