“…It may be possible that a peripheral country be able to exit the Euro zone smoothly. It may be. We are not saying that it is likely or not, or that it will or will not. But only, that it is possible, technically speaking. And we will use today’s letter to examine this possibility…”
Click here to read this article in pdf format: June 11 2012
As we write, the news is out that Spanish banks will get bailed out in the order of EUR100BN (also reported EUR125BN). We have repeatedly said that bailing out banks whose capital vanishes because they hold junk government debt is an exercise in circular reasoning (see our letter: “The EU must not recapitalize banks”, from October 17tth, 2011). This also applies to those bailouts where the pockets are bigger, as in the case of the Euro zone members. Eventually, without deficit monetization, this will affect the credit quality and spreads of Bunds (i.e. sovereign debt of Germany).
Over the past week, we have been introspective. Recognizing that we have been pessimistic (perhaps since we began writing), we tried to look for policy solutions that would prove us wrong. Let’s see…
Today, even Warren Buffet acknowledges that the problem of the Euro zone is institutional, that fiscal integration is required for the zone to survive. We were, however, maybe one of the first to have openly said that the problem of the Euro zone was institutional, back on February 8th and 10th 2010 (yes, more than two years ago!) and that all these bailouts and liquidity manipulations would lead nowhere. We were contrarians back then and wrote in answer to a publication by the Bank of America’s Credit team: “US Fixed Income Situation”, Fixed Income Strategy, February 5th, 2010. In this note, the writers suggested that the crisis was of a short-term nature, driven by liquidity issues, with a longer term solvency problem.
Now, our view is mainstream. Now, with everyone siding with the institutional perspective on the Euro zone, we wonder if it is really impossible for a peripheral country to carry a smooth exit from the Euro zone. Until now, we thought it was and because of that position, we had a consistent view of the problem, whereby the US would step in via currency swaps and end up picking the tab. However, we think we may be wrong here and this is why we just wrote above, that we have been very introspective.
It may be possible that a peripheral country be able to exit the Euro zone smoothly. It may be. We are not saying that it is likely or not, or that it will or will not. But only, that it is possible, technically speaking. And we will use today’s letter to examine this possibility.
When we think about the survival of a currency or related bank runs that precipitate a currency crisis, we are being biased and narrow minded. We view the collapse of that currency as an asset to store value. But in doing so, we neglect the other function money has, which is to serve as a medium of indirect exchange, a medium to transact. Societies can actually live under bi-monetarism, whereby one currency is used to store value and the other, the imposed legal tender, is used to transact. There are multiple living examples of this in the world, and we are particularly familiar with those in Latin America.
The processes in demonetization actually start with this sort of bi-monetarism. The peso, inArgentina, was at one time used to store value and to transact. With the sovereign problems and increasing confiscation via inflationary tax, the peso was dropped as a store of value but continued to be used to transact. The US dollar replaced the peso as store of value. But later, as inflation became more acute, the peso completely disappeared and Argentina was forced to establish a currency board, where the central bank would only issue pesos if they were almost 100% backed by US dollar reserves. And then again, the peso began to be used to transact, while US dollars retained their role as a store of value. As the macroeconomic situation improved in the early ‘90s, US dollar stocks were not exchanged for pesos, but pesos flows (i.e. new savings) were not converted to US dollars.
With this in mind, it is therefore conceivable, that without affecting the status quo under the existing Target 2 structure (i.e. Trans-European Automated Real-time Gross Settlement Express Transfer System), a country like Greece start issuing their own currency with their banks accepting deposits both in Euros, supported by the European Central Bank, and in drachmas. The drachmas would not have to be imposed upon the private sector to transact, but the government could decide to pay all its future debt issuances and operating expenses (including wages) in drachmas, and demand that taxes be paid in drachmas too (A government can also simply default on the euro debt and re-denominate it at an arbitrary exchange rate).
To avoid falling into hyperinflation, the drachma would have to initially be backed by assets that would necessarily have to come from privatizations. In the case of Greece, this is difficult, as most if not all of sovereign assets have been encumbered. But we trust there is always the possibility to create a special purpose trust owning fiscal land, reserves or infrastructure royalties to begin. In other cases, unencumbered gold reserves could be used for that purpose.
It is important here to remember that the price of those drachmas, relative to other currencies, will not depend on the quality of the assets behind, but on the demand, relative to its supply. If the demand is not imposed (if bi-monetarism without capital controls is allowed) and the supply of drachmas will only increase gradually, as wages are paid and redenominated debt is serviced, we could see this currency survive, if the committed austerity programs continue in place. This would represent a scheduled depreciation of the currency, until the fiscal deficits are solved. If they are not, the whole experiment would succumb, just like it did in Argentina, in February of 1981, under the so called “Tablita” (tabla = ledger, and in this case, containing gradual peso depreciations).
The key here is that, after the still ongoing bank runs in Greece, with its citizens having all their savings stocks in Euros, they will afford to keep monetary flows in drachmas (i.e. the cost of having to transact in drachmas will be offset by the fact that their savings are in Euros). This policy would boost the purchasing power of their savings, vis-à-vis, the public services provided by the government, now supplied in drachmas. This policy too, would represent a devaluation of the cost of public workers, for those who managed to convert their savings into euros. And we believe that is the case for the majority of Greeks.
For Germany, this scenario would also be a win-win situation, because the Euros they now subsidize under Target 2 would eventually and gradually be recycled back into the remaining core Euro zone, as the peripheral country imports goods from the Euro zone. In fact, this alternative could well represent a virtuous spiraling process, with the Euro appreciating, Euro sovereign interest rates falling (both in Euros and in drachmas), and stocks (particularly financials) increasing. If that was the case….what would happen to gold ceteris paribus? We think it would plunge, and only be relevant in US dollar, Yen and Yuan terms, as the US and Japanese fiscal cliffs come to the forefront, while China’s situation continues to deteriorate.
In summary, the absolutely necessary conditions for a smooth exit from the Euro zone are:
1) No capital controls and freedom to convert to Euros in any amounts of local currency, at a market rate
2) Acceptance of bi-monetary deposits at banks: Euros and local currency
3) The European Central Bank will address liquidity on the Euro portion of deposits/assets, the local central bank will be the lender of last resort for the local currency portion (Otherwise, the experiment is set to fail, like the currency board failed in 2001 in Argentina, because US dollar deposits were not “insured”. The alternative, if the ECB does not cooperate, is to impose a 100% reserve requirement on the Euro portion of deposits)
4) No legally enforced indexation of Euro denominated contracts (let the market sort it out)
5) No definition (silence) by the government, on the future of the Euro denominated sovereign debt (eventually, a non-hostile renegotiation can be done, within the European Union, leading to the fiscal integration that everyone is now seeking)
6) The local government will pay expenses and demand payment of taxes in local currency.
7) Some sort of stock, hard asset back-up of newly issued local currency (gold, privatized assets)
And finally, the most difficult one (the one Argentina failed to comply with in 1980):
8 A credible plan to reduce fiscal deficits, now denominated in local currency.
If only one of these conditions were not met, an exit from the Euro would end in chaos.