Suitcases full of cash
Jul. 20th, 2011 01:40 pmA splendid piece from Steph Flanders yesterday on an article which hypothesizes how the Greeks (or indeed any country) might exit the euro. Roger Bootle and Ben May point out in a note for Capital Economics that the current situation with the euro is, unusually, unique in the history of currencies.
It's unique because the euro was never really a single currency. Although in terms of cash it was a single currency, when debt was issued by governments, that debt remained the obligation of that government. In other words, the printing presses said it was a single currency and the governments said something else.
But even that is a bit misleading, because state bonds and munis are issued in the US at varying interest rates. These are all in dollars, but the whole thing doesn't fall apart just because, say, California is on the verge of default. So wherein lies the difference?
John Kay in the morning's FT claims that the difference lies in the political vision. While in the US the concept of states' rights is strong, the drive in the EEC, then the EC, and then the EU (the clues are in the names) was to change the mechanisms and hope that greater federalism would follow. For some 45 years this actually worked, and it is still the fading dream of writers such as Wolfgang Munchau. "A crisis? We need more federalism!" Indeed, the EU's driving centre actually WELCOMES crises (ones that their own mechanisms have often caused) because this will necessitate further centralization.
The only reason the plan has gone tits up this time is that the perpetual backers of federalism (Germany, Netherlands, France) now have voters who are beginning to question if this isn't a subsidy too far. The West Germans, in particular, got their fingers burnt with reunification. This time round, they can see the implications of a Federal Europe that includes countries such as Greece.
Indeed, very few people seem to be arguing that this is what needs to be done (certainly fewer than were arguing this a year ago). Now the talk is more of "OK, Greece was a mistake. But the Euro wasn't. Is there an easy way out?"
The dream is that, because Greece makes up such a small part of the euro, and because its debts are, really, in the grand scheme of things, fairly tiny, there should be a solution (Italy is a different matter, of course, but we can come back to that).
What Bootle and May point out is that this dream suffers one serious flaw -- that being that it is not the level of Greek government debt that matters, but the level of Greek banking debt. And not its net debt (amount it is owed minus its deposits), but its gross debt.
Why so? Well, this is the clever bit, clever in the sense that it is so obvious, one feels one should have thought of it before.
Once domestic depositors start to suspect that their country might have to leave the euro, all that they have to do is to withdraw their money from the bank -- in euros -- put it in a suitcase, drive across the border and deposit in another country's bank, in euros. The money is, as it were, very liquid. Now, it's possible to do this with currencies such as sterling, (if, say, a massive devaluation is on the cards), but governments can impose currency controls to stop it. And then there's the currency exchange fees. While Greece is still in the eurozone (a monetary union), it can't stop people from moving euros around within the eurozone.
Now, this is already happening. Smart Greek money has been exiting Greek banks for some time, finding its way into gold, Paris property, London property, etc. I believe that we might be looking at a 15% decline in the value of deposits over the past year. At the moment the ECB is helping out the Greek banks, but the ECB can't cover a complete run on Greek banks (and, if you faced the prospect of your Greek bank deposit being turned into New Drachma and losing 50% of its value overnight, would YOU leave your money there?).
So, as Flanders points out,
If the eurozone promises to guarantee all of the liabilities, this will likely cause political crises in Germany, Finland and elsewhere. And, worse, it wouldn't even solve the problem. Not only would European taxpayers be on the hook for all of this money, but soon it would be one of the other peripherals in the same boat.
If the ECB simply cut off funding (this is, by the way, the US solution and is roughly what the Fed did to New York in the 1970s) then the Greek banking system would collapse. Euros would flee Greece by the lorryload. It would be touch and go whether democracy would survive (I suspect not, which is why the "American solution" isn't that great an answer over here) but, even if it did (say via lorryloads of euro in aid, not to the banks, but to the people via some kind of Marshall Plan), Greece would effectively become a protectorate of the rest of Germany.
So, that leaves "let Greece go". This would probably still leave the banking system insolvent (euros would still have left the country at a frightening rate before all of the technical procedures were in place), but one could go about putting that back together within the New Drachma and, provided once again that "emergency aid" kept the country away from total systemic collapse, within a couple of years we might be back in a sustainable situation.
It must be said that, horrible though all three of these options are, they are preferable to what might happen if Merkel keeps hiding behind procedure in a vague hope that the problem will go away. It won't. If we carry on as we are I fear that there will be a "Black Swan" weekend, where the smallest event might turn Europe into a financial battlezone. We got a taster of this with Italy the Monday before last. Once the situation spirals completely out of control (by which I mean complete loss of faith in the European banking system) then the European governments and the ECB and the banks might suddenly "agree" on a solution to the Greek problem. But by then it will be too late. I'm afraid I can't even begin to calculate how that scenario might play out -- to call it "Lehman cubed" would be an understatement. Perhaps once should try to imagine what happened in Iceland, happening throughout Europe, with a "Lehman cubed" on top of that. We do not realize how much of our civilization basically depends on mutual trust -- trust that your counterparty isn't going to renege on his promise. When Lehman happened a relatively small part of the financial system lost that mutual trust for a relatively short time. So, let's just imagine a few things that might happen, and I'll leave you to work out how it might play out.
1) Greek banks suffer huge run on euros. ECB cuts off funding. Banks appeal to international banking system for help, and they step in. But crisis "spreads" to Ireland, Portugal and Spain, which has revealed that its bad debts are worse than it previously thought. A major Spanish bank with a presence overseas suffers a crisis. Its ATMs stop working in France, England, Italy. A major French bank follows suit. Suddenly it's only 50:50 that any one ATM actually has cash in it.
2) A Europe-wide run on banks begins. All ATMs run out of cash. Queues form early in the morning as people rush to withdraw cash from branches. The price of gold soars through $2,500 an ounce. Other precious metals are in demand. Stores begin to insist that products are paid for in cash. If you can't get your hands on cash, you go hungry. Some people begin to resort to barter to buy food. Political crises emerge throughout Europe. In the UK, France, Spain and Portugal, the army takes control.
3) Insert your own ideas here.
Of course, it almost certainly won't happen. There will be a muddle-through -- probably through an eventual compromise whereby the priovate sector accepts government bond haircuts and, in return, capital requirements are relaxed. Greek bonds are "retired" at about 50%, with the "loss" being shared by taxpayers, solvent banks and perhaps with a bit of help from China. Greece gets some kind of aid from the eurozone for a decade as its financial system is restructured. That, at the moment, is the best we can hope for.
__________
Note: The IMF's report on the euro crisis firmly takes the "more unity" line as the solution, thus fulfilling the vision of Schumann and Monnet.
It says that
I.E., more Brussels power, less national power.
The problem is, and the IMF alludes to this but can't bring itself to accept it, that the timing is all wrong to get the Germans and the French (and the British - but we would always be opposed) to accept it. The German and French governments might accept it, but I don't think that the voters would. And if the German and French governments ee that the voters are madly against it, then they will do what they have been doing for the past two years, they will attempt to "muddle through" in the hope that things will get better. And therein lies the recipe for future disaster.
__________
It's unique because the euro was never really a single currency. Although in terms of cash it was a single currency, when debt was issued by governments, that debt remained the obligation of that government. In other words, the printing presses said it was a single currency and the governments said something else.
But even that is a bit misleading, because state bonds and munis are issued in the US at varying interest rates. These are all in dollars, but the whole thing doesn't fall apart just because, say, California is on the verge of default. So wherein lies the difference?
John Kay in the morning's FT claims that the difference lies in the political vision. While in the US the concept of states' rights is strong, the drive in the EEC, then the EC, and then the EU (the clues are in the names) was to change the mechanisms and hope that greater federalism would follow. For some 45 years this actually worked, and it is still the fading dream of writers such as Wolfgang Munchau. "A crisis? We need more federalism!" Indeed, the EU's driving centre actually WELCOMES crises (ones that their own mechanisms have often caused) because this will necessitate further centralization.
The only reason the plan has gone tits up this time is that the perpetual backers of federalism (Germany, Netherlands, France) now have voters who are beginning to question if this isn't a subsidy too far. The West Germans, in particular, got their fingers burnt with reunification. This time round, they can see the implications of a Federal Europe that includes countries such as Greece.
Indeed, very few people seem to be arguing that this is what needs to be done (certainly fewer than were arguing this a year ago). Now the talk is more of "OK, Greece was a mistake. But the Euro wasn't. Is there an easy way out?"
The dream is that, because Greece makes up such a small part of the euro, and because its debts are, really, in the grand scheme of things, fairly tiny, there should be a solution (Italy is a different matter, of course, but we can come back to that).
What Bootle and May point out is that this dream suffers one serious flaw -- that being that it is not the level of Greek government debt that matters, but the level of Greek banking debt. And not its net debt (amount it is owed minus its deposits), but its gross debt.
Why so? Well, this is the clever bit, clever in the sense that it is so obvious, one feels one should have thought of it before.
Once domestic depositors start to suspect that their country might have to leave the euro, all that they have to do is to withdraw their money from the bank -- in euros -- put it in a suitcase, drive across the border and deposit in another country's bank, in euros. The money is, as it were, very liquid. Now, it's possible to do this with currencies such as sterling, (if, say, a massive devaluation is on the cards), but governments can impose currency controls to stop it. And then there's the currency exchange fees. While Greece is still in the eurozone (a monetary union), it can't stop people from moving euros around within the eurozone.
Now, this is already happening. Smart Greek money has been exiting Greek banks for some time, finding its way into gold, Paris property, London property, etc. I believe that we might be looking at a 15% decline in the value of deposits over the past year. At the moment the ECB is helping out the Greek banks, but the ECB can't cover a complete run on Greek banks (and, if you faced the prospect of your Greek bank deposit being turned into New Drachma and losing 50% of its value overnight, would YOU leave your money there?).
So, as Flanders points out,
"In the event of a serious run on all Greek banks, there would be three possibilities: eurozone governments agree to guarantee all of those liabilities; or the ECB could cut off funding, forcing the collapse of the Greek financial system; or the eurozone could decide to allow or force Greece to get out of the euro.
If the eurozone promises to guarantee all of the liabilities, this will likely cause political crises in Germany, Finland and elsewhere. And, worse, it wouldn't even solve the problem. Not only would European taxpayers be on the hook for all of this money, but soon it would be one of the other peripherals in the same boat.
If the ECB simply cut off funding (this is, by the way, the US solution and is roughly what the Fed did to New York in the 1970s) then the Greek banking system would collapse. Euros would flee Greece by the lorryload. It would be touch and go whether democracy would survive (I suspect not, which is why the "American solution" isn't that great an answer over here) but, even if it did (say via lorryloads of euro in aid, not to the banks, but to the people via some kind of Marshall Plan), Greece would effectively become a protectorate of the rest of Germany.
So, that leaves "let Greece go". This would probably still leave the banking system insolvent (euros would still have left the country at a frightening rate before all of the technical procedures were in place), but one could go about putting that back together within the New Drachma and, provided once again that "emergency aid" kept the country away from total systemic collapse, within a couple of years we might be back in a sustainable situation.
It must be said that, horrible though all three of these options are, they are preferable to what might happen if Merkel keeps hiding behind procedure in a vague hope that the problem will go away. It won't. If we carry on as we are I fear that there will be a "Black Swan" weekend, where the smallest event might turn Europe into a financial battlezone. We got a taster of this with Italy the Monday before last. Once the situation spirals completely out of control (by which I mean complete loss of faith in the European banking system) then the European governments and the ECB and the banks might suddenly "agree" on a solution to the Greek problem. But by then it will be too late. I'm afraid I can't even begin to calculate how that scenario might play out -- to call it "Lehman cubed" would be an understatement. Perhaps once should try to imagine what happened in Iceland, happening throughout Europe, with a "Lehman cubed" on top of that. We do not realize how much of our civilization basically depends on mutual trust -- trust that your counterparty isn't going to renege on his promise. When Lehman happened a relatively small part of the financial system lost that mutual trust for a relatively short time. So, let's just imagine a few things that might happen, and I'll leave you to work out how it might play out.
1) Greek banks suffer huge run on euros. ECB cuts off funding. Banks appeal to international banking system for help, and they step in. But crisis "spreads" to Ireland, Portugal and Spain, which has revealed that its bad debts are worse than it previously thought. A major Spanish bank with a presence overseas suffers a crisis. Its ATMs stop working in France, England, Italy. A major French bank follows suit. Suddenly it's only 50:50 that any one ATM actually has cash in it.
2) A Europe-wide run on banks begins. All ATMs run out of cash. Queues form early in the morning as people rush to withdraw cash from branches. The price of gold soars through $2,500 an ounce. Other precious metals are in demand. Stores begin to insist that products are paid for in cash. If you can't get your hands on cash, you go hungry. Some people begin to resort to barter to buy food. Political crises emerge throughout Europe. In the UK, France, Spain and Portugal, the army takes control.
3) Insert your own ideas here.
Of course, it almost certainly won't happen. There will be a muddle-through -- probably through an eventual compromise whereby the priovate sector accepts government bond haircuts and, in return, capital requirements are relaxed. Greek bonds are "retired" at about 50%, with the "loss" being shared by taxpayers, solvent banks and perhaps with a bit of help from China. Greece gets some kind of aid from the eurozone for a decade as its financial system is restructured. That, at the moment, is the best we can hope for.
__________
Note: The IMF's report on the euro crisis firmly takes the "more unity" line as the solution, thus fulfilling the vision of Schumann and Monnet.
It says that
"National policy makers in the euro area need to move away from the illusion that a national approach to fiscal, financial and structural issues, preserves sovereignty in a monetary union. Instead they should focus on on the fact that interconnectedness requires more common thinking from an area wide perspective."
I.E., more Brussels power, less national power.
The problem is, and the IMF alludes to this but can't bring itself to accept it, that the timing is all wrong to get the Germans and the French (and the British - but we would always be opposed) to accept it. The German and French governments might accept it, but I don't think that the voters would. And if the German and French governments ee that the voters are madly against it, then they will do what they have been doing for the past two years, they will attempt to "muddle through" in the hope that things will get better. And therein lies the recipe for future disaster.
__________