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Sunday, July 12, 2015

Yay For The Schäuble Plan!

Although I am not a big fan of Wolfgang Schäuble (German Finance Minister), his plan for a "temporary" 5-year Greek exit ("timeout") from the euro looks like the optimal solution. Why do I like it? It's my plan, except that I did not specify the "5-year" part. I think the choice of five years as the interval is probably the best choice. (In case it's not obvious, I am not referring to the punitive alternative plan he suggested where Greece hands over 50 billion euros in "assets" so that it can remain within the euro. That alternative was so punitive that the 5-year "timeout" was the only realistic option; in my view, the other one was only there to make it look like Greece would have a choice.)

Update (Sunday evening): Based on leaks, the insanely punitive option has been reduced to merely extremely punitive, and the "temporary Grexit" option I discuss here has been dropped from discussion. Why the Greek government would prefer being crushed by the new set of demands, when the possibility of a relatively clean exit was offered, is a complete mystery to me. The fact that the EU demands are unfair is moot, since there is no way of the political balance shifting in Greece's favour quickly enough to help its economy.

What Happens

The Greeks need to cut their banking system off from the rest of the world (which I believe has already happened). This creates a new currency, the "Greek Euro", which I will denote with the ticker "EUR*(G)". The "rest of the euro" euro is denoted as "EUR*(X)"; the true "euro" EUR would essentially cease to exist. The countries using EUR*(X) will probably be reduced over time, but that's not Greece's problem.

The Greek banking system would probably have to be restructured into "good bank"/"bad bank" entities, including the central bank of Greece. Since it's TARGET2 liabilities are denominated in EUR*(X), it is probably insolvent. The "bad central bank" could remain a member of the eurosystem (for what that is worth), while the "good central bank" could be a less insanely structured "normal" central bank, which is outside the ECB.

How does Greece trade with the rest of the world? The Greek Treasury presumably has some foreign reserves, and it may be aided by other governments/supranational agencies (see below) in exchanging EUR*(G) for other currencies.Companies could apply to harried bureaucrats at the Treasury for foreign currency.

However, the non-bank private sector (or at least non-Greek bank) would carry the load in trading EUR*(G) versus other currencies. As long as the entities involved do not take part in fractional reserve lending or have deposit guarantees (in Greece, at least), it's open season to start trading. For example, bitcoin exchanges, or commodities and securities trading firms. However, EUR*(G) could not be traded in the same fashion as other currencies, which means that hedge funds (for example) could not easily short the currency. That is the entire point of capital controls - a feature, not a bug.

The fact that the "temporary period" will be set as five years makes this attractive. Since the system will be in place for a considerable time, it is worthwhile to invest in the systems to make this trading possible. And since cash trapped in Greece is not getting out any time soon, the "bank run" dynamic we have seen no longer makes sense. Businesses can adapt to the new conditions, as they will stable for at least five years.

As for why foreign governments would help, the Greek government has a reasonably good negotiating position. If Greece is cut off financially, it has no incentive to pay off any of its debts. The Greek government could trade off making plausible commitments to repay debts in exchange for short-term transition aid. Once Greece has control of its currency, it is a much stronger borrower; the only question is its purchasing power. Probably some form of inflation target/nominal GDP target would be needed, in order to provide some form of anchor for the currency. (In the short term, some form of inflation spike would occur, as there would probably be a devaluation of at least 30%.)

Since the Greeks would be using the "euro", there is no need to re-denominate contracts; the Greek government just has to assert that contracts governed by Greek law have to be discharged by euro deposits on the Greek banking system (that is, EUR*(G)). Some businesses run by incredibly thick leaders will be wiped out by this, but they were probably doomed by stupidity in the long run anyway. Creative destruction at its finest.

The only slightly complicated part of the transition is the status of euro notes and coins. The Greek government would have to come to an agreement with the rest of the euro area, but that should be easily reached. (The Greek government has the legal right to print "EUR" notes, which technically should trade 1:1 with EUR*(X), and so it will be giving that right up in exchange for the commitments described below.)

  • The Greek government would print EUR notes with "Greece" (presumably in Greek) stamped on them, and they would trade 1:1 with EUR*(G) bank deposits. Only the most thick tourists would confuse them for "real" euros (EUR*(X)). They presumably would trade at a discount versus EUR*(X) notes.
  • Legacy EUR notes (EUR*(L)?) printed by Greece (marked with a "Y" serial number) could be traded at some fixed exchange rate for EUR*(X) by the Greek Treasury/"Good Central Bank" with foreign central banks. For example, at 1.02 EUR*(L) for 1 EUR*(X). Since the euro area policymakers had an explicit objective to mix the various notes, it would be unfair (and a logistical nightmare) to not honour them at levels close to their notional values. How the private sector deals with them is an open question, but there are limits as to how far businesses can anger their customers.
  • Since it would be a waste of time to try to segregate coins, all EUR coins should officially be treated as EUR*(X). The Greek government would then create new EUR*(G) coins, which have different weights, so that things like vending machines could be adjusted. The Greek government might also set up agreements to buy EUR*(X) coins from other governments to cover this transition period; possibly at a fixed rate versus EUR*(L) notes.Yes, that means that vending machines would effectively be in a "foreign" currency for a period of time.  I assume that Greek civilisation would survive such an ordeal.  

(Update: I added the text below shortly after publishing.)

What Happens After Five Years?

Everyone could pretend that Greece will attempt to re-enter the euro proper at the end of five years, allowing us to return to the "EUR" without qualifications. Realistically, some form of re-denomination could occur, as was the case during the original euro entry. Such a pretence would be useful for helping to anchor the value of the currency. I would view such a step as being an idea, but we have to accept the level of the entrenchment of European groupthink. In any event, I would go along with the idea for the first few years, solely as part of the strategy of exchange rate stabilisation. Although I normally want currencies to float, a newly issued currency needs some form of limitations in order to help markets to find a level.

See Also:

I just saw this post by Nick Edmonds on the theory behind changing the unit of account. He wonders why Greeks would want to hold drachmas (what I call "EUR*(G)")? My response is that they will not have a choice; Greece would be cut off from the EUR banking system. The Greek banking system would only be re-integrated with the rest of the world once the EUR*(G) has found its own level in (non-bank) currency trading. It would only be at that point at which holding EUR*(X) would be feasible for liquidity management within Greece. (Obviously, Greeks hold EUR*(X) deposits in foreign banks; these will be needed for external liquidity needs and for portfolio reasons, but they are not that useful for liquidity management for Greek domestic operations.)

 (c) Brian Romanchuk 2015


  1. As I mentioned in reply to you on my own post, I think we are in agreement that making the Greek banking system operate in the new currency would have to be part and parcel of switching the whole economy to a new currency. My scepticism was about whether taxing in the new currency alone would be enough, as has seemed to be suggested in places. In any event, my main point was not about this but rather to assume that the economy stayed on the old currency and look at how the taxing currency might then be valued.

    1. I agree that "just taxing" is not enough, but I think that also does not capture the full spirit of the analysis by people like Mosler. (There may be less well thought arguments available on the Internet.) There are embedded assumptions which are not captured by the sound bite "taxes drive money", but those assumptions are not exactly hidden.

      He implicitly assumes that government contracts are also denominated in the government currency. This means that government salaries will continuously be issued in the "new currency". Also, VAT obligations are remitted fairly continuously, so there would be a continuous wave of transactions going the other way. Mosler (amongst others) quite often discusses the issue of the government imposing a price versus taking a market price in its dealings with the private sector. However, since spending is not exactly going to keep a currency strong, it is dropped from discussion.

      Entities could attempt to work in an external currency, but that means that every single transaction would have to be translated back to the new currency. This would create a fairly difficult hedging situation. Switching over to use the new currency makes life a lot less riskier. However, this argument relies on a assumption that the government effectively assesses taxes on a transaction basis, which implies a functioning VAT and/or income tax system. This is a hidden assumption, but it holds for the developed countries.

      Finally, it is incoherent for a government to want people to use a new currency, but have the central bank and regulations favour the use of an external currency. Most well-run developed countries do not allow entities to have access to deposit guarantees etc. for foreign currency deposits. Sure, that's a step beyond taxes, but it is a feature of well run financial systems. It does not drive the value of the currency directly, but it helps prevent external units of accounts from getting a foothold.

      Just taxing alone would be enough to give a value to something like TAN, but those are fairly explicitly an instrument that is denominated in an external unit of account. A TAN might be used as an instrument in commerce, but it is not really a currency.

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