Grexit

I’ve been thinking a lot lately about the situation in Greece. The question in my mind is whether this will become a trigger event that leads into the next phase of the ongoing financial crisis. In my mind, by the way, this crisis began at the turn of the century when the credit cycle – two decades into its expansionary phase at that point – finally rolled over. So anyway, here are my thoughts on how the “Greek affair” might play out.

Suppose that Greece simply defaults on its debt. It declares a moratorium on all principal and interest payments until such time as its economy has recovered. Does that mean that Greece must exit the eurozone and return to the drachma?

I would argue not! The Greeks have clearly rejected austerity, but does that mean they want to resurrect the drachma? Do Greeks really want to go the way of Zimbabwe or the Weimar Republic?

If the drachma were resurrected, it would immediately become a banana currency from which Greek citizens would be the first to flee. The Greek central bank would find itself in a position similar to Argentina or Venezuela, under constant assault by the markets and struggling to stave off a currency collapse. Unless the Greek central bank is willing to go the way of Zimbabwe, interest rates will be sky high and could easily lead to circumstances even worse than what the Greeks have already experienced.

My point is, for the foreseeable future the Greek government will not be able to tap the credit markets, whether it remains under the tutelage of the Troika or defaults. It has no choice but to live within its means and run a balanced budget, and there is a strong possibility that the Syriza government understands this situation. In other words, austerity cannot be avoided no matter what path the government takes.

Given that austerity is inevitable, why not give the Troika the middle finger and then rally public support for the measures that need to be taken? If Greek citizens see that the Syriza government has been true to its word, the sense of crisis created by a default may facilitate passage of needed reforms.

The first casualty of a Greek default would be its banking system. But the Greeks have had plenty of advance warning. Surely by now everyone with assets to protect has a bank account in Zurich or Frankfurt or London or New York. Surely even the least sophisticated and least wealthy of Greeks know to keep their cash under the mattress rather than in a bank that could topple any day. Why does Greece need any domestic banks? If there are profitable banking opportunities in Greece, foreign banks will be eager to establish branches, and investors may even start up new, fully-capitalized banks.

I suppose that it would be difficult for the Greek government to run its affairs without any domestic banks. Having defaulted, the government might have to deal with creditors trying to seize any deposits held in offshore banks. But it’s hard to believe that there wouldn’t be at least one bank willing to provide the government with protected accounts, and I’m sure the Greek government would make it worth that bank’s while. The crucial question in all this, of course, is whether the Syriza government will actually attack the corruption and cronyism that plagues the country, and whether this government will provide an environment conducive to economic growth.

In any case, let’s just assume that Greece has defaulted and, as I just described, now refuses to leave the eurozone. What happens?

A Greek default would force its creditors to write down their holdings, and most of that debt is now held by official institutions. That means the European Central Bank and other government entities, which are not supposed to ever incur losses, would in fact incur losses. And that would pose a serious political challenge to the entire edifice of bailouts that has been erected to support the debt of the Club Med countries. It might even call into question the rollout of Quantitive Easing by the ECB this coming March. Eventually, the markets might even start to price in the fact that most governments are bankrupt, and that they are dependent on constant monetization of their debt in order to avoid financial collapse.

From another perspective, if Greece is able to default on its debt and weather the storm, that might inspire the other Club Med countries to push for significant restructuring of their own debt. Spanish elections are scheduled for late this year, and the Podemos party has come from nowhere to lead in the polls. French elections are just over two years away, and the National Front leads in the polls. Who knows how long the current Italian government will last, and the Five Star Movement is waiting in the wings. At a minimum, it’s hard to imagine that these countries wouldn’t at least try to weasel out of taking their share of the losses from a Greek default. German outrage at being asked to shoulder even more losses would surely ratchet up the political pressure.

At some point a schism will develop between the hard money (northern) members of the eurozone, who refuse to finance any more bailouts, and the Club Med (southern) members who refuse to continue down the path of austerity. All of which will bring us to a climactic moment.

I predict that there will eventually be an emergency weekend meeting of the eurozone finance ministers, or perhaps even the prime ministers. The markets will be on the brink, the politics of the zone will have reached a stalemate, and it will be painfully obvious to all the ministers present that the monetary union can no longer be sustained. At that moment, I believe the southern members will ask the hard money members to withdraw from a position of strength, rather than forcing the Club Med members to withdraw from a position of weakness. And faced with a political disaster of epic proportions, I believe that request will be granted as a sop to appease somewhat the bitter feelings that will surely endure for a long time to come.

This may very well be the strategy of the current Greek government, and if so would be all the more reason for Greece not to exit the eurozone after defaulting. Freed of the constraints imposed by Germany and its monetary brethren, the ECB (whose HQ would presumably move to Paris) could open the monetary spigots and provide financing to all the Club Med countries, Greece included. There are nineteen members of the eurozone, and I predict nine of them would remain after this schism (Belgium, Cyprus, France, Greece, Italy, Malta, Portugal, Slovenia & Spain). Together, they would wield enough economic heft to support a currency regime on a par with any large Third World country.

By convincing Germany et al. to exit the eurozone, the Club Med countries would be spared the necessity of re-introducing their legacy currencies, re-denominating bank accounts and financial instruments, and arbitrarily re-writing contracts to the advantage of one party and the disadvantage of the other. Their markets could open normally on Monday morning, and everything would function exactly as it had the previous Friday, except of course that now the ECB has their backs beyond any shadow of a doubt.

But what about Germany and the exiting countries? First of all, I do not believe that they will form a new common currency regime. If they exit the eurozone, there will be absolutely zero political appetite for another monetary adventure. They will resurrect their legacy currencies and carry on as before. There may very well be a currency bloc where different countries peg their currencies to one another. But when monetary pressures build, they will be addressed by simply adjusting the peg, just as was done before the Maastricht treaty came into effect.

So, the emergency weekend meeting concludes with a decision that ten countries will exit the eurozone (Austria, Estonia, Finland, Germany, Ireland, Latvia, Lithuania, Luxembourg, Netherlands & Slovakia ). At this point, conventional thinking seems to be that the countries pulling out will declare an emergency banking holiday for a day or two while all the accounts in each country are converted into its legacy currency. I do not agree, and here is my alternative scenario.

I think that instead, Germany et al. will announce that in the next few days, each country will bring back its own legacy currency. These resurrected currencies will not replace the euro, but rather will circulate alongside the common currency. There will be no automatic re-denomination of accounts, and all contracts will be honored as written. When the markets open on Monday, the euro will drop sharply but everything throughout the entire eurozone will function normally, just as it did on the previous Friday.

Then, when each exiting country has put in place the technical requirements for resurrecting its legacy currency, its central bank will hold auctions where it sells some of the newly created currency for gold and foreign currencies that it wants to hold as reserves, thereby injecting appropriate amounts of the legacy currency into the banking system. In the early days these resurrected currencies may only exist in electronic form, just like the euro when it was first introduced, but notes and coins should start to circulate within a matter of weeks. Simultaneously with its central bank injecting the resurrected currency into the banking system, the government of each exiting country will auction debt denominated in said legacy currency. *

With only the Club Med countries remaining in the eurozone, the common currency will drop sharply against the legacy currencies coming back into existence. While the government debt of the Club Med countries may be money good, now that the ECB has their back, it’s money good in a rapidly depreciating currency. That means euro interest rates will quickly move back toward levels that reflect the risk of inflation, probably north of 5%. The combination of higher interest rates and a depreciating euro will allow the exiting countries to retire their euro-denominated debt at a significant discount in terms of their newly issued legacy currency.

The process I’ve just described will have a lot of market players screaming in outrage. In particular, anyone holding German debt or similar assets, with the expectation that they would be protected in the event of a eurozone breakup, will be shocked to find they are not shielded at all. And since there have been no defaults, since there has been no breach of contract, plain vanilla credit default swaps would not be triggered.

A lot of citizens from the exiting countries would also be quite unhappy to see the value of their euro-denominated savings shrink with the depreciating euro. To mollify their own citizens, each exiting country would therefore issue tradable warrants giving holders the right to convert euros into the legacy currency at the same rate where the legacy currency was converted into euros back when the common currency was launched. Each citizen and “qualified” corporation would receive those warrants in amounts equal to two or three years of income. In addition, banks headquartered in the exiting country would probably receive warrants in the amount of twice or thrice their capital. (As an aside, this could go a long way toward recapitalizing those still questionable banks.)

So there we are! Aside from Greece, the eurozone has broken apart without any defaults, without any banking holidays and without any credit default swaps being triggered. And even the Greek default was quickly cured when the ECB began massively monetizing its debt. Of course, none of the underlying economic problems that led to the breakdown have been resolved. The structural imbalances and impediments to economic growth still remain. And the division of Europe into a northern and southern bloc could easily lay the groundwork for the world’s next great conflict. **

As long as I’m painting “what if” scenarios, consider how the struggle in Ukraine might turn out. With Europe divided, the Club Med countries remaining in the eurozone will surely seek to solidify and expand their economic heft. It’s not hard to imagine the rump eurozone pushing east. The ten northern European members that withdrew could be replaced by ten new members from the Balkans. Once the eurozone bumps up against Ukraine, it’s easy to imagine a deal with Russia. In return for energy, trade and banking agreements, the rump eurozone accepts the dismembering of Ukraine and gives official recognition to the Republic of South Ukraine, a nation allied with Russia and bordering Moldova. I think you can already see the nightmare developing.

I could go on and on with possible scenarios on how the breakup of the eurozone might turn out for better or worse. Belgium could split up, with Flanders joining the Netherlands and Wallonia joining France. Northern Italy could secede, become independent and join the northern bloc. Maybe Ukraine leads to WW III, or maybe Germany and Russia come to agreement on carving up the country along ethnic lines. Who knows, maybe Texas secedes and becomes the capitol of a new USA, the northeastern states become the USSA and join the rump eurozone, and Latin America becomes a colony of China. Stranger things have happened.

Addendum (15 February 2015)

The more I watch negotiations between Greece and the eurozone authorities drag out, the more convinced I become that the Greek objective is to break up the eurozone. I think it’s universally agreed that a return to the drachma would be a disaster. What Greece really wants to do – I think – is remain in the eurozone and have its debt monetized. And that’s exactly what France, Italy, Spain, Portugal and numerous other countries want.

The problem: Germany and other hard-money countries are adamantly opposed to debt monetization policies. The solution: convince Germany et al. to pull out and leave the eurozone to its weak members. And a Greek default is exactly what is needed to force the issue.

I edited this post to correct some errors in the original version. For any purists out there, here is how those paragraphs were originally written; the errors should be obvious.

*

“Then, when each exiting country has put in place the technical requirements for resurrecting its legacy currency, its central bank will begin auctioning off a portion of its euro reserves and thereby inject some of the newly resurrected currency into the banking system. In the early days these resurrected currencies may only exist in electronic form, just like the euro when it was first introduced, but notes and coins should start to circulate within a matter of weeks. Simultaneously with its central bank injecting the resurrected currency into the banking system by selling euro reserves, the government of each exiting country will auction debt denominated in said legacy currency.”

**

“So there we are! The eurozone has broken apart without any defaults, without any contracts being breached, and without any banking holidays being declared. Of course, none of the underlying economic problems that led to the breakdown have been resolved. The structural imbalances and impediments to economic growth still remain. And the division of Europe into a northern and southern bloc could easily lay the groundwork for the world’s next great conflict.”