As Simon Johnson points out here and here, the Euro might be in some trouble. One problem is that one or more of the PIIGS might leave the union but the more serious problem is that Germany might and it seems obvious that without Germany there is no Euro.
The first potential problem, that some or all of the PIIGS might leave the monetary union is really, in my opinion, no trouble at all. If they left, as the weaklings of the union, the Euro only would only get stronger and more to the point, leaving the Euro only makes things worse for the PIIGS. On the other hand, if Germany decides to issue its own currency instead of bail these countries out then the Euro would surely dissolve. So what can be done about the weak links?
Well, the point of one of these countries leaving the Eurozone would be that it could begin issuing its own currency. This, of course, would constitute a default on their debt which promise to pay in Euros and in the short to medium run their external payments trouble would only get worse. After all, the new currency would certainly be worth far less than the Euro just for being less liquid and on top of that the whole point of issuing it would be to monetize fiscal deficits. The new currency would have virtually no purchasing power internationally.
So why might a country consider this? Well, one thing a domestically issued currency would accomplish is keeping the domestic banking system liquid. This will soon be a major problem for Greece. Currently the ECB is accepting Greek government bonds on repo but this will soon end and then the Greek banking system will find itself hard up to obtain liquidity.
What about government finance? This works out the same either way, only the language we use to describe it differs. In the Eurozone the Greek government will soon find it can’t sell debt externally (probably when the ECB stops accepting it on repo), out of the Euro the same thing will happen so in real terms the only resources available to the Greek government are taxes and domestics buying their bonds. If the Greek government tries to consume more in real terms then it can afford by printing its own currency the result will be hyperinflation, if they try to do this while keeping the Euro the result will be default. In neither case will the government get more resources.
So what’s the solution? Well, what the PIIGS need to do is get on with the business of defaulting in a coordinated manner and with German backing. What I have in mind would play out in the following way:
1) The PIIGS get their domestic constituents to agree to a set of austerity measures that reign in government expenditures (this may well be the hardest part). Given those measures, which they commit to going forward, they calculate how much of their existing debt they can afford to pay back. Hopefully it’s a decent number, let’s say 70% for all of them.
2) They announce that the face value of all outstanding bonds is now reduced to the amount calclulated above, so in our example they write the debt down to 70 cents on the Euro.
3) With the fiscal austerity measures in place and the debt written down to an affordable level we come to the clincher. The rest of the Eurozone, meaning Germany, guarantees the remaining outstanding debt and and any new short-term debt issuance for a period of time. The guarantee is contingent on the respective governments sticking to the austerity measures. This accomplishes the most important part, the ECB can now accept the debt on repo and keeps the domestic banks funded.
The point here is that for the most part the deed is done on the existing debt, they bought stuff with paper that promises Euros, they don’t have the Euros. Other than Germany just assuming the debt, something that they would be ill advised to do, default of one sort or another is inevitable. Furthermore, default is only such a disaster for the domestic economy if it leaves the banks without liquidity. This way they can keep the local banks funded, be able to issue more short-term paper to keep their governments running and do it all in a way that should be acceptable to Germany, in particular it shouldn’t actually cost the German treausury any money.
Finally, they should do this all at the same time. Far better to get it done once then to have each country get run by the market in sequence with some sort of ad hoc fix applied each time. One of the lessons of the countries leaving gold in the 30s was they were best off when they did it together, otherwise the ones still on gold got squeezed after the others had devalued.
Of course, this is all predicated on the PIIGS being able to get their populations to agree to the auserity measures and this is looking pretty much impossible for Greece. So the prognosis is not that good.
Senior Quantitative Portfolio Manager, Co-Fund Manager
Feb 7, 2010 at 10:48am