Friday, May 25, 2012

Leaving the Euro again

Yesterday's coverage of the latest European summit seems designed to reinforce my view of basic confusion expressed yesterday pretty clearly.

For example, the Wall Street Journal's "Europe Girds for a Greek Exit" reports that the talk was all about eurobonds, stimulus, or bailout as a way to avoid Greek exit from the Eurozone, repeating the senseless mantra that sovereign default cannot occur in a currency union.
"We want Greece to remain in the euro zone," German Chancellor Angela Merkel told reporters after nearly eight hours of talks. "But the precondition is that Greece upholds the commitments it has made."
I salute Ms. Merkel for not giving in to the camp that wants endless wasted spending disguised as stimulus, to be followed by inflation. But really, why would Greece not "upholding its commitments" mean it has to "leave the eurozone?" Why is it impossible to turn off the bailout spigot, and let Greece default and stop running deficits, while it stays in the euro?

Actually, the article, quotes, and other coverage is deliberately vague on a central question: Are we preparing for Greece to decide to leave the Euro, or are we preparing that the rest of Europe will try to kick it out? The quote reads a lot like the latter!

How do you kick a country out of a currency union? Greece has every right to say "the euro is legal tender in Greece," no matter what the rest of Europe does. Sure banking will be a bit harder if the ECB cuts off the Greek central bank, but unilateral use of another currency is an economic possibility. Kosovo and Montenegro do it.

The mantra continues,
...fears mount that Greece won't be able to carry out the painful surgery to its public finances and its economy needed to stay in the currency zone.
 At least the fact is dawning that a currency switch is the same as default:
In addition, euro-zone members would likely have to take a large hit on governmental and central banks' loans to Greece. There is a risk that some euro-zone commercial banks could face heavy losses on their exposure to the Greek economy. 

A lot of coverage concerned "eurobonds," an idea that has been stuck for years on just who is going to pay for them.

News flash: eurobonds have already been issued. They are called euros. ECB reserves are just particularly liquid floating-rate debt. The ECB issues reserves in return for sovereign debt and lends reserves to banks who load up on sovereign debt. This action is functionally the same as issuing Eurobonds to buy sovereign debts. What happens of the ECB's holdings of sovereign debt or its bank loans turn out to be worthless? If the ECB needs to be "recapitalized," it has the explicit right to call up the member states and demand funds, which means the member states have to kick in tax revenues. This is exactly a eurobond. For better, or, likely, worse. 

The ECB has propped up Greek banks for months through its lending operations and, increasingly, its emergency-lending program, known as ELA.

Under ELA, banks borrow from their national central bank, in this case the Bank of Greece, with approval of the ECB's governing council. The default risk resides with the Greek central bank and, ultimately, the Greek government.
This is a great case of wishful thinking, I'd say. Oh sure, the ECB doesn't have credit risk...if the banks collapse because the Greek government defaults on its debt, the Greek government will pay us back!
To ease the fallout on Spain and others, the ECB could issue more three-year loans to banks, analysts say. More than €1 trillion in these loans have been doled out since late last year. 
A trillion here, a trillion there, and pretty soon you're talking real money -- real debt. 


A quick response to some emails and comments. Yes, I understand that devaluation can change a trade balance towards exports. (I try to avoid the mercantilist implications of writing "improve the current account" or "raise competitiveness.") 

If the US Fed were to say "we buy and sell Euros at $2 per Euro," US prices and wages would not instantly adjust; our exports would become cheaper and imports more expensive, and we would import less and export more for a while.

The reason is superficially clear: prices and wages are a bit sticky. The precise mechanism of such stickiness is the subject of a huge academic investigation and is, I opine, still a little unclear. But it's not really controversial what would happen in the US.

But nominal prices are not always sticky. For example, when countries joined the euro, nominal prices changed by orders of magnitude, overnight, with no output or trade effects whatsoever.

The challenge for theory -- and for predicting what would happen to Greece if it left the euro -- is to figure out which kind of experience applies.

For a small country to suddenly leave a currency union, adopt its own currency, and instantly devalue that currency,  along with likely capital, exchange, trade, and other controls, is a quite different experiment than for a large country, with a well-established currency to devalue.

Does the price and wage stickiness that applies to a US company with longstanding contracts in dollars apply to Greek contracts that expect 10 euros, suddenly told that's going to be 10 drachmas, which are now worth 5 euros? Or do people in that circumstance focus on the euro value and treat the event exactly as they would being told that they are going to get 5 euros? Just how "sticky" will Greek nominal prices and wages be? Will the political constituencies be who don't want explicit euro cuts be mollified if they are paid in Drachma instead?  It's not obvious!

Here I'm willing to offer my Keynesian colleagues a friendly wager: Let's look at Greece 6 months after Drachma introduction and swift devaluation. I bet it will be a continuing basket case, and that Greece won't be exporting lots of Porsches back to Germany. If return to the Drachma and devaluation produce a swiftly growing Greece based on a hot export sector, well, I'll at least say I was wrong. No, you don't get to say it's awful but it would have been worse otherwise.