In the last couple of weeks the euro crisis reached yet another climax. Ahead of a Greek bond maturity in the coming March, the eurozone countries pressed the Greek Government to come up with a new round of austerity measures before agreeing to sign a new “bailout” deal. If the Greek government failed to deliver, it would supposedly be faced with an incontrollable default and an exit from the euro, which would send the country back to the Middle Ages.
In this post I will explain why this is all nonsense. The reality in bullet points is as follows:
– The Greek Government is solvent. It has been solvent for over a year now at least.
– Because it is solvent, it does not need to default; its creditors do not need to take a haircut.
– The German Government is insolvent.
– The ECB is insolvent too.
– Greece can easily leave the euro.
– The only one who can threaten with a euro exit is Greece, not the other eurozone states.
– The euro crisis is about to end.
I know that by writing this upfront all my credibility has evaporated. I will regain it by the end of this post.
After a small theoretical intro, I will explain what would happen if Greece left the euro. By understanding this part, it will be easy for you to understand all the statements I made above. If you have not already done so, I suggest that you read my previous post about TARGET2 (here) before reading further.
Central banking, governments and solvency
Central banking used to be a dull task. It did not involve doing anything because central banks had one purpose only: to keep the gold of the state in a vault and issue papers with fancy colors and faces which would represent a claim against it. At some point central banks came up with a business model which was supposed to absorb banking crises and smoothen the business cycle. They started to get active in the capital markets and purchase securities by issuing (“printing”) new money. The new money would be identical to the old and would be backed by (but not redeemable in) the assets of the central bank. In a very simplified way, a typical modern central bank’s balance sheet looks like this:
The asset side is usually dominated by financial securities and FX reserves, although gold has remained a very important reserve asset for all central banks, particularly in Europe. The liability side is almost fully comprised of the monetary base, what is commonly called hard money. The monetary base is effectively a split of the central bank’s assets in small pieces each one of which is held by the country’s commercial banks and the public. Commercial banks add a lot of leverage on these deposits and issue short-term liabilities convertible to the central bank’s currency. People call these liabilities money and use it for their everyday transactions. But what happens with this money in the real economy is not our concern here. What we are focused on is the central bank and particularly the following crucial points:
- By definition, the central bank’s balance sheet is at all times balanced. Thus, its liabilities will always be worth as much as its assets.
- Central banks hold too little capital and their ability to absorb losses is limited. For this reason they usually buy safe government securities and major currencies for their FX reserves.
- A central bank can never go bankrupt because it does not have to repay its liabilities. If a central bank takes big losses on its investments, then its equity will drop to zero and the currency it issues (the monetary base) will be revalued downwards against gold. An alternative is that the government covers all the losses by recapitalizing the central bank in order to preserve the value of the currency.
- Because of (1), (2) and (3), the value of the currency is fundamentally linked to the value of the central bank’s investment portfolio.
A government has a much more complicated task which is though well understood by everyone. A government is called to provide a set of services that the economy considers as important for its functioning. In order to ensure that it can sustainably provide these services it relies on the following tools:
- Taxation: A government exerts sovereign power over its people. It has the right to impose taxes and collect them by force of law. If the government needs to raise revenue it can increase taxes.
- Austerity: A large part of its expenses is discretionary. The government has the right to reduce its expenditure in order to meet its budget goals.
- Inflation: The third tool is a sneaky one. It is not controlled by the government but by the central bank. If the economy is in bad shape and the government’s finances are bad, the central bank can increase the money supply in the economy. Then, if the money is used wisely, the condition of the economy improves and so do the government’s finances. If not, the increase of money creates inflation which boosts government revenue (like taxation) and reduces real public expenditure (like austerity). The government likes it either way.
So inflation without being a tool that the government can directly use, it remains a tool that the central bank will use exactly at the time the government will need it. The overlap of interests of the two institutions makes the central bank’s independence almost irrelevant.
Lastly, solvency refers to the ability of an organization to meet its long-term obligations by the use of its resources. Technically, it is defined as the condition where the value of the assets of the organization exceeds that of its liabilities. Insolvency is the opposite situation. When a private company is insolvent it needs to reassess its business model in order to return back to solvency. This is a day-to-day process that every company (and every household) goes through. If it fails, it is thrown out of business, it disappears from the face of the earth.
However, governments and central banks hold a monopoly in their business and a dedicated (subdued actually) client base! They cannot go out of business and they cannot disappear. Therefore, for what follows I will need to give a very clear definition of solvency for them:
- A government is solvent when with its current fiscal policy it can meet its real long-term obligations.
- A central bank is solvent when its currency can at minimum maintain its value against gold in the long-run.
This definition of solvency is similar to defining long-term sustainability within certain restrictions: The government’s restrictions are that it cannot rely on inflation; in order to ensure solvency it needs to reassess its fiscal policy. The central bank on the other hand has the restriction of not being able to raise equity. It can expand its balance sheet, but it cannot take losses. Similarly to companies and households, governments and central banks are constantly faced with insolvency. It is the reassessment of their business model that ensures that they become solvent again.
From the euro to the drachma
With the theoretical framework in place, we now want to look at what would happen if Greece left the euro and went back to the drachma. The conversion would entail two actions:
First, the Greek government would declare the drachma legal tender within Greece. This would mean that civil servants would be paid in drachmas, that taxes would be paid in drachmas, and that all contracts signed under the Greek law would be converted into drachmas. The State in this way would create the demand for drachmas.
Second, the Bank of Greece would create the supply, simply by redenominating its liabilities in drachmas. This would mean that also the deposits of the banks’ customers and the loans they have taken would be converted into drachmas. It is as simple as it was ten years ago. Only one thing has changed: the balance sheets of the central banks of the Eurosystem have since then ballooned. This is how the balance sheets of the Bank of Greece and the ECB look like at the moment:
I have described before that the ECB is a vicious central bank. And it has now been drunk with the same poison it has been serving the eurozone all along. If the BoG would go back to the drachma, it would necessarily have to redenominate the TARGET2 liabilities to the ECB in drachmas as well. Here is what I believe would happen afterwards:
The TARGET2 liabilities of the Bank of Greece by the end of 2011 amounted to roughly 100 bn EUR. Assuming that the conversion takes place on a one-on-one basis, the TARGET2 liabilities will be converted into GRD on the BoG’s balance sheet ( to ) and on the ECB’s balance sheet ( to ). After the conversion the ECB will find itself with an illiquid, unhedged GRD deposit, larger than its own capital which yields a meager 1%. For a reason that I will explain later, the ECB is faced with only one sensible option at this point: print drachmas herself. The Greek Government, desperate for cash will issue 100bn GRD in bonds in various tenors (at a coupon of around 5% for the 10-year tranche) and sell them to the ECB ( to ). It will then deposit the GRDs in the Greek banks and possibly use a small part to recapitalize them ( to , recapitalization not shown). The banks will be able in this way to repay the loans to the BoG, and the latter will clean up its balance sheet from the toxic TARGET2 liabilities ( to ).
Let’s see now what happens when FX trading begins for GRD/EUR and let’s assume that the GRD collapses immediately by 50% against the EUR.
In this case the Greek government will have to call its lawyers and declare bankruptcy for all its EUR bonds. It can obviously not repay them. The EU/IMF loans will be given super-seniority and will still have to be repaid. But the ECB will be writing 50bn EUR off its revaluation accounts (50% times 100bn) and the entire 40bn from its Greek bond holdings, this one against its capital. As of December 2010, the ECB had only 5bn EUR of capital and another 20bn EUR in revaluation accounts. The amounts have not changed much since then. The ECB is caught in its own trap and is officially insolvent.
By that time the euro will look very shaky. Money managers across Europe in fear of their cash holdings being converted to another currency they transfer any deposits they have in peripheral countries’ banks into German bank accounts. The ECB then will continue to expand its balance sheet and register claims against the NCBs of the peripheral countries like it always does through TARGET2 undermining even further the value of the euro. The game will be over. The peripheral countries will switch back to their own currencies and gently ask the ECB to monetize their TARGET2 liabilities.
But remember what happens when a central bank is insolvent. The value of the currency drops because it is fundamentally linked to the central bank’s assets, pro rata of the ECB’s exposure to each of the new currencies. Contrary to common perception and initial intentions, TARGET2 has in the last years transformed the euro from a german currency (if it ever was) into a “Mediterranean+Ireland” currency. Periphery is the new core, to paraphrase the known fashion motto. Therefore, the euro cannot decouple from the drachma, it will follow her all the way down. The failure of the euro will bring down the Fed, the Swiss and the Danish central banks and the price of gold will skyrocket. The only possible backstop is the eurozone taxpayers who can be served the bill of recapitalizing the ECB. But by that time the bill will be counting hundreds and hundreds of billions of euros.
In my post about TARGET2 I described this mechanism as the flaw in the euro’s design. The ECB is doomed to fall prey to it. Up to 2009 the member states indirectly bore the responsibility of maintaining the implicit currency peg between the member states’ currency. They did this by funding their balance of payments deficits with public borrowing. Once a few countries were cut-off from the capital and money markets, the ECB naively assumed this role by expanding its balance sheet with the TARGET2 gimmick. Effectively, TARGET2 works like a masqueraded GRD/DEM currency swap exposing the ECB to currency risk that arises because of the TARGET2 dynamics. As the crisis deepens, the ECB is automatically getting increasingly exposed to the risk of a euro breakup, while at the same time increasing the probability of the breakup.
Because of this fact, my view is that things would evolve differently if Greece left the euro. The ECB will not let herself and the world implode. What the ECB will do is keep her role as the ultimate hedger of GRD currency risk and become the market maker for Greek Government bonds, with the Greek Government taking full advantage of it. Greece will restart talks with its creditors and will offer them a bond swap deal where the old EUR bonds will be exchanged with new GRD bonds with the same coupon and same duration. The banks will be delighted: currently they are negotiating a 70% haircut, but in this case they would be offered with a security paying 5% free of credit risk, since the BoG has now a new drachma printer at its disposal. If the PSI deal has gone through by that time, the Greek Government in order to restore its relations with the banks will offer to reverse the deal. But then the banks will be facing a very large currency risk. The ECB will be there for them:
First the banks will swap their old EUR bonds with new GRD bonds in . With the intermediation of the NCBs (not shown) the ECB will offer a currency hedge to the banks  if no one else is ready to take this side of the trade, assuming all the currency risk. After this transaction here is what happens:
-The banks have taken on the credit risk of the Greek government bonds. They had the credit risk before, but now the risk is mitigated by the fact that the Greek government can refinance its bonds from the BoG.
-The banks did not assume any FX risk, the ECB did. The ECB also bears the FX risk on the 100bn GRD bonds it purchased in the monetization phase. It will do whatever it takes to keep the exchange rate at least close to parity intervening in the FX markets whenever necessary. With 5bn EUR in capital and 140bn of GRD exposure it can only take up to a 3,5% loss before it consumes its capital. It is on its own best interest to do so. However this won’t be difficult and you will understand why below.
-The Greek Government repays all the loans to the EU states and keeps a portion outstanding towards the IMF. With the 100bn GRD it got in the beginning, it has now the opportunity to start the biggest infrastructure project ever undertaken in Greece. It will place all its money into a Growth Fund and will hire a team of professionals to manage it within a narrow mandate to boost employment and the competitiveness of the Greek economy. The Growth Fund will be one of the biggest Sovereign Wealth Funds in Europe, second only to Norway’s. The amount of money it will have at its disposal will be larger than Qatar’s Investment Authority (Qatar’s SWF, with total assets of about 85bn USD). At the same time it will be able to throw money again into the Greek economy, push asset prices higher, attract foreign investment, put back people into work and run a budget surplus. Not just a primary surplus, not cyclical, but structural! In fact it will be able to attract so much foreign investment that the price of the GRD will tend to appreciate, so the ECB will eventually find itself able to sell Greek bonds and reduce its exposure.
Why is it going to run a budget surplus? Because the measures it has taken already should guarantee a surplus once money starts flowing again within the Greek economy. At the onset of the crisis the Greek Government was indeed insolvent, but the fiscal measures it has taken afterwards, I am pretty confident that render it solvent, provided that it deals with the severe liquidity squeeze it faces at the moment and provided it has opportunities for growth.
From then on the future of Greece is solely on the hands of the Greek Government and the Growth Fund. Yes, to some extent it will be a planned economy, but this is not bad if the planner has a vision and ideas. Especially in the case of Greece, there is hardly anything that cannot be improved and I guess that the political conditions have changed after what’s happened in the last two years. Greece will be able to rebuild from scratch its public sector, courtesy of its new central bank, based in Frankfurt. As a percentage of GDP, its total debt will have increased a lot, but the economy will be growing again and the budget surplus will ensure long-term solvency.
With this in mind you can understand why the ECB will have no other option but to monetize the 100bn TARGET2 claims herself if Greece left the euro and why it won’t have a problem pegging the EUR to the GRD. The monetization would give the best chances for Greece to recover and create the growth it needs to ensure that the drachma will not devalue against the EUR over time. The ECB has to make sure, that at some point in the future it will be able to get off its books the Greek Government bonds. It will manage to do so once Greece is strong enough to be able to preserve the value of its currency without the ECB’s intervention. The smaller the Growth Fund is, the smaller the chances of Greece to recover and of the ECB getting rid of the unhedged exposure are. The ECB will not find it difficult at all to reduce its exposure. The growth prospects of the Greek economy will be very bright after this and foreign investors will want to have a larger piece of its future. As investors will be investing in Greece again, the ECB will not actually be increasing its exposure to the GRD. It will be able to offload the bonds from its balance sheet relatively quickly. The ECB will not struggle at all to defend the drachma. It will only offer risk hedging to the investors that are unwilling to take on the risk themselves.
But then, if the transition is successful, the other deficit countries will opt for the same solution. They are in good position to do so: Banco Portugal has unusually large holdings of gold; the Spanish Government has low levels of government debt; the Irish Government will not hesitate for a second given the volume of its TARGET2 liabilities. Slowly the euro will start to disintegrate with more countries following, but even though the countries that will possibly stay in will include Germany and the Netherlands, the reality will be that the ECB will become the shadow central bank of the once-upon-a-time “peripheral” countries. It will be released from its duty only when these economies stand back on their feet and the ECB manages to offload all their bonds from her balance sheet.
Let’s see now what happens in the event that Greece leaves the euro from Germany’s side, taking first the scenario where the drachma collapses. As I described above, this will mean that the euro collapses as well. Germany might return to the Deutschmark or it might not. It makes no difference.
If Germany wants to decouple its currency it will have to recapitalize BuBa by hundreds of EURbn (BuBa TARGET2 assets as of Oct-11: 500bn EUR and rising fast). These will come from the German economy through taxation. And you know who is going to pay, not the money managers who moved their deposits to the German bank accounts at the last minute. It will be the German people again.
But this won’t happen. In face of potential riots in front of the Bundestag and the ECB’s offices, similar to those in front of the Greek parliament, the German Government will make sure that the Bundesbank or the ECB (depending on the currency) proceeds with the plan I proposed above, keeping the drachma and the other currencies at parity with Germany’s currency for as long as they regain their competitiveness. We won’t see any riots in front of the Bundestag. Instead we will see news headlines reading “Gone!”, “Raus!” and who knows what else. The ever-ignorant media will stick to their propaganda and present things as if Greece and the other countries left the euro, even though the reality will be that no one ever left.
But with the reinstitution of the old currencies in the periphery, investors will not be interested to hold those Bunds anymore when they yield less than 1%. With the growth potential that the old currencies will unleash, asset prices will drop and yields will rise. This is going to cause a fast deleveraging process that will reduce the money supply within Germany, something that some will consider as destructive for the German economy. But in reality, it will save the German economy from a bubble that keeps growing. Investments will be able to earn again a return, preserving the value of capital while risk premia will subside. The shift will also save the foreign markets for Germany’s products and, since Germany is a creditor nation, increase the value of her foreign investments. Given the quality of the German media, I cannot be sure whether the German public would be able to understand why this is going to work for its own long-term benefit.
In the beginning of the post I made a number of “absurd” statements. I will now revisit them one by one.
-In 2009 the Greek government was obviously insolvent. Since then it has taken an enormous set of tax and austerity measures which under normal circumstances should be enough for it to balance its budget and ensure long-term solvency. The reason that they all fail is because Greece’s money supply decreases, rendering any effort to balance the budget hopeless. So, in order to answer the question whether Greece is solvent, given my definition in the beginning, we should be asking whether Greece could be able to meet its long-term real obligations with its current fiscal policy and without its money supply having ever decreased. I cannot answer the question with absolute certainty, but I think that 100bn EUR in the government’s bank account and a bold growth plan would make a big difference! Competitiveness in the goods market is not at all an issue if the economy grows and attracts foreign investment. It naturally follows that if Greece is solvent it does not need to default, although it needs to put a serious effort to reduce its debt burden over the next few years and then return to macroeconomic normality.
-In 2009 the German economy also failed as I described in my first posts (here). Since then however, it has been flooded with more than 500bn EUR thanks to a flawed monetary system. The German Government has taken some measures to reduce its budget deficit but again solvency in real terms seems to be a very remote probability. The fact that with a 500bn EUR bailout the German Government still has to put any effort in balancing its budget indicates with a high degree of certainty that Germany is insolvent. Of course, no German politician would admit that. Hypocrites rule in every country. The people will inevitably feel the pain when their real income decreases over time and when an export-led recession puts them out of job, but then again the media will be there to remind them how “disciplined” they have to be when it comes to fiscal policy.
-The simple observation that the ECB has an exposure of 140bn EUR to Greece with only 5bn EUR in capital is enough to answer any question of whether Greece will ever be expelled from the eurozone and let the drachma devalue. If Greece decides to exit, the ECB will make sure that the drachma will not lose any value against the euro. In the process it will also offer 100bn GRD to the Greek government to help her in this common goal.
-No country can force Greece out of the euro. It is not permitted by any treaty. But most importantly, the Eurosystem cannot freeze “funding” of the Greek banking system even if Greece defaults without at the same time imposing immediately capital controls, which is against EU law. The bluff that Greece will be expelled from the euro is ridiculous. In the end, the only one who can eventually take a decision to exit the euro is Greece herself. At the moment she has every reason to get out but the people are so intimidated of this prospect and the politicians so naive that they won’t even bluff with it. Of course, in the prospect of Greece playing this card the powers that be managed to put in place just the right person in the position of the Prime Minister. If an ex-central banker says that the euro exit would be catastrophic, who is going to stand up against him?
As usually, I have left the best part for the end.
The ECB has been insolvent for years. Its business model is based on a fundamentally flawed balance of payments mechanism within TARGET2. From the moment that a structural balance of payments deficit was created for a single country the ECB entered into an automated path of self-destruction at full speed. The current approach of dealing the crisis with austerity measures accelerates the destruction of the euro.
With this business model the ECB ensures insolvency by routinely increasing its exposure to the black holes it creates. We don’t have to wait to see what has happened with our common currency. It is almost entirely backed now by TARGET2 claims collateralized with government bonds that can never be repaid. The M3 money supply of the euro area is close to 10trn EUR. At the moment of this writing, 10trn euros are already worthless and the ECB with the rest of the Eurosystem is the most failed central bank ever in the history of mankind. It is rapidly sending down the value of trillions of euros of assets down to zero. Soon, widespread social chaos will ensue in the deficit countries due to the lack of money. The destruction of the value of the deposits in the surplus countries and an export-led recession will create chaos there too and gold-rush hysteria.
I have not seen anywhere, anyone being concerned with this simple question: What is the euro backed by? I am 100% convinced that once the world realizes that the euro is currently and increasingly backed by the assets that the euro itself renders worthless, the euro will count only days, if not hours of life. If the Eurosystem fails to do what it has to do we are faced with a crisis several times harsher than those of 2008 and 1929.
I don’t think however that we will reach that point. In my perspective the possible scenarios for the eurozone bode down to two options only. Europe will eventually have to choose one of them very soon.
- Abandon the euro. This would be a great option for the countries now suffering from it but a terrible one for the world economy. The euro was supposed to create value by becoming more than the sum of its parts and by boosting the liquidity of all EUR denominated assets. With the dissolution of the euro, this value will be permanently lost and the euro will be worth less than its parts. It is a terrible waste of value for the world economy which the rest of the world should not and will not allow to happen.
- Heal the euro itself in a way at least similar to my simple proposal (see here and here) so we can put this crisis behind us. This requires that the Eurosystem admits responsibility for the reasons of the crisis and that the German Government admits that with its current stance it is destroying the life of its own people. The political ego of both institutions precludes that.
Two possible scenarios, each one more unlikely than the other! What can be done?
Since the crisis is a fabrication of the Eurosystem, it starts and it ends in Frankfurt. All the talks in Brussels or the member states’ capitals are absolutely irrelevant to the solution of the crisis. The ECB has to be finally served an ultimatum by the deficit countries, backed either by a threat of a euro breakup or by the threat of a lawsuit at the European Court of Justice: the Eurosystem should immediately monetize the full amount of TARGET2 liabilities while simultaneously demonetizing the TARGET2 assets. It is the only solution that still makes sense, the only solution that can be effectuated immediately with a click of a button. If this does not happen inside the euro it will inevitably happen outside of the euro. Why wait?
I will close this post here with an optimistic note. Given enough time, fairness and economic reality have an incredible record against fraud and collective ignorance. It is only a matter of time before life in a spectacular turn of events gives the solution to the problem that has troubled millions of people across the continent for too long already. This won’t happen because someone is currently working out a solution, but because it is mathematically inevitable if we want to avoid a complete metldown of the world economy.
Before the final solution is given however, I’d rather set my blog’s doomsday clock to only one minute to meltdown. Just in case somebody considers doing something stupid…