EURUSD

The recent fiscal and financial crisis confirms that the model is unworkable.

The model is this. In a single currency system a country with lower productivity than the average should experience falling wages and prices.

This lower cost base encourages inward investment from other members of the system which over time restores productivity, and wages and prices rise to the average.

What has actually happened is the lower productivity countries increased their wages and prices faster than the system’s average, enabling them to purchase more, better value imports from the more efficient members of the system (but sell less to other members of the system). This created
growing current account and fiscal deficits, which were financed by the banks of the whole system at low interest rates because there was no currency risk, and because no core tier one capital is required to support sovereign lending. This lending boosted the system’s money supply and inflation in the low productivity countries. 90% of the money supply in the Eurozone doesn’t exist in tangible form. It sits in the liabilities side of
commercial banks’ balance sheets as deposits. In the Eurozone, any bank deposit is equivalent to any other within the system, unless a bank is on the verge of collapse, in which case its Euro Bank deposit is not the same as a Deutche Bank deposit.

When it became clear to the commercial banks that there is such a thing as sovereign risk and that this debt may have to be written down against scarce capital, their willingness to lend evaporated, leaving it to the central banks to supply liquidity.

The European central banks have been creating massive amounts of new electronic money to keep banks afloat. The borrowing banks offer Government bonds as collateral. So the deficit countries are being financed by the central banks from within the system. The Bundesbank is the dominant creditor. Indeed the combined deficits of Ireland, Greece, Portugal and Spain, are matched by the increase in the assets of the central banks since 2008. The Bundesbank has created 325Bn Euro deposits since 2008.

A Greek default will create losses for central banks which will have to be covered by the taxpayer. So the fiscal transfers, explicitly forbidden in the Euro set up, rules at the request of Germany and will actually happen. The German taxpayer will be bailing out the Greek Government via their central bank. This backdoor method of financing debtor countries is political dynamite.

So either the Euro system is dismantled or it moves to a fully integrated system where Brussels has direct tax raising powers and the mandate to transfer tax receipts from strong to weak.

Assuming the latter is not going to happen, we can consider the options:-

All Greek Government bonds would be forcibly re-denominated in the new Drachma, and the interest paid in the same. This is what would be called a ‘credit event’ and it would trigger large payments to banks who have insured their Greek debt using credit default swaps (UK banks are major underwriters of these). This will cause a minor banking crisis within Europe, and a few banks will need Government equity.

The Germans may not be too keen on this because their exports to the Med Euro would immediately become 30% dearer. However imports would be 30% cheaper, which would allow German consumers to buy more such goods and let them enjoy much cheaper holidays, just as they did when they had the D mark. Nord Euro interest rates would be around 4% and Med Euro rates between 6 and 7%. Sterling would rise against the MedE and fall against the NordE.

4. Germany leaves the Euro and it drops 30% in value.

The Greeks are not stupid; already 20% of domestic bank deposits have been moved off-shore, some of it into London property where above £1m prices have risen by nearly 7% in the first six months of this year. Greek banks hold 40bn of their Government debt on their books. This is 180% of their core tier 1 capital. In the event of a default, they would be all insolvent, and would need to be recapitalised, but who by? I, just like the authorities, have no idea.

They are already excluded from wholesale markets, and have to get their liquidity from the ECB (100Bn outstanding by the end of May). But the ECB has said it will refuse to accept Greek debt as collateral should a default be declared. Greece is insolvent. To become solvent it would need to run a budget surplus of 7.5% of GDP by 2015.

The maximum possible is 2.5%. Assuming 2.5% can be achieved, without a restructuring of debt, the ratio of debt to GDP would rise from the current 140% to 400% by 2050. There has to be a restructuring (a polite term for default). This would require that Greek bonds be reduced to 20% of face value. This would cost 140Bn Euros. Portugal and Ireland would follow, which would cost another 200Bn. The charge would be to the ECB, the banks and their shareholders. In total: 5% of Eurozone GDP.

My opinion is that Greece should leave the Euro and default.

The new head of the IASB which oversees accounting standards is throwing banks a lifeline, for when the Greeks default. He proposes that banks will be able to write off bonds by discounting the expected income stream using the original not the current rate of interest. This is a massive help to the banks. If a bank bought Greek debt at a 5% yield, it could use that as the discount rate instead of the current market rate, which is 20%. This is yet another example of how institutional arrangements

are being made ready for the default, and to reduce the contagion.

The IMF undertook a post mortem following the Argentinean debt crisis in 2001. The parallels with the Greek situation are uncanny. The IMF concluded: ‘when debt dynamics are clearly unsustainable, the IMF should not provide its financing. To the extent that such financing helps stave off a needed debt restructuring, it only compounds the ultimate cost of that restructuring’ A pan-European banking sector stress test has just been published, but apparently the banks are not being forced to model the impact of any sovereign debt default. So, unsurprisingly almost all passed except for a few small Spanish Building Societies, a couple of Greek banks (!) and an Austrian bank. No UK banks failed, but Barclays Core tier one capital dropped from 10% to 7%.

The press are suggesting Italy is in trouble and could go the same way, I think not. Most Italian debt is held by Italians. Italian households have the lowest personal debt in Europe (one of the outcomes of a large cash economy) and Italian banks are mostly well capitalised. However, a MedEuro would help Italy a lot, so I guess they would be willing members.