Sunday, February 08, 2015

What Looks Crazy at First Might Be the Ideal Solution: Meet Greece's New Currency, the U.S. Dollar

There is an undeniable internal logic to the idea that Greece should jettison the euro and adopt the U.S. dollar as its national currency.

Several astute readers pointed out that for Greece to renounce the euro and transition to a newly issued national currency (drachma) is fraught with numerous structural difficulties. It is not easy to issue and distribute enough new currency to grease commerce from a standing start.

Since adopting a new drachma is problematic, the obvious solution (at least to me) is for Greece to follow the example of other countries with currency crises and adopt the U.S. dollar as its national currency.

Before you dismiss the idea out of hand, hear me out. It might not be as crazy as it seems on first blush.

Here is a straightforward three-point plan to set Greece on a sustainable, positive pathway. But before we can understand how the plan resolves Greece's no-win situation (yet another Kobayashi Maru scenario), we first need to understand very clearly why the euro currency failed.

I have covered this many times before:

If we had to distill the dynamic down to a single paragraph, it would be this: By accepting the "strong currency" euro that was supported by promises of fiscal prudence, Greece and the other weaker economies of Europe artificially inflated the credit market's willingness to lend them money. At the same time, the euro also lowered the cost of goods from Germany by eliminating the labor-cost arbitrage of currencies.

I know this may sound complicated, but we can grasp the core dynamics using household analogies.

The willingness of lenders to lend and the rate of interest they charge is based on economic fundamentals: the balance sheet of assets and liabilities, and cash flow: how much income goes to pay liabilities and how much is left over as surplus to spend or invest.

Households and nations with weak balance sheets (i.e. liabilities exceed assets) and weak cash flow balances (i.e. much of the nation's income is already committed to entitlements and liabilities, so relatively little is left to fund future borrowing) will find it difficult to borrow a lot, and the rate of interest they will pay will be high.

Nations have another mechanism to differentiate between strong and weak balance sheets: national currencies. Countries with weak cash flow and risky balance sheets will have weak currencies, as people price the risk into the currency.

In effect, Greece was like the poorer brother who suddenly got the wealthier sibling's credit card. In this sense, the euro was a scam, because it stripped the market of the pricing mechanism that we call currencies. By pricing all money the same regardless of national balance sheets and cash flows, then weaker countries got the credit card of their stronger brethren.

Predictably, these nations over-borrowed. When presented with the opportunity to borrow huge sums at low rates of interest, it is "rational" to accept the opportunity.

Who benefited from this elimination of market pricing via currencies? Germany and the banks. In pre-euro days, it took a lot of Greek drachmas to buy expensive goods from Germany. After the euro was introduced, German goods became cheaper in terms of hours worked and interest rates paid.

German exports to the rest of Europe have been strong, and these exports within Europe are the backbone of the German economy. (Exports are roughly 40% of the German economy, the highest in the world for major economies. Exports make up about 10% to 15% of the economies of Japan and the U.S.)

The pool of apparently creditworthy borrowers expanded greatly, and the banks promptly began lending vast sums to both the public and private sectors of these fundamentally weaker nations.

You can't fool Mother Nature with artificial games for long, and now reality has trumped artifice: the nations with weak balance sheets and cash flows cannot support the monumental debts they acquired during the decade of the euro-scam.

If you eliminate the market's ability to price risk and credit, the market breaks down. That is the eurozone in a nutshell.

The no-win situation is clear: if it wants to continue using the euro, Greece must pay its debt and interest in euros. Its economy simply isn't large enough or productive enough to do this, so that's simply not possible. Wishing it were possible doesn't make it possible.

As a result, the weaker, over-indebted nations are in death-spirals of higher taxes and higher debt servicing costs. Each bleeds vitality and trust from the economy, driving it deeper into fatal contraction.

These nations are also in political death spirals. I spoke at length with a well-informed young Greek friend who has lived in both Germany and the U.S., so he is well-acquainted with the perspectives of Germans and Americans.

He reports that the Greek people are profoundly divided on the question of whether to stay in the eurozone or risk leaving it. He said that even within the various political parties, there are two camps. In his opinion, the odds of either camp surrendering their deeply held beliefs and fears is very very low. Those who want to stay in the euro are terrified that a return to the drachma would wipe out the nation's savings and further reduce the already diminished incomes of households: in effect, the middle class would be wiped out.

Others see a deeply sinister master plan in all this: pushing Greece back to the drachma would immediately render the nation poorer and make its assets very cheap to foreign Elites, who would rush in and snap up Greek assets at fire-sale prices. Greeks would lose their country.

This is indeed part of the dynamic when nations radically devalue their currency: if a villa in Greece was 300,000 euros before the return to the drachma, it might be only 100,000 euros when the drachma is re-instated. Priced in euros, the whole of Greece would "go on sale".

I hope you can see that there are two parallel no-win situations here, a financial one and a political one. This is the Kobayashi Maru scenario on a national scale, and there is no exit if you stay within the rules of the game: euro or drachma, etc.

Here's my "crazy idea that's not so crazy if you think it through": Greece should adopt the U.S. dollar as its currency while renouncing all debt denominated in euros. I don't mean a "haircut," I mean billiard-ball bald: 100% of all debt denominated in euros would be renounced. Not one euro will be repaid.

The reason is that the banks (lenders) knew darn well that Greece remained a weak economy, and eliminating the currency arbitrage by accepting the euro did not magically strengthen Greece's financial fundamentals. It was all a scam that the banks exploited, including the European Central Bank, and so they will have to accept the losses now that the scam has collapsed.

Nobody put a gun to the head of lenders who fronted Greece stupendous sums of money at low rates of interest. It was their gamble and they lost. End of story.

Whatever else you can say about the U.S. dollar, it retains global trust as a medium of exchange and a transparent store of value. Your $100 bill is good in Laos, Bolivia, Russia, China and everywhere else. Its value fluctuates because the market is free to set the risk of holding dollars.

Ultimately, all fiat currencies are simply physical measures of trust. People know the U.S. has plentiful problems of its own, but they also know the problems are well-known and transparent to all, so the market can price risk in the dollar. They also know the U.S. isn't going away tomorrow, and that there are enough dollars floating around the globe that there will always be someone who will accept the dollars in trade for tangible goods at a transparent price.

The problem with returning to the drachma is the risk of the transfer is unknown, and so the risk will be transferred to the drachma. By making the process into two steps--exit the euro for the dollar, then later, if the Greek people choose to, exit the dollar for the drachma--the risk and distrust is removed from the initial step of exiting the euro.

The compelling logic of moving one's cash out of Greece--capital flight--disappears once people's euros become dollars.

Here's the beauty of Greece accepting the dollar: since Greece cannot print dollars, then everyone will know the currency cannot be depreciated by the Greek state. If Greece can print drachmas in unlimited quantities, then the drachma will quickly lose whatever value it begins with. In contrast, regardless of the policies of the state or central bank of Greece, the dollar will still have the same value day to day.

All euros in accounts would convert to dollars.

This will immediately restore trust and trade, both domestically and internationally, as everyone will know the U.S. dollar will retain its value everywhere.

Does Greece need U.S. approval to take the dollar as its interim currency? No--the dollar is ubiquitous and in sufficient quantity that there are enough physical dollars floating around the world to serve as the currency for a small nation such as Greece. (Consider that the USD is already the currency of Panama, El Salvador and Ecuador.)

The third critical step in my plan is that Greece must reach a political consensus on taxation and governance. Everyone knows that tax avoidance has undermined the Greek state's finances, and the people of a democracy have to reach a consensus themselves: it cannot be imposed by bureaucrats from afar.

The State needs enough income to do what the people want it to do, and so everyone is going to have to pay taxes. Those who evade will have to be shunned/coerced by public opinion into compliance, for the national good. The institutions of taxation will have to restore trust in their fairness and transparency.

Greece must have a transparent national dialog on taxation and governance, and reach a consensus via the democratic process. Without this step, then it won't matter what currency Greece uses, it will slip further into a death-spiral of dysfunction.

So here is the 3-point plan:

1. Renounce all debts denominated in the euro, i.e. a 100% writedown.

2. Accept the U.S. dollar as the national currency of Greece.

3. Engage in a transparent national dialog and reach a consensus about taxation and the role of the state in the Greek society and economy.

We might add a fourth point: renounce scams and kicking problems down the road rather than addressing them directly, sweeping dysfunction under the rug, etc.

There is a compelling internal logic to Greece adopting the US dollar as its currency: when trust in national currencies and institutions is lost, then the black market becomes the trustworthy place to engage in trade. The world's favorite black market currency is of course the U.S. dollar. In this sense, for Greece to officially accept the U.S. dollar as its currency is simply a recognition of the natural progression from a currency that is no longer viable to one that is.

I first broached the idea of Greece adopting the dollar three years ago in A Crazy Idea That Might Just Work: Greece's New Currency, the U.S. Dollar (May 14, 2012) 

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