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The
worst-case scenario for Greece, should it be unable to secure further
bailouts, might be that it would have to live within its means. Presently, spending
only the money coming in is considered unbearably brutal. If Greece could
only leave the euro, it could install its own printing press, inflating its
sorrows away. Any economist will object: it’s complicated. But it
isn’t: Greece could introduce a high-flying New Drachma, quite
literally.
First, please note that any country may default on
its debt. The trouble is that the day after a default it might be difficult
or impossible to obtain a loan at palatable terms. As such, any country
considering a default must conduct a risk/benefit analysis. A country that
has a primary deficit, i.e. a budget deficit before paying interest expenses,
faces the challenge that such deficit would be eliminated overnight (because
the deficit could no longer be funded), causing a massive shock to the
economy as government spending would come to an abrupt holt. To mitigate such
a shock, it is usually the lesser evil to beg for leniency from creditors, in
return for austerity measures. It is in Greece’s interest to promise
the stars to get yet another loan. In contrast, once a primary surplus has
been achieved, Greece may well find a default attractive to cut its overall
debt burden; the shock from being shunned from the credit markets would then
mostly be a shock to the creditors.
It’s because of these dynamics that countries
tend to default only after an agonizing period trying to cut expenditures.
Some succeed: look at Ireland. The country appears to be regaining the
confidence of the markets. However, political realities may make it difficult
for Greece to ever get on a sustainable fiscal path.
However, if a country defaults without first
eliminating its primary deficit, policy makers may be tempted to repeatedly
default without ever getting the house in order. If creditors are dumb enough
to provide another lifeline, good luck to them ever being repaid. In such a
situation, credit is more typically provided through the countries’ own
printing press, in the case of Greece by introducing a new currency.
Introducing a new currency in a debt-laden country
that has been unable to eliminate its primary deficit may be doomed for
failure, but since when has bad policy stopped politicians from trying to
implement it? There are logistical and legal challenges, such as what
obligations would remain euro denominated and what obligations will now be
New Drachma obligations. More importantly, if Greece were to introduce its
own currency, odds are that those that can, would
reject it; as a result, the euro would remain the default currency for
business.
In contrast, pensioners and government employees
might have no choice but to accept the New Drachma as payment. Quite likely,
these groups would cry foul that their new currency is worthless, demanding
to be paid more. Not long thereafter, and with a media friendly Greek drama
playing out on the streets, the government might relent, printing more money
to appease the protestors. Inflation and hyperinflation may well take hold,
in turn relegating the New Drachma to the history books.
Some policy makers may suggest capital controls and
a variety of oppressive tools to force the adoption of the New Drachma.
Unfortunately, the little money left in Greek banks may evaporate faster than
policy makers can act, as savers would likely take their money abroad. While
it may cause a complete collapse of what little public infrastructure is
left, the upside of a dysfunctional government is that the black market may
fill the void. After all, it’s only money we
are talking about, and some ingenious entrepreneurs will always find a way to
keep life moving along. Anarchy, however, might well be used to describe the
situation if things turn sour.
Optimists that we are, we believe it doesn’t
have to be that way. No, we do not expect the Greek to learn German and adopt
their habits. But Greece might have an opportunity to turn the crisis into an
opportunity. The government should embrace reality and recognize that
swapping the euro for the New Drachma in some forceful fashion would be a
non-starter.
How about introducing a currency in parallel to the
euro? A currency irresistible because of its benefits? All those in favor of
the gold standard, please close your eyes and ears! How about a currency that
offers value, yet is inflatable? In our opinion, the euro is about as close
to a gold standard that investors can obtain these days, as individual member
nations cannot print their own money and – so far at least – the
European Central Bank (ECB) has only printed a fraction of what the Federal
Reserve (Fed) has. We are not suggesting such a currency for the strong
countries, but for Greece, it might provide them with a lifeline, one
that’s only for Greeks to lose. The currency idea we have in mind is
directly borrowed from the airlines: a frequent flier program –
let’s call it the “Drachma Program.”
The Greek Government would have the exclusive
authority to issue Drachma Points (DPs). In order to get government services,
DPs would have to be paid. The government would set the price of government
services in DPs. The government would, in turn, estimate what portion of the
typical government employee’s and pensioner’s consumption is
comprised of government services. That portion would have to be paid in DPs;
remaining expenses would continue to be paid in euro, until DPs receive wider
acceptance.
The government should make DPs transferable. As
such, a market would be created that creates an exchange rate between euros
and DPs.
We know that, without a doubt, benefits of
government employees and pensioners will have to be cut to be sustainable.
Rather than forcing almost the entire economy into an underground economy,
the rest of the economy could continue to embrace the euro, while the public
sector would embrace DPs.
If a Greek government were to introduce price
controls, shortages would be created. By limiting DPs to the public sector,
should the DPs be mismanaged, there would be a shortage of public sector
services. That, in turn, may not be the worst outcome, as the private sector
would then have an opportunity to make up the shortfall.
A way to balance income and expenses may be for the
government to collect revenue in (strong) euros and pay expenses in (weak)
DPs. Government employees and pensioners can be paid partially in DPs, but
creditors should be paid in euros (possibly after what is becoming a
customary “haircut”) – at least until DPs are well
established in the marketplace.
So, would this idea work? It ultimately depends on
how exactly it is implemented. Odds are that Greece would inflate this new
currency away anyway, just as it is likely to do with a New Drachma. However,
if Greece wants to leave the euro, the new currency should be introduced
while still allowing business to be conducted in euros; the banking system
could accept both euros and DPs. With a gradual introduction and the currency
value linked to government services (rather than nothing as is the case with
a fiat currency, or gold as in the gold standard), such a transition may be
feasible.
Ultimately, holders of Greek debt have a choice:
accept a restructuring with a 60% “haircut” or accept a New
Drachma that’s worth only 40% of the euro (or less?). Either way,
losses will have to be taken by creditors. Moreover, any short-term loss may
simply be a first step towards further losses down the road if Greece cannot
devise a sustainable budget.
While we ponder about Greece, the market has
obviously moved on to worry about bigger economies. Greece’s policy
makers may dream about the benefits of their new high-flying mileage program
and how to market it to the people, but policy makers in the rest of Europe
should focus on the health of their banking systems. We cannot prevent
sovereigns from defaulting on their obligations, but they can make banks
strong enough to stomach potential losses. Governments should get used to the
idea, as supporting banks may cost them dearly, including their ratings.
The alternative for governments is to go down the
road of doling out frequent flier points. It might just work – being
the first in line for having accumulated more points than your peers may make
them appear priceless; until you notice that the premier status lines are
just as long as the lines for everyone else. Thought of from an American
perspective: if you are a good citizen accumulating DPs, you get to skip the
line at the DMV!
Axel Merk
Manager, Merk Hard Currency Fund
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