By Warren Mosler, an investment manager and creator of the mortgage swap and the current Eurofutures swap contract and Philip Pilkington, a journalist and writer based in Dublin, Ireland
Recently the Greek economist Yanis Varoufakis responded to the euro exit plan that we published on Naked Capitalism a few days ago. While Varoufakis was broadly supportive of the plan if an exit was absolutely necessary, he criticised some of the details therein.
Before we deal with some of the issues he raised – some of which are very important – we should first note as clearly as possible that neither one of us is advocating exit from the Eurozone for any countries therein. We both agree with Varoufakis that this would probably be a more painful option than simply staying in the currency union even with the current austerity programs in place.
In addition to this, both of us have published pieces arguing that the Eurozone will likely weather this crisis and the ECB, in some shape or form, will probably step in to backstop the debt of the peripheral governments in the coming months.
We merely published our sketch of an exit plan because both of us believe that it is always good to have a Plan B at the ready should any contingencies arise. We also think that having a viable plan in hand strengthens peripheral governments bargaining power vis-à-vis their neighbours.
But more on this in a moment. First, let us deal with some of the issues that Varoufakis raised. (All numbered points in italics are Varoufakis’, below is our response):
1. All contracts by the government to the private sector (abroad and domestically) will be renegotiated in the new currency after the initial depreciation of the latter. In other words, domestic suppliers will face a large haircut instantly. Many of them will declare bankruptcy, with another large lump sum loss of jobs.
First of all, there may not be any initial depreciation of the new currency if the government initiating the exit gets the exchange rate right. Since the new currency is required to pay taxes we anticipate that there should be a fairly consistent demand for it especially when it is first introduced.
Take the example of a domestic industry – say, a cement manufacturer that sells its goods to the government. It would be paid in the new currency and provided that the currency’s value remains somewhat constant the new currency can then be used to pay workers. In addition to this they will, as they do now, price their output relative to their costs so there would be no threat of bankruptcy.
Perhaps the key point here is that we do not anticipate a severe shortfall of demand for the new currency. Since it is released into the system slowly, and since it is required to extinguish tax liabilities, and finally since there will be an immediate need for cash in circulation, it should be widely sought after by economic actors.
If, on the other hand, a company has loans outstanding in euros they may need to convert some of their profits from the new currency into euros to service these obligations. Again, this has as much to do with how large the profits they accumulate are, as it does with the exchange rate between the two currencies. If their real income falls they might take a hit. But such is business.
Then there is the question of where these businesses get their inputs. If these inputs come from the domestic economy they will be able to pay for these in the new currency. If they come from abroad they will cost more money, if indeed the new currency does depreciate when introduced and even then the costs would be passed on to the consumer.
2. The banks will run dry and will not be kept open by the ECB. Which means that the only way Ireland or Greece or whoever adopts this plan can keep its banks open is if they are recapitalised in the new domestic currency by the Central Bank. But this means that bank account deposits will, de facto, be converted from euros to the new currency; thus annulling the beneficial measure of no compulsory conversions of bank holdings into the new currency.
This seems to us the most important point that Varoufakis raises. European banks do indeed have problems with both euro and dollar denominated liquidity and these problems will only worsen should there be a default and exit. Hence, we are back to the prospect of bank runs and other financial nasties.
In this case the government in question would, of course, only be able to provide liquidity in the new currency. The problems caused by this will only be as substantial as the amount by which the exchange rate between the new currency and the euro diverges. In the meantime, depositors will be exchanging euros for the new currency in order to meet ongoing payments (payrolls, taxes etc.). Once again, we underline the fact that we believe that the demand for the new currency would be quite strong and devaluation limited.
However, if a bank’s net worth (equity capital) falls below required minimums for any reason, the government will have to take it over and reorganise it. Options will then include: selling the bank as an ongoing business or selling the assets to other institutions. Both of these could lead to large losses for equity holders and, if the losses are severe enough, losses for depositors. It is not unheard of for depositors to suffer losses of the order of 25% during liquidation. We do advocate full deposit insurance be put in place to protect deposits denominated in the new currency, but deposits in euros will still be at risk and in this sense Varoufakis’ concerns have merit.
3. The authors claim that the above ill effects will be lessened by the government’s new found monetary independence which will enable it to discontinue austerity programs immediately and adopt counter-cyclical fiscal policy, as Argentina did after its default and discontinuation of the pesos-dollar peg. This may be so but all comparisons with Argentina must be taken with a large pinch of salt. For Argentina’s recovery, and associated fiscal policies, was far less due to its renewed independence and much more related to a serendipitous rise in demand for soya beans by China.
The extent to which soya bean price rises led to the Argentine recovery is subject to much debate. Certainly, it allowed Argentineans access to foreign reserves which they could use to extinguish foreign loans, but to what extent it was the cause of the recovery is a definite grey area. We hold that the fiscal policies initiated by the Kirchner government that removed substantial fiscal drag played a significant role in the recovery.
Varoufakis, by saying: “Argentina’s recovery, and associated fiscal policies, was far less due to its renewed independence and much more related to a serendipitous rise in demand for soya beans by China”, seems to imply that the fiscal policy expansion was somehow ‘allowed’ by the rising soya bean demand and the influx of foreign currency reserves. This is not the case. When Argentina ended the dollar peg they became able to extend government spending in as large quantities as they saw fit – that is, practically speaking: reducing fiscal drag by as much as the inflationary pressures created thereby were tolerated.
After depegging, Argentina’s fiscal position could be run into deficit without risking insolvency or causing interest rates to skyrocket, both of which were the key constraints on government spending throughout the dollar peg era. In this way, the Argentinean example is perfectly viable as a comparison to a Eurozone country undertaking an exit. If the exit is undertaken and a floating exchange rate adopted, fiscal policy can be run into deficit until political limits, devaluation or inflation allows it to run into deficit no more.
4. While it is true that the weaker currency will boost exports, it will also have a devastating effect: The creation of a two tier nation. One nation that has access to hoarded euros and another that does not. The former will acquire immense socio-economic power over the latter, thus forging a new form of inequality that is bound to operate as a break on development for a long while – just like the inequality that sprang up in the post 1970s period did enormous damage to our countries’ real development (as opposed to GDP growth numbers) in the second post-war phase.
Once again, the currency may not depreciate very significantly but even if it does, as the economy is brought back to full employment and output through reduced fiscal drag and increased exports, the government is then free to address distributional issues as it sees fit. The key point here would be to highlight these issues clearly prior to the exit taking place.
5. Last, but certainly not least, even if one country exits the eurozone in this manner, the eurozone will unwind within 24 hours. The European System of Central Banks will break instantly down, Italian spreads will hit Greek levels, France will turn instantly into a AA or AB rated country and, before we can whistle the 9th Symphony, Germany will have declared the re-constitution of the DM. A massive recession will then hit the countries that will make up the new DM zone (Austria, the Netherlands. possibly Finland, Poland and Slovakia) while the rest of the former eurozone will labour under significant stagflation. The new intra-European currency wars will suppress, in unison with the ongoing recession/stagflation, international and European trade and, therefore, the US will dive into a new Great Recession. The postmodern 1930s that I keep speaking of will be a tragic reality.
We should again reiterate that we are not actually calling for an exit. We simply believe that the governments should have a contingency plan and, most importantly, that this contingency plan would steer them away from the very real desire to peg their new currency to either the euro or to some other foreign currency in the case of default. As we wrote in the original plan, should this happen we expect another Argentinean/Russian style financial collapse within a few years of the new currency peg being adopted.
We should also point out that having a viable exit plan and having this exit plan and its possible results openly talked about gives the peripheral countries more bargaining power vis-à-vis their austerity loving neighbours. At the moment we should be focused on drafting any sort of national strategy that can give power back to sovereigns vis-à-vis the Eurozone. (In this, we know that Varoufakis sympathises as he has recently shown interest in our jobs program funded by tax-backed bonds which one of the authors [Pilkington] is currently trying to flog in Ireland).
We also think that it is unlikely that an exit will actually occur. We both think that the ECB will almost undoubtedly step in to backstop the unruly debt burdens of the periphery. However, this will probably mean that the periphery will be kept on ‘life support’ while austerity continues to be imposed upon it. Once again, it is imperative that countries within the periphery have as many bargaining chips as possible in their negotiations with their fellow Europeans.
Lastly, we should note that, should a nation exit the Eurozone in the manner we have outlined, a worldwide deflationary collapse might actually work to their advantage. Why? Because with their new currency they could undertake an Argentinean-style jobs guarantee program which would maintain full employment domestically while real terms of trade shifted dramatically in their favour as worldwide prices fell. Or, to put it another way: peripheral countries like Ireland would no longer have to rely on export-oriented growth in a world plagued by massive deflationary contraction. Instead they could run fiscal deficits to maintain full employment and high living standards while having little concern for the potential devaluation of the new currency caused thereby because worldwide prices would be falling at the same time.