As Wall Street rushes to “increase the probability” that Greece leaves the Eurozone, a “Grexit” is becoming an increasingly consensus view. This should not come as a surprise, as we’ve urged investors to Remain Calm for almost three years now, considering that European nations have defaulted on their debt a stunning 73 times since 1800, with Greece in default more than 50% of the time! For a brief and humorous review of the situation, you might check out this two-minute Lending Merry-Go-Round – thanks Justin!
However, it is important to consider that the European Union has always been a political project, not an economic one, so it is likely that Germany will continue to buy time to put structural reforms in place in order to keep the EMU together. We highly recommend reading this conversation, complements of Investor Insight, with Niall Ferguson in the Sunday Times of London, to gain some perspective on the game of chicken between Athens and Berlin.
That being said, and with all due respect to the British historian, we continue to assign much higher odds to a break-up of the monetary union, which is ultimately the most efficient solution, although perhaps we are placing too great an emphasis on policy-makers acting rationally. The logic is really quite simple, as recently articulated in Dr. Hussman’s Weekly Market Comments: “Even in the event of various liquidity injections, there is virtually no chance of addressing the solvency of Europe – the ability of each government (much less the banking system) to sustainably pay their debts – within the constraints of the Euro. As long as the Euro exists as a single currency, individual countries can’t inflate away the real value of their debt, or restore their trade competitiveness through exchange rate depreciation against other countries.”
So, while Wall Street warns of catastrophic consequences if any country were to exit the Euro, history demonstrates that orderly defaults and debt restructurings combined with devaluations are inevitable and even beneficial. A properly executed EMU break-up would provide a powerful policy tool via flexible and more competitive exchange rates, allowing peripheral countries to grow without the burden of high debt levels. Jonathan Tepper, Chief Editor of Variant Perception, published an extremely thorough Primer on the Euro Breakup back in February, the key conclusions of which, we’ve shared below with permission.
- The breakup of the euro would be an historic event, but it would not be the first currency breakup ever – Within the past 100 years, there have been sixty-nine currency breakups. Almost all of the exits from a currency union have been associated with low macroeconomic volatility. Previous examples include the Austro-Hungarian Empire in 1919, India and Pakistan 1947, Pakistan and Bangladesh 1971, Czechoslovakia in 1992-93, and USSR in 1992.
- Previous currency breakups and currency exits provide a roadmap for exiting the euro – While the euro is historically unique, the problems presented by a currency exit are not. There is no need for theorizing about how the euro breakup would happen. Previous historical examples provide crucial answers to: the timing and announcement of exits, the introduction of new coins and notes, the denomination or re-denomination of private and public liabilities, and the division of central bank assets and liabilities. This paper will examine historical examples and provide recommendations for the exit of the Eurozone.
- The move from an old currency to a new one can be accomplished quickly and efficiently – While every exit from a currency area is unique, exits share a few elements in common. Typically, before old notes and coins can be withdrawn, they are stamped in ink or a physical stamp is placed on them, and old unstamped notes are no longer legal tender. In the meantime, new notes are quickly printed. Capital controls are imposed at borders in order to prevent unstamped notes from leaving the country. Despite capital controls, old notes will inevitably escape the country and be deposited elsewhere as citizens pursue an economic advantage. Once new notes are available, old stamped notes are de-monetized and are no longer legal tender. This entire process has typically been accomplished in a few months.
- The mechanics of a currency breakup are surprisingly straightforward; the real problem for Europe is overvalued real effective exchange rates and extremely high debt – Historically, moving from one currency to another has not led to severe economic or legal problems. In almost all cases, the transition was smooth and relatively straightforward. This strengthens the view that Europe’s problems are not the mechanics of the breakup, but the existing real effective exchange rate and external debt imbalances. European countries could default without leaving the euro, but only exiting the euro can restore competitiveness. As such, exiting itself is the most powerful policy tool to re-balance Europe and create growth.
- Peripheral European countries are suffering from solvency and liquidity problems making defaults inevitable and exits likely – Greece, Portugal, Ireland, Italy and Spain have built up very large unsustainable net external debts in a currency they cannot print or devalue. Peripheral levels of net external debt exceed almost all cases of emerging market debt crises that led to default and devaluation. This was fuelled by large debt bubbles due to inappropriate monetary policy. Each peripheral country is different, but they all have too much debt. Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level. Greece and Portugal are arguably insolvent, while Spain and Italy are likely illiquid. Defaults are a partial solution. Even if the countries default, they’ll still have overvalued exchange rates if they do not exit the euro.
- The euro is like a modern day gold standard where the burden of adjustment falls on the weaker countries – Like the gold standard, the euro forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionary bias, where the burden of adjustment is always placed on the weak-currency country, not on the strong countries. The solution from European politicians has been to call for more austerity, but public and private sectors can only deleverage through large current account surpluses, which is not feasible given high external debt and low exports in the periphery. So long as periphery countries stay in the euro, they will bear the burdens of adjustment and be condemned to contraction or low growth.
- Withdrawing from the euro would merely unwind existing imbalances and crystallize losses that are already present – Markets have moved quickly to discount the deteriorating situation in Europe. Exiting the euro would accelerate the recognition of eventual losses given the inability of the periphery to grow its way out of its debt problems or successfully devalue. Policymakers then should focus as much on the mechanics of cross-border bankruptcies and sovereign debt restructuring as much as on the mechanics of a euro exit.
- Defaults and debt restructuring should be achieved by exiting the euro, re-denominating sovereign debt in local currencies and forcing a haircut on bondholders – Almost all sovereign borrowing in Europe is done under local law. This would allow for a re-denomination of debt into local currency, which would not legally be a default, but would likely be considered a technical default by ratings agencies and international bodies such as ISDA. Devaluing and paying debt back in drachmas, liras or pesetas would reduce the real debt burden by allowing peripheral countries to earn euros via exports, while allowing local inflation to reduce the real value of the debt.
- All local private debts could be re-denominated in local currency, but foreign private debts would be subject to whatever jurisdiction governed bonds or bank loans – Most local mortgage and credit card borrowing was taken from local banks, so a re-denomination of local debt would help cure domestic private balance sheets. The main problem is for firms that operate locally but have borrowed abroad. Exiting the euro would likely lead towards a high level of insolvencies of firms and people who have borrowed abroad in another currency. This would not be new or unique. The Asian crisis in 1997 in particular was marked by very high levels of domestic private defaults. However, the positive outcome going forward was that companies started with fresh balance sheets.
- The experience of emerging market countries shows that the pain of devaluation would be brief and rapid growth and recovery would follow – Countries that have defaulted and devalued have experienced short, sharp contractions followed by very steep, protracted periods of growth. Orderly defaults and debt rescheduling, coupled with devaluations are inevitable and should be embraced. The European periphery would emerge with de-levered balance sheets. The European periphery could then grow again quickly, much like many emerging markets after defaults and devaluations (Asia 1997, Russia 1998, Argentina 2002, etc.). In almost all cases, real GDP declined for only two to four quarters. Furthermore, real GDP levels rebounded to pre-crisis levels within two to three years and most countries were able to access international debt markets quickly.
Maybe Silvio was on to something. “I’ll tell you the crazy idea that I have in mind . . . If Europe doesn’t pay attention to our demands, we should say ‘ciao ciao’ and leave the euro.”