Eichengreen and Temin on the challenges of redenomination

The gold standard was preserved by an ideology that indicated that only under extreme conditions could the fixed exchange rate be unfixed.  

The euro has gone one step further by eliminating national currencies.  Modifying the policy regime unilaterally is
even more difficult than under the gold standard.  

While it is conceivable, in theory, that an incumbent member of the euro area could opt to reintroduce its national currency and then depreciate it against the euro, there is no provision for doing so in the Lisbon Treaty.  

It similarly is conceivable that an incumbent member might choose to disregard its treaty obligations.  But, even then, if the decision to reintroduce the national currency and convert all the financial assets and liabilities of residents into that unit was not done instantly, a period of extreme financial instability would follow, as investors withdrew their money from the domestic banking system and financial en masse, creating ‘the mother of all financial crises’.  

This spectre raises the question of whether the operation can be done at all, parliamentary democracies not being good at taking decisions overnight.

("Fetters of Gold and Paper", Eichengreen and Temin)

Reconciling libertarianism and financial stability

Earlier this year, Daniel Stern posted the following (abridged) comment:

What I want to hear more about is reconciling, as a policy matter, the libertarian impulse and the admission that some of our institutions are "too big to fail."
The essence of libertarianism is responsibility for the consequences of one's actions.
Once we agree that certain institutions are absolved from those consequences, we're no longer libertarians. We're simply capitalist corporatists, and the only question is who gets the money.

Banks (and frankly, all financial institutions) are special. The state has a legitimate interest in financial stability, the money supply and credit creation. I would argue that the state has a more compelling interest in the stability and functioning of the financial system than in any other realm besides national security and domestic tranquility.

Constitutionally, the federal government is empowered to mint coins. It is not empowered to print paper currency or to regulate or, God forbid, bail out banks. But since the Republicans passed the National Banking Act in 1862 (the Democrats having left the legislature to form their own government in Richmond), the federal government has arrogated to itself the right to do whatever it wants in money and banking. Further federalization included the Federal Reserve Act of 1913 and the myriad legislation of the New Deal, most notably the FDIC. While unconstitutional, in my opinion this legislation was essential to prosperity and financial stability.

The history of the US banking system under state regulation before the Civil War was not pretty. Anyone could get a charter (“wildcat banking”) and any bank could issue bank notes (and then dishonor them). It was a Ron Paul Disneyland. Which was fine, so long as you weren’t actually living in the United States at the time. 
Banking panics were routine, and depressions (yes, depressions) were common, and the money supply was volatile and uncontrolled.

But even after the passage of the NBA and the FRA, there was still no concept of TBTF or the realization at the policy level that bank failures were catastrophic for the real economy. Hoover allowed large banks (in New York and Detroit) to fail, wiping out their depositors’ money and sparking a run on the entire financial system. Under Hoover, M2 shrank by something like a third, bringing prices down with it (M2 x velocity = price level x GDP). M2 goes down, NGDP goes down. This is not negotiable.

This carnage was brought to an end by FDR, who (1) ended the deflationary fetish of the "gold drain" so that the Fed could focus on credit growth; and (2) ended bank runs with the bank holiday and deposit insurance.

Other than the US, there is no major country on earth which has allowed a major financial institution to default on its debts. Ireland is now spending over a third of its GDP bailing out its banks (some of whom one might not have thought were TBTF).

I do not believe that the Constitution or sound policy allows the federal government to regulate chickens, eggs, toys, cigarettes, gas mileage, wages, prices, light bulbs, shower heads or toilets. 


But because the government must protect and maintain financial stability, it must regulate the financial system and do whatever is necessary to maintain stability, including bailouts. (Which is why it must regulate banks and TBTF nonbanks.)
In a bailout, shareholders must lose everything, and management must be fired. But creditors (esp. depositors) must be protected. There is no alternative.

So my answer to Dan’s query is that rational libertarianism presumes the existence of a powerful state which can defend its legitimate (but limited) interests.

The true cost of the Wall Street bailout

From The Banker:

In November 2008, ABC News warned US taxpayers that government support for the country's financial sector would cost up to $7.5 trillion. It cited figures from macroeconomic analysis firm Bianco Research showing that, in 2008 dollars, the cost of the bailout would be more than the combined costs of the Marshall Plan, the Louisiana Purchase, the Korean War, the Vietnam War and the entire historical budget of NASA, including the moon landing.

The Treasury now expects TARP to cost the taxpayer nothing, yes, nothing. It expects TARP to make a profit. (Not like the Fan/Fred and UAW bailouts.) 

The US government did not give Wall Street $800B. The government lent Wall Street about $300B, which it will get back, in full, with interest plus profits on the warrants for which it paid nothing.

"Six reasons to be bearish"-- revisited

Three months ago I wrote posted an item listing “six reasons to be bearish”. They were:
1. Inadequate money growth
2. Contracting credit aggregates
3. Low growth in nominal GDP
4. The prospect of higher taxes on income and investment
5. The euro crisis
7. The outlook for lower growth in China.

Since then, none of these worries have gone away, although we may be seeing progress on money growth. However, since I listed these reasons to be bearish, the Dow is up by 650 points. So what did I miss?

First of all, as the saying goes, “the Dow climbs a wall of worry”. What I think this means is that unless you have a secret worry that no one else knows about, your worries are already baked into the market.

Secondly, in a world of 0% interest rates, with bond prices headed in a Japanese direction, the stock market offers compellingly attractive relative value, unless you are worried about another Black Swan. But there are always black swan events. You can’t stay in cash waiting for the next one.

Right now, the earnings yield on the S&P 500 (forward) is 7.4%. This compares with a 2.7% yield on the 10-year, for an equity risk premium of 4.7%. And there is plenty of upside: long-term earnings growth, and the possibility of a lower risk premium.

EU wants to fine ratings agencies for downgrades of European countries

I like the idea: Governments can fine rating agencies for government ratings that the governments don’t like. It makes sense, but it doesn’t go far enough. Why shouldn’t governments also be able to fine newspapers for stories they don’t like?


(Reuters) - EU finance ministers will discuss this week how to penalise rating agencies for passing judgement on countries based on "wrong analysis", a senior EU politician said on Tuesday.

Didier Reynders, the finance minister of acting EU president Belgium, said the bloc's economy chiefs would discuss such a regime when they gather this week to examine controls for the agencies, whose downgrades of countries at key moments in Europe's debt crisis have angered some politicians.

Building on remarks that he wants a new EU markets watchdog to be able to fine rating agencies, Reynders said: "It must be possible to penalise. If after some weeks or months [why not after a couple of days?] it is possible to say it a downgrade was a wrong signal, what is the responsibility of the rating agency?"

"It is quite difficult to say that there is no responsibility if it is possible to prove it was a wrong analysis, a wrong signal. The penalties is the capacity to impose some responsibility on the rating agencies."

Reynders' comments illustrate growing frustration with the agencies but leave many questions unanswered about how such a penalty scheme would work or whether it would win the backing of European countries and the parliament to be introduced.

It is not clear who would decide that an agency's analysis or a particular rating change was "wrong".

Sharon Bowles, the chairwoman of the influential economic affairs committee in the European Parliament, which must give its blessing to new laws, was critical of the idea. "You cannot penalise rating agencies for getting their predictions wrong," she told Reuters.

The EU's finance ministers are acutely sensitive to the danger of further downgrades, such as one threatened on Tuesday by Standard & Poor's for Ireland as the cost of supporting Anglo Irish Bank rises.

Representatives of the three big agencies -- Standard & Poor's, Moody's and Fitch -- have been summoned to a meeting of finance ministers this Friday in Brussels to defend the way they take rating decisions.

Some in this group, including Germany's Wolfgang Schaeuble and France's Christine Lagarde, have also found it hard to forgive an S&P decision to demote Greece to junk status, as they struggled to mount a rescue, the cost of which was pushed up by the downgrade.

Required reading for opponents of bank bailouts

From today’s FT:

Ireland’s finance minister has vowed to stand behind Anglo Irish Bank, the lender at the centre of the country’s property meltdown, saying that allowing it to fail would “bring down” Ireland.

In an interview with the Financial Times, Brian Lenihan, finance minister, said Ireland had no choice but to act.

“Any Anglo failure would bring down the sovereign. It is systemically important not because of any intrinsic merit in the bank, but because of its size relative to the national balance sheet. No country could contemplate the failure of such an institution,” he said.

[Note: Anglo-Irish has liabilities of EUR 80 billion.]

Ireland is getting very ugly

It appears that Ireland is coming close to the brink. From the Irish Times:

THE GOVERNMENT'S borrowing costs hit a record high again yesterday after two credit rating agencies warned that Irish State debt faces further downgrades.

The cost of State borrowing jumped as the yield on 10-year Government bonds jumped by a quarter of a percentage point to 6.72 per cent.

The bond yields are now trading at levels similar to Greece at the start of April - only a month before the Athens government sought international support.

The yield premium investors demand to hold Irish 10-year bonds instead of benchmark 10-year German bonds reached a record 4.53 percentage points before narrowing to 4.48 percent.

The increasing debt costs came despite reports of bond purchases by the European Central Bank to help stabilise the markets amid investor fears about the mounting cost of Ireland's bank bailouts.

The ECB purchases focused on securities with maturities of as long as five years, the reports said.

The mounting pressure on State borrowing comes as the Financial Regulator and the Department of Finance prepare to announce a final estimate of the final cost of bailing out State-owned Anglo Irish Bank.

The bill is expected to surpass the current estimate of EUR25 billion, rising to about EUR28 billion to EUR29 billion with the possibility of the cost increasing further under a stress case but not above the EUR35 billion estimate of credit rating agency Standard and Poor's.

Minister for Finance Brian Lenihan will announce plans to meet tougher capital targets at Anglo, including a restructuring of part of the bank's bond debts.

A voluntary buyback of subordinated debt at Anglo is being planned but the Department of Finance has ruled out any possibility that investors in the bank's senior bonds will not be repaid.

The end of the two-year blanket Government bank guarantee from midnight tonight has increased the nervousness of the markets.

Some EUR4.2 billion of senior debt at Anglo and EUR1.8 billion of dated subordinated debt will not be guaranteed from tomorrow, which has led to market concerns that the Government will seek to share the bank's losses with these investors.

Ratings agency Moody's downgraded Anglo's unsecured senior debt by three notches on Monday, citing a small risk that the Government might not support this debt.

S&P analyst Trevor Cullinan estimated that the bill could rise above EUR35 billion in an interview. He said that any increase above this figure would lead to further downgrades.

The Government is coming under pressure to assure the financial markets that it can afford the cost of the banking rescues and cut the biggest budget deficit across the European Union.

PM Brian Cowen said that the Government would be providing details shortly of "a manageable way forward" of how Anglo will be dealt with in the long term. "We are determined to do what's necessary to achieve international confidence and build domestic confidence," he said.

Cowen denied that the country was close to a "tipping point".

The cost of insuring Irish sovereign debt against default soared to a record 519 basis points (5.19 per cent) from 488.5 yesterday.

Foreign Policy Note: Negotiating with God's messenger

I watched Mahmoud Ahmadinejad interviewed on Fox News. If you haven’t seen it, you should watch it. This is no ordinary guy. Obama is way out of his league when he thinks that talking to this thing will make any difference.

I have seen a lot of dictators interviewed on film or TV. This specimen falls into the category of the charismatic  megalomaniac. (And this was through a translator; in Farsi I'm sure he's another Jon Stewart.) Had Hitler been alive during the TV era, he would have been as effective, appealing and scary. Ahmadinejad is smart, funny, evasive and a consummate liar, much like the late, lamented Saddam Hussein. (And Stalin and Mao and Castro and Ho and for all I know Pol Pot.)

He is a profoundly dangerous person. The West is fundamentally ill-equpipped to deal with such a personality (just as we were at Munich in 1938 and Yalta in 1945). The West is all about reason, negotiation, and the measured application of leverage (“Doesn’t everyone want peace?”).

Like Hitler, Ahmadinejad is serious and rational. He believes that it is his holy duty to advance the cause of Shi’a Islam and to eliminate, in the name of God, the “Zionist Entity”, which both Hitler and he would agree on, for different reasons.

WW2 was about the “have not” powers versus the “have” powers. That is precisely what is happening today with the “other” powers: Russia, China, and Iran. Except that Russia and China ultimately do want peace and prosperity, on their own terms, while Iran places no value on peace (Jihad is a commandment). It seeks to pursue Islamic goals by nuclear means.

Ahmadinejad is no Brezhnev. Peaceful coexistence is not his goal. If he destroys Israel, he goes to heaven.

How do you deal with a serious, rational, fanatical enemy? I don’t know, but it would be wrong to think that you can "negotiate" with a fanatic.

Sneaking out the eurozone's back door

If you are plotting to leave your wife for your massage therapist, it’s probably not a good idea to leave your therapist's name and phone number on the white board by the phone.

Similarly, if you are a bankrupt European country plotting to leave the euro and restructure or redenominate your loans, you might not want to set up a "Working Group on Debt Restructuring and Currency Strategies" in the Finance Ministry (even without the hastily hand-written sign on the door). It would be on Drudge the next morning (“Greece Plots Deadbeat Strategy”).

The NY Times reports that when the eurozone realized they had a Greek problem, they formed a secret committee called the "Committee With No Name, (as opposed to, say, the "Greek Debt Crisis Committee"). 


The Committee With No Name is the right name for a debt restructuring task force in Greece or Ireland. And the committee with no name should located be on a top-secret military base on a remote island with no population and a total blackout of all electronic communication.

As Vincent Truglia has said on his blog, euro exit has to be a total surprise not only to the FT, the EU and the ECB---but also to the Greek Parliament and the Greek people. The minute the wires light up with word of such a plan, it’s game over. No more loans from Germany, no more bond buying by the ECB, no lines of credit anywhere in the world. It means going cold turkey without the 12 steps.

So if you are going to Plan B, whatever it is, you have to secretly cook up the entire scheme, write the Emergency Presidential Decree and the ex-post enabling legislation, decide which famous Greek faces go on the currency, and who's cousin gets the printing contract. ("Constantine, save some for the family.")


You will have to draw lots to see who’s going to make those calls to “Europe”. On second thought, maybe it’s better to just send emails:  “Dear [insert first name], I’m sure you were surprised and upset when you opened your paper this morning. Please allow me to...”



JFK faced a very similar when he decided to “secretly” prepare for a Cuban invasion in 1962. There is a great scene in Thirteen Days when Johnny Apple of the Times confronts Kenny O’Donnell about the quite visible trainloads of troops and tanks headed to Florida. O’Donnell tells him “Johnny, it’s just an exercise”.  Apple replies “Yeah, and the name of the exercise is Castro spelled backward”. O’Donnell replies “Shit. Give me your boss’s phone number.”

It is easy for Greece to get Europe to lend it money because it owes their banks (and now the ECB) so much. It is not at all easy to stiff Europe and force them to once again recapitalize their banking systems.

There is one thing I do know: every phone call, email, fax and water-cooler conversation at the Greek finance ministry is being monitored by at least 20 security services, including ours. I wonder where that remote island is? The French know.

Yet another "jobs bill"

The AP reports that the Senate failed today to move a Harry Reid bill that “would prohibit firms from taking deductions for business expenses associated with expanding operations in other countries”.

In other words, the profits that businesses make abroad will still be confiscated at the 35% rate (the US being the only country which taxes foreign profits), but expenses associated with expanding abroad would not be deductible according to the bill. This is in order to discourage US businesses from doing business abroad. 

So it is of course a “jobs bill”, and how can anyone be against jobs?

So, therefore, if GE open a gas turbine factory in Bavaria, that’s a bad thing, because it should have been located in New York, where we need  jobs.

And when BMW opens a factory in South Carolina, that’s a bad thing too, because it should have been located in Bavaria, where they need jobs too! Don’t you understand economics?

My best effort to think out the end-game for the Eurozone

The principal threat facing the global economy today is the risk of a default by a eurozone member on its debts. That would be Greece or Ireland.

We need to ask the following questions:

1. What is the EU’s current strategy for resolving the financial crisis on the periphery?
2. What are the prospects for success?
3. What are the potential downside scenarios?
4. How would these downside scenarios play out in the global and US capital markets?

The EU strategy is as follows: The combination of the implementation of credible austerity policies over the next two years, bridged by the backstop provided by the Eur440B*
“European Financial Stability Facility” will provide the PIIGS (or should I say the GIs?) with a path back to market access and financial stability.

[*In today’s FT, Wolgang Munchau explains in detail why (1) the EFSF is much smaller and more punitive than markets think, and (2) that basically it is a band-aid that won’t solve anything. Heavy stuff.]

I don’t see how the austerity plans will bring down deficits and borrowing needs to a level that allows spreads to come in and market access to resume. Spreads for Greece and Eire have remained sickeningly wide since the facility was announced in May. Hold your breath that they will tighten. They will widen.

Two bad things will happen: (1) the pain of adjustment (see: depression) will ultimately become politically impossible; and (2) the debt markets will remain closed such that that the peripherals must either hit the eject button or issue debt under the stability mechanism’s guarantee (and your guess is as good as mine what these bonds would yield: what rational person would buy those bonds? It’s the ECB or nobody).

My view is that by this time next year, one or more of the peripherals will have hit the wall: the deficit targets will not be met, the pain level will be unbearable, and the markets will remain closed (i.e., even higher yields than now). Refinancing under the stability mechanism solves none of these problems.

This would then force the EU (Germany) to decide between an even bigger, almost open-ended facility, or letting (watching) the sick countries do what they have to do (default, reschedule, redenominate, repudiate) whatever.

I just don’t see the German electorate agreeing to refinance or guaranty the entire periphery. They didn’t sign up for it. Merkel agreed to the stability facility in the face of strong domestic opposition. Germany joined the eurozone on the explicit condition that it would not be responsible for the debts of other eurozone members. This is in the treaty, and also in the German Constitution (according to the Federal Constitutional Court). In my opinion, Germany will not backstop the entire eurozone, nor should it.

Therefore, I see three possible outcomes (by yearend 2011):

1. A peripheral announces a distressed exchange offer of new, long-dated, euro-denominated, low-yield  bonds in exchange for its outstanding (higher-yielding) debt. Since most euro-denominated government debt is issued under domestic law, creditors would have little alternative to accepting the offer.

2. A peripheral unilaterally leaves the euro, reverts to its domestic currency, and redenominates all debts, public, private and foreign (including to the ECB) into the domestic currency at an arbitrary exchange rate. Again, creditors would have no effective legal recourse for debt sold under local (esp. Greek) law. This seems to be the most likely and the least disruptive solution. The national central bank could then allow the currency to decline in value in an orderly fashion (assuming it has any reserves left), create inflation to reduce debt burdens for private and public debtors, and allow nominal wages to rise (maybe).

3. A peripheral redenominates and repudiates its debts. This is unlikely because not only would it cause a punitive backlash from the EU (expulsion, tariffs), but also because it would wreck the Greek banking system (although the Greek banking system is pretty dead under all scenarios except hyperinflation).

Let’s take this thought experiment to the next step. If we accept scenario #2 (unilateral redenomination) as the most likely, what are the consequences for the global capital markets? We are really going out on a ledge here, but it is worth the brain exercise.

The day that Greece exits the euro, and redenominates its currency and all contracts into drachma, what happens?


Spreads on the rest of the indebted peripherals (the PIIGS) would skyrocket, irrespective of their finances at that moment. (The other peripherals would at this point dust off their own exit plans. Once one goes, can the others hang on? Spain? Italy?)

European bank spreads would gap out by hundreds of basis points, and the European interbank market would shut down. The ECB would fill this gap with massive free liquidity, such that banks would not fail immediately due to the shock. That will be a bad day for the president of the ECB (who is going to be a hard-money German!).

If, as and when the other PIIGS go to Plan B, then the crisis morphs into a 1931-style debacle: every man for himself; the strong win and the weak go under. Nations act to protect their banks. The interbank market just evanesces; it’s gone.

Banks in the redenominating nations would receive unlimited local currency liquidity from their revived central banks. The defaulting banks’ euro and dollar denominated debts to European banks and the ECB would be unilaterally redenominated into local currency by law. (Remember Latin America in 1982?)

You would then be looking at a European banking crisis. If additional PIIGS go under, the banking crisis becomes a meltdown. The immediate liquidity issue can be addressed by the ECB (unless the top German starts channelling Andrew Mellon); but the solvency issue must be addressed by the national fiscal authorities. [The EU cannot and will not recapitalize banks.] Government bonds can be swapped for peripheral bonds, or there could be temporary accounting forbearance (remember that?). But anyway, it’s awful, and worse than Lehman. Bad for stocks, good for the dollar, treasuries, and gold.

What happens to the redenominators? Well, they immediately lose access to all international credit including the ECB. They go cold turkey. But they can still finance their fiscal deficits and banking systems by using their unlimited ability to create local currency. So, they face inflation, drastic depreciation and a depression that is probably less severe that what they would have gone through under the euro. Over time, they would regain competitiveness, and perhaps even credibility if they avoid hyperinflation. Or, they descent into Zimbabwean chaos.

What does this mean for the euro? Initially it depreciates, sending a deflationary shock worldwide (the ECB can do nothing to stop this--besides raising interest rates!). The ECB will also have to face a big writedown on the bonds it bought from the peripherals (which is why it resisted this policy for so long).

How much the ECB can do to stem deflation depends on the degree to which the Germans will allow it to engage in unconventional policies (QE). Germany will be in the cockpit with respect to both rescue and monetary policy.

I think it’s inevitable that Germany will exit the eurozone and restore the Deutshe Mark within the next two years (yes, an extreme prediction, but is the alternative more credible?). Is that the end of the euro? Hopefully.

As the euro goes down, the dollar, the yen and the RMB go up. Treasury and JGB yields go down, unless the BoJ and the FRB lean against the wind and expand their money supply to offset what is happening in Europe. This could be inflationary in Europe, the US and Japan, which is not a bad thing. The Fed will resist any deflationary shocks coming from Europe.

What happens to global aggregate demand under such a scenario? Who knows? Can the Fed engineer domestic prosperity when Europe is hurting global confidence and investment? It is worth positing that a burst of worldwide inflation is just what the doctor ordered.

The indicator to watch is Greek and Irish bond yields, not the euro.

Ireland's choice: prolonged depression or immediate euro-exit

Desmond Lachman in today’s FT:

The Irish government is hoping that Ireland will somehow grow its way out of its public finance problem. However, such hopes would seem to be fanciful in the light of both the substantial amount of budget deficit-cutting that lies ahead as well as of the large effective monetary policy tightening being forced on Ireland by the financial markets. The IMF estimates that Ireland needs further fiscal tightening of at least 6½ percentage points of GDP over the next two years.

In the absence of debt restructuring and of a euro exit, IMF-imposed austerity runs the real risk of plunging Ireland deeper into depression and deflation.

If it is indeed inevitable that, in the end, Ireland will be forced to renege on its government’s debt obligations and to exit the euro, from an Irish perspective it is better that it be done quickly without pointlessly prolonging pain and saddling the country with a mountain of official debt. For at least that route might offer Ireland some prospect of recovering from its present economic depression.

A libertarian addresses the UN

Czech president tells UN to stay out of economics

Sat, Sep 25 2010

UNITED NATIONS, Sept 25 (Reuters) - Czech President Vaclav Klaus on Saturday criticized U.N. calls for increased "global governance" of the world's economy, saying the world body should leave that role to national governments.

The solution to dealing with the global economic crisis, Klaus told the U.N. General Assembly, did not lie in "creating new governmental and supranational agencies, or in aiming at global governance of the world economy."

"On the contrary, this is the time for international organizations, including the United Nations, to reduce their expenditures, make their administrations thinner, and leave the solutions to the governments of member states," he said.

Klaus appeared to be responding to the address of the Swiss president of the General Assembly, Joseph Deiss, who said on Thursday at the opening of the annual gathering of world leaders in New York that it was time for the United Nations to "comprehensively fulfill its global governance role."

Deiss suggested the world body should get more involved in economic and financial issues and not leave them solely in the hands of forums like the Group of 20 club of key developed and developing nations.

Klaus, a free-market economist who oversaw a wave of privatization in the 1990s after communism collapsed in his homeland, also said the world was "moving in the wrong direction" in combating the economic crisis.

"The anti-crisis measures that have been proposed and already partly implemented follow from the assumption that the crisis was a failure of markets and that the right way out is more regulation of markets," he said.

Klaus said that was a "mistaken assumption" and it was impossible to prevent future crises through regulatory interventions and similar actions by governments.

That will only "destroy the markets and together with them the chances for economic growth and prosperity in both developed and developing countries," he said.

The Czech president, a vocal skeptic of global warming, said the United Nations should also keep out of science, including climate change. U.N. Secretary-General Ban Ki-moon has made fighting climate change one of his top priorities.