Hi all. Sorry for being away—it couldn’t be helped. Enjoy the new post. More will be forthcoming on a steady basis. GLWe are about to experience the Euro Exit Crisis.
Mish Shedlock and I have a private bet as to whether Italy or Spain will exit first—he says Italy, I say Spain. But either way, it’s gonna pretty much suck.
The whole point of exiting the eurozone is because a country no longer has the money to finance its continuing operations. Insofar as Spain, Greece and possibly Italy, that moment will arrive shortly—possibly within days in the case of Spain. So if a sovereign government reaches this moment, it will have no choice but to exit the EMU and revert to a local currency which the government can then devalue.
By doing this, the government simultaneously has all the cash it needs to continue operations, and also inflates away its debts. The private sector gets a shot of adrenaline insofar as foreign trade is concerned, because its goods and services become that much cheaper on the foreign markets. And the employment situation gets a boost, as those producers selling their cheap goods and services overseas begin to hire more workers to fulfill demand.
The downside is that the government gets shut out of foreign bond markets, its financial sector takes a huge hit, and prices for essential goods and services rise dramatically, hurting the poor, the lower middle-class, the elderly, and the unprepared.
Even with these negatives, though, a forced conversion and devaluation is a boon to bankrupt nations. It is, basically, a reset of the economy: And historical experience shows that though it hurts a lot in the short term, it helps to reignite an economy, and get the people moving once again. This has been true of the United States in 1933, Germany in 1948, Latin America in the 1980’s, Argentina and Uruguay in 2001.
But it’s crucial to understand both the sequence and the mechanics of the process, in order to be able to anticipate what will happen, and thus make sound investment choices.
Once the political decision to exit the EMU has been taken by a country’s leadership, this is what it has to do:
1. The government decrees the creation of a new local currency, and establishes its convertibility on a one-to-one basis with the euro. (Let’s call the new local currency the nueva peseta.)
2. The government makes these nuevas pesetas available to the local financial sector, and orders everyone to convert. Thus the local Central Bank takes all of the local banks’ euro-denominated deposits and converts them into nuevas pesetas. And all the local banks in turn convert their retail customers’ euros into nuevas pesetas as well—all of these conversions taking place on a one-to-one basis.
The government thus has exchanged all these newly minted nuevas pesetas it has created for euros—euros which are now in the government’s coffers.
3. At the same time as it obliges the financial sector to convert to the nueva peseta, the government by decree says that all local debts of the government are now to be paid in nuevas pesetas. Any euro-denominated bond or contract that the government signed is now automatically—and irrevocably—in nuevas pesetas. All pensions and government salaries are also in nuevas pesetas.
4. The government also decrees that all private debts—as well as all consumer debts with the banking sector (ie., credit card debts, mortgage debts, etc.)—are to be converted to nuevas pesetas on a one-to-one basis as well.
5. The government decrees a wage-freeze and a price-freeze—obviously. If it does not implement a wage-and-price freeze, consumer prices will go to the moon, creating runaway inflation. This is not to say that there won’t be hoarding—there will be, regardless of the wage-and-price freeze. And a black market will also sprout up. But a wage-and-price freeze will halt any possible inflationary panic; or at least slow it down enough to keep it from becoming hysteria.
Capital controls would not be necessary, due to the fact that depositors’ euros had been converted to nuevas pesetas. Certainly dollar deposits would flee the second the announcement was made—but cash dollars account for a relatively small amount of a prospective euro-exiter’s balance of payments.
6. The government also tries to convert all sovereign debt obligations into nuevas pesetas. This won’t necessarily happen—it could be that the sovereign debts have riders that make it impossible to convert. It could be that foreign bond holders have the political leverage to prevent forcible conversion of euro-bonds into nueva peseta-bonds. But the government will most certainly try to convert its foreign debt from euros into nuevas pesetas—and will likely succeed in at least a tranche of these outstanding bonds.
7. Once the government has converted as much of its obligations as possible to the new local currency, it devalues the nueva peseta—hard. An initial devaluation of 20% to 30% is historically reasonable (see the Latin American countries during the 1980’s), with an eventual devaluation of a full 100% within 6 to 18 months.
I insist: This is the rational approach to eurozone exit.
So if we posit the rationality of this decision and its implementation, then in order to be effective—and in order to minimize panic—all of the aforementioned steps (except step 6) would have to be accomplished as swiftly as possible: Say over a weekend.
This is totally doable: Modern financial technology would easily allow a government to forcibly convert banks’ euro deposits into nueva peseta deposits almost instantaneously. Ditto with retail banking customers’ deposits and debts.
Step 7—the devaluation of the nueva peseta—will also happen immediately: On Sunday night of this very busy weekend. The devaluation of the nueva peseta is of course the whole point of this exercise: The government is exiting the euro and devaluing the nueva peseta in order to re-ignite the economy.
The problem wouldn’t be the implementation—the problem would be leaks: If any sector of the public gets wind of what’s coming up, then you would get what happened in Argentina in 2001—huge convoys of armored trucks, carrying the oligarchy’s money away, before it can be converted by the government.
So if a government makes the decision to exit the eurozone, it will have to be swift and surprising. If it takes too long, or if the decision is long-winding, or if there are leaks, then there will be a massive capital outflow like Argentina in 2001, which will cause terrible damage.
Critics consistently claim that no country can exit the eurozone, because if it does, it will be shut out of the bond markets—and thus will not be able to borrow money with which to buy necessary imports, like grain, oil, etc.
This is a stupid objection—because it ignores the mechanics of an EMU exit and reversion to a local currency: If a government forcibly converts its banks’ and people’s euro-deposits into nueva peseta-deposits, that government will have essentially confiscated all those euros. Obviously: It’s printing up nuevas pesetas, and forcing everyone to take them in exchange for euros.
And where do those euros go? To the government’s coffers.
Thus in the short-to-medium term, the government will have no need of the euro-bond market, because it will have all the euros it could possibly need.
(It also explains the need for swiftness and secrecy in the decision and implementation of this decision: If there’s a leak, the capital flight will leave the government without any euros—which the government can’t allow. Of course, the argument can be made that the government is stealing the euros from the people—which it is. But I’m not arguing the morality of these decisions—I’m arguing the practical aspects of it from the point of view of a desperate government that is facing bankruptcy and has thus decided to exit the eurozone.)
Though the government that exits the eurozone and forcibly converts to a local currency will have all the euros it needs to cover its international balance of payments in the short-to-medium term—including all necessary and essential imports like grains and oil—this does not mean that it will never have need again for the international bond markets: It means that in the short-to-medium term, the government that exits the EMU will be sitting pretty in terms of its hard-cash position, and thus have the ability to flip the bird at the euro-bond markets.
Again, continuing on this rational scenario: Euros will be needed in order to buy necessary imports, like grain and oil. To prevent hyperinflation of the nueva peseta, the government will likely subsidize some of the larger local importers of grains, oil and other essential imports in order to cushion the impact of rising oil and food prices on the general population. The way this subsidy will happen is by selling the euros the government confiscated to these local importers at a better exchange rate than the open market, with the understanding that the grains and oil the importers buy will be sold at lower prices to the general population.
All is not sweetness and light in this scenario: A whole slew of small-to-medium businesses will go bust—with the concomitant bump up in unemployment—because these businesses will have foreign currency liabilities they cannot meet because their locally-sold products are now that much cheaper due to the devaluation of the nueva peseta.
However, the point that matters is that now the government will have both euros and nuevas pesetas to throw at the population—which they will, and thus ease their country into this new phase.
This article was adapted from a longer post which appeared in my Strategic Planning Group. That post was called “Investment Ideas for the Euro Exit Crisis”. If you’re interested, check out the preview page. GL