Thursday, 24 May 2012


Back to the future?

Notwithstanding all official denials it is unimaginable that the ECB and Euro member countries are not making contingency plans for a possible Greece exit from the Euro.

The scenario most likely to evolve is that an inconclusive Greek election on 17th June 2012 will spark a run on Greek banks.    This will make the burden on the ECB and its constituent Central Banks too heavy to carry.  In order to avoid replacing depositors on the liabilities side of Greek Banks' balance sheet, the ECB will have to stem the funding to Greek banks.  

This will lead to implosion of the Greek banking system and a forced reversion of Greece to their own currency.    Banks will be closed for an indeterminate period until Drachma notes will be available and laws are passed to redenominate all accounting, bank deposits and contracts under Greek law from Euro to Drachma.   Greece will unavoidably default on liabilities which cannot be converted to Drachma due to their being drawn under a foreign jurisdiction.     That much is pretty certain.

What is less certain is whether the contingency plans ostensibly being made ( in spite of denials)  would be robust enough to ensure that the fire is ring-fenced around Greece and that contagion does not spread to other jurisdictions, particular Cyprus, Spain, Portugal, Ireland and Italy.

Hopefully the measures I proposed in my previous post will be taken in time to ensure that Greece remains an isolated event and that other countries watching the turmoil in Greece would double their resolve to speed up their structural adjustment programmes.

If all moves as planned would it mean that a GREXIT without contagion would in effect restore enduring stability to the Euro system?

Absolutely not, is the resounding answer to such question.

Greece is not the only country causing instability to the Euro.    Germany is causing similar instability but from the virtuous side.   But make no mistake about it.   Chronic deficits are destabilising, no doubt.   But chronic surpluses are equally destabilising.    

So having undertaken GREXIT to remove destabilisation from the vicious side would GEREXIT also be required to remove destabilisation from the virtuous side?  

In theory this would be perfect solution for restoration of growth to the remaining 15 Euro countries with Germany losing its present competitiveness as it reverts to an appreciating DM whilst the Euro minus Germany falls to below parity with the US$.  

In practice however this is institutionally unfeasible and optically damaging for the Euro which could become perceived as a common currency for weaker countries and would prejudice its ambition for reserve currency status.

However Germany must still do something to ease off the instability it is generating to the system from the virtuous side.  Just as Ireland, Spain, Portugal, Ireland and Cyprus are undergoing a prolonged internal devaluation process, cutting wages and benefits to become internationally competitive again,  Germany should immediately undertake an internal revaluation process.

Germany should tolerate domestically a higher level of inflation, encourage private sector wage settlement at a higher level to compensate for the wage freeze suffered during the prolonged integration of the East to the West,  and consequently encourage a shift of demand from domestic brands to imported brands and shift of production to relocate to other Euro area countries with comparative cost advantages.

Such moves are totally within Germany's own jurisdiction, need little parliamentary intervention, are perfectly in line with the German Constitution and are far more effective for promoting growth than Euro bonds or Fiscal Union.   They may even be poltically popular for Mrs Merkel's re-election ambitions.

Euro bonds and Fiscal Union may come later.

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