Tuesday, June 30, 2015

Euros without the Eurozone

This 2 euro coin is issued by Monaco, which is not a member of the Eurozone

Grexit isn't what people take it to be. The standard narrative is that Greece is approaching a fork in the road. It must either stay in the euro or adopt a new currency. I don't think this is an entirely accurate description of the actual fork that Greeks face. Over the next few months, Greece will either:
  • A) stay a member in good-standing of the institution called the "Eurozone" and continue to legitimately use that institution's currency, the euro, or
  • B) leave the Eurozone while continuing to use the euro 'illegitimately.'*
This means either the status quo of de jure (official) euroization or de facto (unofficial) euroization. In both cases, the euro stays.

The probability of a new drachma emerging is awfully low. The widespread idea that a sick country can rapidly debut a new currency and, more importantly, have that currency be universally adopted as a unit of account is magical thinking. Greece has been using the euro as a universal "language of exchange" for fifteen years. Switching over to a new unit is about as unlikely as Greeks suddenly beginning to speak German, network effects and all. Consider too the fact that Greeks don't want the drachma—they have consistently voted for euros. Syriza has no mandate to bring a new unit into existence. ***

Option B isn't an odd one. All sorts of countries 'illegitimately' piggy-back off the currencies managed by others. Zimbabwe, Ecuador, and Panama use the U.S. dollar without being card carrying members of the Federal Reserve System while Andorra, Kosovo, Montenegro, Monaco, San Marino, Vatican City use euros without being part of the Eurozone. Nor can the Eurozone can do anything to prevent de facto adoption of the euro by Greece. It's a decision that Greeks get to make themselves.

If Greece leaves the Eurozone on a de jure basis while staying a euro user, what will it be giving up?

The Greeks would NOT be losing the price stability and commonality already provided by Eurozone membership. These are presumably the features that lead most Greeks to declare in polls that they want to stay in the euro.

However, Greece would no longer get access to Eurozone lender of last resort facilities. One could argue that the nation would be better off without these facilities, given the discipline that a true 'no bailout' policy would enforce on both the banks and the government. Greece also loses direct access to the monopoly supplier of euro banknotes. A Greek banker can currently ask to have their Eurozone account be debited and a batch of freshly printed paper euros trucked over to their vault. Gone is that functionality. Panama has survived, even prospered, for decades without access to the Fed's discount window or Fed cash facilities.***

Greece would also lose its seat on the ECB Governing Council and therefore any say in determining monetary policy. Greece's one seat probably never gave it much influence anyways, especially compared to Germany's dominant influence in ECB decision making. Nor would Greek data be considered as an input into Eurozone policy decision should Greece leave. However, as it clocks in at just 2% or so of the Eurozone's total size, Greece's data could never have had much influence on the aggregates that ECB policy makers watched to begin with. Official user of euros or unnoffical, Greece will always lack an independent monetary policy.

Another concern is that Greece might not be allowed to use the ECB's Target2 real time settlement mechanism anymore. However, Denmark, Bulgaria, Poland, and Romania all connect to Target2, despite not being Eurozone members. Surely Greece would qualify. If not, it wouldn't be too complicated for Greek banks to set up their own payments system.

Lastly, Greece would forfeit all seigniorage revenues. Eurozone members currently get a share of the profits that the ECB earns on its monetary monopoly. I don't see this loss as being a big deal. Seigniorage has long since been eclipsed by taxes as the key source of a modern government's revenue.

The upshot is that whether Greece remains a legitimate member of the Eurozone or an unofficial user of the Eurozone's chief monetary product, the implications are about the same. There is no fork in the road, at least not from a monetary policy perspective; just a continuation of the same euro path as before.

I've left two features out. If Greece leaves, the claims and liabilities it has on the Eurozone must be unravelled and settled. Having invested around 200 million euros in the ECB when it was formed, Greece would have to be bought out by remaining Eurozone members at a reasonable price. Counterbalancing this would be Greece's obligation to unwind the debt that it has amassed to the Eurozone in the interim. This debt, known as its Target2 deficit, currently clocks in at around 100 billion euros, far in excess of the capital it is owed. It would take an incredible outlay of resources to pay this amount off. The advantage to the Greek population of staying in the Eurozone is that their debt need never be settled. After all, Target2 debts are by nature perpetual. Only by leaving do they face a final day of reckoning.

However, if Greece puts little-to-no cost on squelching on its debts, it may as well just leave the Eurozone without paying back the 100 billion it owes. It gets to continue to ride piggy-back on top of the euro, enjoying (almost) all the same benefits of being a Eurozone member, without being on the hook for anything. Why not perpetually bum cigarettes rather than pay for them?

Which is why Greece has a certain degree of power over the remaining Eurozone members. Should it shrug and leave, the remaining members are on hook for its unpaid tab. And once Greece goes down the de facto euroization path, how long before the next largest debtor to the rest of the Eurozone decides to shrug and leave? As Nick Rowe says, the last one holding a common currency is the sucker since they'll be left with everyone's bad debts. To keep the system going, the Euro project's architects need to do their best to ensure that Greeks aren't incentivized to just shrug and bum a free ride on the euro. I don't envy them their task, it's a difficult one.

The other aspect I've left out is the Greek banking system, which is probably insolvent. Once cutoff from the central bank that prints the stuff, Greek banks simply wouldn't be able to meet the rush to convert deposits into euro banknotes. The only way to return the banking system to functionality would be to chop the quantity of Greek bank deposits down to size so that the banks' asset base would be sufficient to absorb the run into cash. We're talking a multi-billion euro "bail-in" of depositors. The prospect of such a hit certainly tilts the decision between A and B back towards A.**

* Having been cut off from additional ECB lending, one might argue that Greece has already gone halfway towards exiting the Eurozone.
**  Paragraph added July 2.
*** Added cash facilities on July 2.
**** Added last two sentence to this paragraph on July 3.
Note: apologies for the constant additions, but this subject is complex and the situation getting more complex by the day, so rather than writing two or three posts I'm adding bits to the original.


  1. Finally.

    Somebody who understands the contingent Target2 liability (apart from Sinn).

    Good stuff.

  2. Nice post!

    If my understanding is correct then the background to the Greek crisis is that the lack of an Independence CB meant it was unable to have appropriate monetary policy, which led to a deeper recession than was necessary and an ever worsening fiscal situation.

    At least one benefit of a new Greek currency would be that the now independent Greek CB could expand the money supply to offset the fiscal shocks it is suffering and minimize their effects on the real economy.

    The facts that most Greeks don't like that option and would probably prefer to stay with the Euro probably indicates they don't trust their own CB to enact sensible monetary policy (and they may be right). But taking that path does mean they will likely go through a deeper recession until Greek prices adjust to the new Greek reality.

    1. "At least one benefit of a new Greek currency would be that the now independent Greek CB could expand the money supply to offset the fiscal shocks it is suffering and minimize their effects on the real economy."

      Is this any help if Greeks continues to set prices in euros?

    2. Good point.

      But (to channel some MMT) if the Greek government starts to demand tax payments in new dracma's , will continuing to set prices in euros (and presumably use Euros as currency) be a viable option for Greek residents ?

    3. Why not? Nations in Africa and South America have remained dollarized in terms of the unit-of-account for long periods of time despite a local currency alternative.

  3. Can you please explain target2 liability. Your post implies that if Greece fails to pay it's debts, the remaining euro area members are stuck paying them. You write "Should it shrug and leave, the remaining members are on hook for its unpaid tab." But that's not actually true, is it? The owners of Greece's debt obviously would not get paid by Greece, but the other Euro area members would not be required to step in and pay the bond holders. Now obviously they've already bought a lot of greek debt, but that was a choice not an obligation.

    1. Not bonds. Greece has a debt to the ECB that it has amassed over the years. If it leaves without paying it, who is liable? Answer: the ECB's shareholders. Who are they? The 18 remaining members of the ECB.

  4. But doesn't a defecting government sit on a potential gold mine if they abandon the Euro? I don't think there is any hard rule that all those Euros in people's bank accounts have to be written out of existence if they are replaced by a re-established national currency. A government could forcibly buy all those Euros, putting the re-established national currency into circulation, while ending up with a big pile of hard currency to pay off creditors with. As long as the Euros go abroad they are effectively sterilized and won't cause inflation at home.

    Is this a completely daft idea, or if feasible, an incentive for individual countries to abandon even Euroization after a transit period?

    1. What happens to the value of the re-established national currency?

  5. As you point out, the euro has only been in circulation for 15 years. The idea that this short period of time has created an overwhelming social pressure or inertia in favor of the euro as a unit of exchange seems odd. Most living Greeks clearly remember a time when they used drachmas.

    If olive oil producers post a euro price for their olive oil for foreign customers and a drachma price for drachma-using domestic customers, and the price ratio doesn't reflect the euro-drachma market exchange rate, then market forces will compel the producers to re-price. And if most Greeks are being paid in drachmas, then obviously olive oil producers will be compelled to post drachma prices if they want to sell most of their olive oil.

    Why not nationalize the banks, including the Bank of Greece. Then "tax" all euro-denominated accounts at 100% and transfer all of those euros to government accounts. At the same time issue an equal number of drachmas and credit each of those accounts with drachmas through a direct transfer on a 1-1 basis. Everybody wakes up with drachmas in their accounts. Use the taxed euros to pay off euro-denominated government debts, and hold the rest as foreign reserves.

    Pass legislation that requires every labor contract and existing private domestic debt relationship to be re-interpreted in drachma terms 1-1. Companies will be compelled to accept payment for their products in drachmas in order to meet their own payment obligations to employees.

    Pass additional legislation by which the Greek government stands ready to assume all euro denominated debts owed abroad (credit card, whatever), and those private debts are then replaced with drachma debts to the Greek government. Basically, you submit your credit card bills and other bills from foreign firms to a government office. They pay with the taxed euros - then they charge the debtor a drachma debt on a government account. (What to to with those debts then becomes a matter of policy.)

    There are a lot of state run services in Greece. If Greece refuses to accept euro in direct payment for those services, or for payment of taxes, while offering euro-for-drachma exchange at par, they can reduce the domestic circulation of euro notes rapidly.

    1. "Most living Greeks clearly remember a time when they used drachmas."

      Yes, but they have long since forgotten the array of drachma prices. They are familiar only with the array of euro prices and the evolution of those prices over time. The ease of using this ongoing form of expression and the benefits it provides as a collective body of information is not something that can be easily overcome. Much like the shape of the keyboard has long-since been locked in, so is a nation's pricing language. As I've mentioned in my previous post, countries can overcome the network effects at some cost and during times of stability--but they prefer to do so very carefully and with long lead times. Greece is neither stable, nor does it have time. Even after a drachma's arrival, olive oil producers will continue to post prices in euros, effectively leaving Greece on the same euro standard that it was on before.

      Of course the main reason for not introducing a drachma is that the Greeks don't want one. They've voted for the euro.

    2. I think you're overdoing it JP. Yes, I agree that the transition would be much more confusing and chaotic than it would be if there had been an organized transition plan with a long lead time. But it's just a currency; not a the language of scripture.

      The hypothetical olive oil producer will post prices in euros if it has paying euro-holding customers, but also post prices in drachmas if it has paying drachma-holding customers. This really isn't that big a deal. Companies convert list prices into other currencies all the time when they go into markets where that currency is used.

      Whether a company keeps the books with one accounting measure or another depends on who is demanding to see those books. It's pragmatic. There would be a lot of griping about the transition, but that's what accountants are paid forr.

    3. Think about how dollars and bitcoin circulate concurrently. Tens of thousands of merchants accept bitcoin but set their prices in dollars, basically taking the last-second bitcoin-to-dollar exchange rate as the basis for the price for their goods. The same would occur with drachmas, with euros being the de facto standard and drachma amounts being a last-second calculation.

      It's a big deal because it means you never get a drachma-induced export boom. As with bitcoin, price variations in drachma would be transmitted smoothly and rapidly to retail prices. But sticky prices are what you need if you're trying to lift yourself up via an external devaluation.

    4. I mostly agree, however, promoting export is just one aspect of the potential monetary reform. The other one is that the government would want to continue transferring wealth. And a switch to drachmas helps them to a certain extent, for example by:
      - requiring banks to hold reserves in drachmas
      - preventing banks to offer euro-accounts
      - regulating or taxing transactions settled in something else than drachmas
      - requiring that the debt it itself owes to the ECB/IMF/... be settled in drachmas
      and so on.

      By the way, the Greek situation is a wonderful example of problems of debt-based liquidity: if something fails, someone needs to pay for it and they won't be happy about it. This is why I try to avoid holding fiat. I buy fiat on demand when I need to settle fiat debt (the reverse of what, in your example, Bitcoin-accepting merchants do).

      It is also an example of the Cantillon effect: producing money is a purely redistributive process. If they Greek government can't produce it, they can't redistribute it, rather someone else (like the ECB) will redistribute it. This is also why I try to avoid holding fiat.

  6. Egildo TagliareniJuly 1, 2015 at 6:44 PM

    When we adopted Euro, double circulation and double pricing lasted for a year. Seemed hard for entire countries (especially elderly people) at the time. It wasn't a big deal, as it happened at fixed change rates.

    Anyway, we experienced also that at shop-level, when it came to "compel sellers to re-price" the market forces didn't do so good a job. And that's an euphemism.

    1. "the market forces didn't do so good a job. And that's an euphemism."

      You mean that shops didn't want to make the euro switch?

    2. Egildo TagliareniJuly 2, 2015 at 6:01 AM

      I mean that most of 'em cheated on the conversion, as double circulation & pricing was lifted.
      And purchasers didn't act as the "rational player" they were supposed to be. That's because at the shop level, in the realm of reality, you gotta factor-in even the distance from home, in customers choices.

      So i'd say swapping currency in a developed country is feasible, but it comes at a cost (to be balanced with macro advantages, of course).

  7. Great post, this is my first time reading your blog and a worthy introduction indeed.

    Just a question - I know you're referring to the Professor Sinn's article in Project Syndicate on TARGET2. However, is TARGET2 balance really a debt? Assuming the imbalances totaling up are on account of Greeks withdrawing cash in large amounts or sending moneys out of Greece into safer climates like Germany. Is this not their own money? How does Greece "owe" this money to the rest of the EU?

    My views are shaped by this blog post by Frances Coppola and I'd be really keen to hear your thoughts as well.


    1. Think about it this way. A Greek who banks at Piraeus Bank in Athens sends a 100 euro payment to a German. The German now holds a Piraeus Bank 100 euro deposit. The German wants to cash out immediately. It would be awkward for him/her to drive all the way to Greece to get a 100 euro note. Instead, this individual ask their German bank, Deutschebank, to execute this transaction on their behalf. Deutsche goes ahead and pays the German 100 euros in cash. It in turn tells Piraeus that, having taken on Piraeus's obligation, Piraeus now owes Deutschebank 100 euros. Piraeus can courier some cash the next day to settle and everything is solved. But Target2 allows the Greeks to do something special; they needn't settle that debt at all. Piraeus can perpetually have Deutsche pay out cash on their behalf while letting its obligation to courier cash pile up.

      However, once Greece leaves this system, they'll face the fact that those debts to Deutschebank must finally be paid off. It needs to courier a large cash payment to settle... or default.

      This is a highly simplified story, by the way. But in essence that's how it works.

      Frances's post is sound. But she isn't convincing on Target2 deficits not being debt. I think JKH nails it in the comments section.

  8. Anoop
    It's about the location of the receiving bank vs. the origin of the deposit, not the nationality of the account holder. If a Greek citizen wires his own money to a bank in Germany, the money (not the person) is leaving the country, which is what the target2 balance is telling us. It does not necessarily mean that locals are losing money to foreigners. The Greek banking system becomes indebted to the German banking system, not necessarily Greeks to Germans. That debt, in addition to the national debt is what's on the table in case of Grexit.

    Sinn writes:
    Second, the Greek government is driving up the costs of Plan B for the other side, by allowing capital flight by its citizens.

    1. 'The Greek banking system becomes indebted to the German banking system'
      Not quite. The Greeks have a contingent T2 liability to the ECB, the Germans have a contingent asset with the ECB. At this point everyone has been paid. If Greece leaves T2, the contingent liability becomes an actual liability, which given the circumstances will be repudiated by Greece. It is not the German system that loses its former assets, but the whole ESCB according to the capital key of each nation. That asset was never really an asset anyway. It couldn't be sold. It couldn't be redeemed. It couldn't be foregone. It couldn't be pledged. Its just an accounting identity. Should the ECB be recapitalised by tax payers, then the tax will equal the Greek originated euros now held in the rump euro area. so real net goods that had gone to Greece are a dead loss as there are no 'savings' and there's some redistribution, probably in Germany's favour.

    2. "That asset was never really an asset anyway. It couldn't be sold. It couldn't be redeemed. It couldn't be foregone. It couldn't be pledged."

      I agree with pretty much everything, although I'd point out that Target2 balances do earn interest. So not just accounting blips. They're like perpetual non-negotiable bonds.

    3. Given the interest arrangements, does that mean technical Grexit would occur when Greece suspends interest payments on its T2 liability (they control it), or when the ELA facility is withdrawn (ECB controls it by stating available collateral is insufficient) ?

    4. Thanks Hugo
      Strange, I was always under the impression that countries were on the hook according to their exposure to others. And that that was what Sinn was fretting about. But if not, he's more European than I've given him credit for.

  9. De facto is like the Simbabwe solution. Government income is through payroll tax, business tax, vat, import duties, etc. These are all collected in various types of tradeable forex such as us$, euro, pound, rand, pula. It all goes through the banking system eventually ending up in the government account. Government expenditure is primarily in US $ for wages, services, etc. As the government cannot print these currencies and does not have one of its own then monetary policy is non-existent. Also as it cannot borrow it only spends its income so it has no fiscal deficit. This results in low wages and poor services. Business cannot upgrade so stagnation results. There is minimal inflation.
    Greece can go down the same route but politically difficulties will arise. Greece, reportedly, had a large government sector with employment and services. This has to be paid for and it is not clear that the de facto method will do so. In other words Greece cannot exist without borrowing.

  10. JP

    I'd be interested in your thoughts about this idea that the Greek banking system is currently "running out of cash" in the current ELA freeze.

    I can't find anything written about this, but it seems to me that the constraint is that because of the ELA freeze, the commercial banks are running out of reserve balances they need to purchase the cash for their machines.

    Moreover, I don't see why there is any constraint on the ability of any NCB including the Greek NCB to issue banknotes other than the cost of production and associated operating costs such as transportation. Those costs come right out of the NCB equity position, other things equal. They are minor costs relative to the monetary value of the banknotes. Its not as if the NCB purchases the monetary value of the notes with an equivalent monetary debit, as is the case with the commercial banks.

    The technical question here is what is the correct explanation for why the commercial banks are unable to stock their ATMs with more cash.

    Thoughts? I figure if anybody knows the right answer for sure, its you.

    (Maybe I have it wrong and there's some sort of physical embargo on cash imposed by the ECB, but I don't see it.)

    1. Good question. I wish I knew the answer off the top of my head.

      Another theory is that the ELA freeze didn't directly lead to cash limits. The ECB's decision to cap ELA meant that Greeks could no longer make deposit payments to the rest of Europe. Knowing their deposits were marooned, Greeks would have converted them en masse into something more portable like cash, facilitated by the Greek NCB. To prevent the banking system from disappearing into cash, Greek authorities allowed the banks to narrow their cash windows to 60 euros a day. So the banks can easily stock their ATMs with cash, but are limited in how much they can pay out.

      Just a theory, though. If you find out more, post the answer here.

    2. Nothing more by way of objective description elsewhere.

      But just to elaborate on my own “theory”, I think that the ELA cap and capital controls are complementary. Capital controls prevent the disappearance of reserves from the Greek banking system, and given the ELA cap, that prevents the Greek banking system from going “overdraft” in its reserve position (also reflected in a corresponding Target2 liability increase) by not being able to “cover” that overdraft via ELA.

      In addition, if my interpretation is correct, the ELA cap separately caps the banks in acquiring more banknotes from the Greek NCB – because they don’t have the excess reserve balances to pay for them. This is actually separate from the capital controls issue. Without the ELA cap being binding on excess reserves, banknotes could still be issued even in the presence of capital controls.

      Beyond all that, there are a couple of weird things here:

      a) In a blogosphere that is rife with analysis (correct or incorrect) of such technical details as Target2 flows and ELA etc., I’ve seen nothing on this. Googling it is a bust so far.

      b) It is almost twilight zoneish that the mainstream media is absolutely uniform in how they have described this issue in their reporting. The story goes that the banks are running out of “cash” (banknotes) because they can’t get it through ELA. That is indirectly correct almost by accident. The fact is that the banks can’t get the reserve balances they need to acquire banknotes (if my interpretation is correct) – not that the central bank is holding back the supply of banknotes apart from that. If you consider the acquisition of banknotes then to be a swap at the margin of an ELA liability for banknotes, then the media reporting is effectively correct by way of a shortcut explanation. This is very weird I think.

    3. Some feedback for you from Twitter:


    4. The media is completely clueless on central bank accounting, so it is not surprising they get thus messed up.

      From a balance sheet perspective central bank reserves and paper bank notes are almost identical, so anything that constrains greek banks ability to fund deposit flight with CB reserves is going to apply to bank notes as well.

      Greece seems to be a cash based society, so I think this is why the focus has been on atm withdrawals.

  11. This is a good post and I agree with almost all of it. I'm just going to focus on the disagreements because, well, that's how the internet works.

    When you say that Greek banks are insolvent and that the only way to keep them open, if Greece loses access to the ECB's lender of last resort function, is "bailing in" depositors, I think that is making things too back and white. Yes, it is true that if depositors continue to convert their deposits to cash and/or deposits at non-Greek banks at the pace they have been, Greek banks will not be able to honor those requests without continued new lending from the eurosystem. Obviously, that's why Greek banks are closed now. But, first, there is no direct relationship between the "true" net worth of Greek banks and the movement of deposits. And, second, thre are a numebr of tools to control bank runs available even without the cooperation of the eurosystem.

    On the first point, we all know that solvent banks can be subject to runs -- taht's why lenders of last resort were created in the first place. And on the other side, plenty of arguably insolvent banks do manage to hold onto deposits. It's not like deposits at Greek banks have gone to zero, after all. Insolvency anyway is a fuzzy, uncertain and basically subjective judgement. Greek banks have lots of assets on their books that are probably worthless if the current slump continues but would not be if there is a recovery. Similarly, the desirability of Greek deposits depends a lot on what is happening in Greece. I'm pretty confident that if there were a robust recovery a lot of the run would reverse itself.

    On the other hand, if that doesn't happen, it's not necessary to either shutter the banks or reduce the value of the remaining deposits. There is no reason you can't have a "soft freeze" in which deposits are available for payments within Greece but limits are imposed on conversion to cash or payments outside of Greece. As long as deposits can't leave the Greek banking system there is no need for a haircut. And payment between Greek banks can continue to happen through reserve accounts at the bank of Greece just as now. the only problem will be enforcing the capital controls -- but that's a problem that needs to be solved anyway.

    1. On your first point, if Greek banks could reopen and restore the convertibility of deposits into standard euros without facing a bank run, then that would definitely make an exit from the eurozone (while staying euroized) extremely attractive relative to staying in the eurozone.

      If that doesn't happen and the run continues the implication is that a Greek euro is not worth the same as other euros. A soft freeze would stop the run and allow banking to continue functioning, as you point out above. I am fairly certain that Greek euros would quickly fall to a discount relative to standard euros. This would result in a capital loss to Greek depositors. I think the loss would roughly equate to the size of the hair cut I mentioned in my post. But as you point out, an economic recovery would alter the payoffs. The discount would narrow and maybe a Greek euro would return to par after a year or two. If so, Greek depositors might end up not losing a thing. Incidentally, the hair cut scenario I described would probably have a similar result should a recovery occur. As part of the process of being bailed-in, depositors would get bank equity, and this would rise in value as Greece pulls out of its nosedive.

      A Greek euro scenario brings in a lot of weirdness. How would Greeks set prices, in Greek euros or standard euros? What about the value of existing Greek issued cash, which is marked with a Y on its serial number?

    2. Within Greece, prices would simply be quote din euros. Non-Greek as well as Greek euros would be accepted, altho presumably if a significant discount developed people would not make paymetns within Greece using accounts at non-Greek banks, but would convert them first.

      The tougher question, I think, is what happens to payments by Greeks elsewhere in Europe. But it's important to realize that it would be the rest of Europe that would have to "redenominate" here, not Greece.

    3. On the larger point I agree with you that many of these scenarios could end up at the same place. But I think there is a real benefit to being clear that the first step does not require either redenomination or depositor haircuts. You may in effect get them eventually, they aren't necessary to solve the immediate problem.