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Perhaps more surprising than the results itself was the market’s reaction to Britain’s exit from the European Union: for such a momentous event, it was very mild, not getting materially out of recent trading ranges, and with the FTSE100 (though a poor proxy for the British economy) back where it was before the vote at the time of writing, with only the rather modest GBP re-rating remaining material.

Portfolios almost unchanged

I couldn’t find any noticeable distressed prices in my watchlist(s) and only sold Panmure Gordon, in the Stamp collection, on the grounds that being a small broker focussed on the London small cap market may not be very promising, as business is delayed or shifts to other places. Companies I hold are are biased towards exporters and  otherwise not UK-centric stocks, which has worked reasonably well despite the London listing bias.

Is the market right?

Is the market dominated by trading noise, or is it successfully predicting that Brexit will have little negative impact? Uncertainty will certainly be there but the outcome is hard to predict. Negative scenarios are all other the press, but one can imagine a few positive ones as well:

  • On consumer confidence, ex-UK consumers will probably ignore it, or plan holidays to the UK. UK consumers might prove stoic, optimists perhaps balancing pessimists. It’s hard to imagine that it wouldn’t at least slow down the housing market (in transaction volumes if perhaps not prices).
  • Business investment should be down, from some plans being frozen or moving elsewhere, though the outlook seemed pretty positive before the vote, down a bit from there may remain positive.
  • Sterling devaluation, if it persists, which is not a given, may help a bit. It could also remain at a sweet spot: big enough to help but small enough not to trigger enough inflation for the Bank of England to have to tighten monetary policy. Indeed, business investment slowing down may be all the tightening that’s needed.
  • Last but not least, there may be positive impact from EU re-focussing (see below).
Doc Marteens with Union Jack toe

Britain kicks arse? (credit: I Ransley via Flickr)

The European Union becomes the Eurozone

A potential positive side-effect of Brexit is that it might help refocus the European Union on improving its institutions, in particular finishing off building the Eurozone.

The United Kingdom was perpetually only half-way in, making the whole system an unwieldy variable geometry construction, both adding complexity and slowing down integration as exceptions piled up, and other member states had a strong incentive to get their own special case deals. When membership was irreversible this made sense, but if it turns out leaving has a precedent, that is not an unmitigated disaster, then there’s a way out. Then, variable geometry need not be inside the EU but between EU membership and the various forms of association around it (e.g. Norway or Switzerland style deals).

This enables the EU to become the Eurozone: the Eastern European states are committed to join; Denmark is de-facto in economically as they operate a fixed exchange rate system with the Euro; Sweden entry seems permanently suspended due to a failed referendum, but then they, or other reluctant members, could choose to either come in or leave and get a UK style deal.

So we have both a simpler and clearer framework institutionally, and an incentive to escape the current deadlock on Eurozone construction, as the choice between further integration or dismantlement becomes clearer and clearer. If this works out, it could be of great benefit to everybody, including the UK, which would be (much) better off with prosperous partners.

As a short term little bonus, if some business, financial or otherwise, moves from London to the continental financial centres, it’s a mini-Keyneysian stimulus programme for the Eurozone, which may help accelerate the recovery process.

Maybe the whole world will in the end need to thank UK voters for their selfless, if unwitting, sacrifice.

I think the latest Super Mario move is genius, again, notwithstanding the apparently negative trader reaction.

Not only does a subtle move with tricks that have a potential real effect is probably the best to do domestically for the eurozone (balancing monetary firing power and political capital), but it avoids too strong a move being equivalent to a monetary tightening in the dollar zone, which would make it harder for the Fed to finally do a token rate increase — which is long overdue, if only for signalling purposes and to take that  uncertainty out of the system.

Super Mario and star CGI

Super Mario at work (credit: phobus on Flickr)

What are we going to do when he’s gone?

Much has already been said about the Greek “deal”, most of it unsurprisingly negative. No question it’s a sorry deal in many ways, but I’ll skip that today and try to cover some of the positives.

The Eurozone’s future is now on the table

It has been long known that the euro can be seen as two very different projects: one is a building block on the way to some kind of Federal Europe, the other is a purely technical shared currency, which is doomed to be a form of synthetic gold, because the strength of such a currency is the binding factor — otherwise the stronger members will leave.

Deciding where to go has been procrastinated since 1999 and absent any crises looked like it would be forever. But this crisis has put the debate back on the table. It could still simmer for a while, but I think the debate has advanced more in the past few months than in the last decade.

The historical track record of loose currency unions is abysmal, so if federalism doesn’t progress, we’re probably in for an implosion, if possibly a slow one. I would still bet on (some form of) federalism winning the day in due course.

The Greek debt sustainability debate is over

Today’s Draghi comment that a Greek debt write-off or some kind or other is “not controversial” reflects the speed at which the official consensus has changed. It’s striking that everybody, from the IMF to Schäuble, now agrees on that, despite being a total taboo at least in official speech a few short months ago. Varoufakis has at least comprehensively won the argument here, if not yet a solution.

Defaulting on the IMF was very useful

The catalyst for the above may have been the default on the IMF. Funny how now that the option is full default or a write off by other official creditors, the latter has become their top priority.

Also the silly long term GDP extrapolation modelling methodology has flipped to Greece’s advantage. Now they extrapolate 2 weeks of capital controls to an exhaustive disaster for the next umpteen years.

As such I don’t think a few weeks of capital controls are that bad. No actual production capacity is destroyed, people can go back to work doing whatever they were doing before when it’s over. It could push a few marginal businesses to bankruptcy but I don’t think you can project much out of that. Out-of-model factors will surely have an order of magnitude greater influence on the final outcome. The good thing is IMF models will now probably tend to underestimate Greek recovery, pushing for a better (than otherwise would be) deal.

The deal is technically pretty open

The deal is actually quite open. Everybody seems to expect Greece to get smashed, and it could, but if the politics follow it’s also possible for the deal to produce a reasonable outcome, e.g. the open-end negotiation on debt rescheduling going somewhere decent.

The deal does buy time

As a 3-year deal, if it doesn’t fall on some technical hurdle or outright sabotage, it does leave time for European politics to mature. It would get a bit easier if Tsipras’ Greece wasn’t the only unorthodox (in being of a Keyneysian and somewhat federalist inclination) government in power. In a positive scenario you could imagine both a shift in PIGS and greater tolerance in the Northern countries. It is still pretend and extend, but if we can pretend and extend until the next treaty, and that’s in 2 rather than 20 years, good.

Here and in its open-ended character, it is better than the “referendum question” deal.

Merkel has still not spent any political capital on this

Merkel’s approval rating hasn’t been dented at all and she has effectively not used any of her large stock of political capital, indeed may have again increased it. That can be seen negatively — reward for being tough — but also positively — the “kick the Greeks out of the Euro” constituency may be losing out in Germany.

It also means she’s got capital left for an actual compromise and or federalist steps. Not a given she will use it, but the outlook could be worse.

Benefits of capital controls

As a parting shot I’ve noticed a few positive side effects of capital controls:

  • people with some savings allegedly accelerated paying off debts or taxes, as a bail-in risk mitigation, thereby improving the position of the state and banks, contributing to offsetting some of the negative impact
  • nearly everybody in Greece now has an ATM card (some bank branches were open for that issuing cards) and greater access to online banking
  • it shows how an emergency (semi-)exit could work in a currency union: keep the union currency for paper cash, and use trapped banking currency as a new digital-only currency, by just replacing the exit/ATM limits with an auction system, aka a forex rate between the trapped digital deposits and the union currency

Frances Coppola tries to understand why Greece’s creditors are apparently so stuck into recommending policies that are economically irrational for all parties. Her hypothesis is that the main players see the current programme as punishment — on a moral level — for Greece’s past misdeeds. While some people certainly think like this, it seems a far fetched idea that this explains the situation, or that it is the majority view of the main players.

Theoretical Plurality

First, while I broadly agree that a debt reduction and a stimulus programme (or at least no more austerity) would be best in the current circumstances, I don’t think that this view is universally agreed. Macro-economics is the study of complex highly interdependent systems and our analytical toolset, both theoretical and empirical, is extremely inadequate. Nobody knows for sure what works and what doesn’t. Everybody is making educated guesses, often tainted by ideological bias — when competing models are a draw based on facts, it’s only human to choose based on ideology.

So I believe it’s still possible for some to believe fiscal rectitude and austerity work. It’s all a question of degree: every measure under consideration, taken in isolation, works some of the time to some extent. Is it unbelievable that the like of Wolfgang Schäuble still genuinely believe more austerity would produce the best long term outcome for the Greek and European people? A hint is in the whole ‘schwarze Null’ nonsense, which is about applying a similar medicine to Germany itself. The negative effects are less drastic given Germany is doing okay at the moment, but are still negative in what Frances sees as ‘obvious’ economics. How to explain it then? Self punishment? I don’t think so. One can be rational — as much as one can be talking about economics — and accept the Washington Consensus, as one can be rational and reject it.

Institutional Inertia

Still, is this view that of a majority view of European policymakers, or even the insiders in the institutions? It’s not so obvious, many insiders, prominent academics and finance professionals are on record supporting what we could call the Varoufakis View. Still the institutions remain inflexible. My bet here is that the main culprit is institutional inertia. There’s nobody in the IMF, or in the European Commission, who is in charge of Theory.

Weak leaders like Lagarde, Moscovici or Juncker seem to consider it’s above their pay grade to discuss theory or make any change to the orthodox models their institutions have been using for the past few decades. Everybody under them follows — while on official business, despite some being critical in research papers or in op-eds as ex-staffers — and there’s nobody above them. Minister or head of state level meetings, as Varoufakis has reported, are not places where theory is debated. My view is thus institutional inertia is the main culprit here. The IMF is on autopilot, and it will take some grave trouble for someone to look at the settings of the theory autopilot. A little default on June 30 could well be cathartic.

This is also true at the Eurogroup or European Commission level. The orthodox model is embedded in treaties and the rule set underlying the Eurozone. And renegotiating treaties is hard. Still, it will have do be done, or undone, some day. The current setup is extremely fragile, and if it doesn’t fail during this crisis it will fail during the next.

Both the IMF and the Eurozone are in dire need of structural reforms.

Where’s SuperMario?

The ECB has been remarkably neutral. This can be seen when both sides claiming to have it against them. The Greek side complains being on a tight leash, and they are (no short term financing tricks allowed, ELA allowance always kept to a few days’ worth) but then the orthodox side sees an ever increasing ELA liability — that can be defaulted on in case of exit — that they think should have been suspended, and capital controls introduced, long ago. The official ECB position that Greek banks are solvent with a liquidity problem is a bit farcical to be honest. But maintaining that farcical position seems an astute way to spend the minimum political capital required until a deal is made at the political level. My bet is that Mario Draghi may have taken Varoufakis’ side, but his hand depends on everyone — including Varoufakis himself — not realising it.

It’s to note that a Greek IMF default may be considered a positive for the ECB, as it may help push the commission/eurogroup to do the obvious debt swap and move the shortly expiring Greek bonds off its books and onto the EFSF/ESM, giving more room for manoeuvring by eliminating the risk of outright default on the ECB — which would make it possible to do whatever it takes to keep Greece in the euro.

German bonus ball

It’s really a sideshow, as only some of the players in the Greek drama are German, but I think there’s a great cultural misunderstanding when outsiders blame Germans for being moralistic in a punishing way. First, the whole idea of being externally moralistic towards other cultures is quite alien to the whole postwar German culture, for very obvious reasons. Second, there seems to be a weird Germanic view of causality that’s easily mistaken for morality but is really purely functional. In a nutshell, the person who causes damage pays for it, regardless of whether the damage was intentional or accidental. It’s pure causality, free of moral loadings. Third, the bias towards austerity and balance sheet prudence can be observed in many aspects of German life, including people’s sex and love lives. And who could argue that excess savings in the bedroom are directed from the Bundesministerium der Finanzen?

Chaos German Style (paperclips) Advert

A sense of humour

The general assumption in the Greek crisis is that, in so far as there is one, plan B — Grexit — is the introduction of a new currency. I think that actually Greece using the euro outside of the Eurozone is more likely as plan B. It’s still very unlikely because it doesn’t make sense at all from the point of view of the Eurozone, but it’s fun to play with as a thought experiment, and discussing it may help understand why it won’t happen.

There are well known advantages to having your own currency, but in this case a new currency would have big problems,:

  • Risk of non-adoption by people on the street because they don’t trust it
  • Inflationary spiral caused by the economic situation, the sudden introduction and the above
  • Logistic issues (printing new banknotes, converting contracts) which is essentially impossible to do over the weekend, and impossible to announce in advance

The alternative is just to keep using the euro while being outside of the Eurozone. Like Kosovo does, or like Ecuador does with the US dollar.

Map of euro adoption

Going lilac? (source: Wikipedia)

How would it work out?

Paper money

According to the Greek central bank there are about €2000 of paper euros in ciculation for each person in Greece (the actual number may be more or less depending on net flows of notes and coins from other Eurozone countries, but you’d expect this to be a conservative estimate because of net incoming tourists presumably arriving with more euros banknotes than they leave with). These are not going anywhere in case of Greek exit from the Eurosystem, so Greeks have more than enough paper banknotes to go round for a long time, even if they can’t print their own new ones.

(Note that this abundance of paper euros also makes the risk that nobody is interested in new drachmas higher than it would otherwise be.)

No central bank

Grexit would happen through the suspension of the ELA, which would in turn push all Greek banks into bankruptcy (as a liquidity problem at the very minimum) which in turn would exclude them from the electronic payment systems (SEPA, etc). This would also make the Greek central bank insolvent. They could just close it down, which would allow them to default on €50-100 billion worth of Eurosystem liabilities. If you’re a unilateral adopter of the euro you don’t need a central bank, the ECB remains your central bank, at arm’s length.

Look ma, no debt!

While we’re defaulting, given a primary surplus the Greek government can operate with no debt at all, and will be better off than the status quo, even if they can’t borrow for the foreseeable future. So they can default on the whole debt stock from the Troika lenders, and why not the private sector as well given under a balanced budget they don’t need borrowing at all, so maintaining a good credit rating on the markets is pointless.

Having no central bank, the Greek treasury can operate their payments by opening commercial bank accounts (with no overdraft needed!) like any business, with Remnant Eurozone banks, e.g. Deutsche Bank. They can use online banking to manage it, no need for the banks to have branches in Greece. They can also use new Greek banks (see below).

Capital flight is good for you

With no central bank, the Greek banks would have no access to clearing accounts in the Eurosystem. But there are several options here. First, we can assume they would lose all their Eurozone assets (most being owned by the ECB as collateral, and Remnant Eurozone governments could enact special confiscation legislation for local law assets owned by Greek banks, fair game), as well as their liabilities (ECB funding, etc). What is left is basically the local Greek-law loan book, and local Greek euro deposits. As of late December this was approximately balanced. With capital flight it actually improves every day: the loan book can’t walk away, but the deposits (liabilities for banks!) shrink, and capital = loans – deposits, which gets more positive with every euro leaving. Assuming the impairments on the loans are not too far off fair value, and the Eurosystem exit doesn’t create too much new defaults (arguably a risk, but much less so in the Kosovo scenario than in the own currency one), we have solvent banks. If all else fail, a haircut on remaining large deposits should help rebalance.

Liquidity for non-Eurosystem euro banks

These Greek banks are illiquid outside the Eurosystem though, with no access to clearing accounts, but there are solutions:

  • Sell the solvent domestic loan books + domestic deposits to Remnant Eurozone bank(s) for €1. E.g. National Bank of Greece could become part of, say, Santander, who can get liquidity for their new Greek subsidiary operations from the Spanish central bank, still a Eurosystem member, and they have spare borrowing power there given their large balance sheet. Problem sorted. And Greek depositors get their €100k guarantee backed by Remnant Eurozone taxpayers as their deposits are fungible with domestic Eurozone deposits!
  • With the same solvent loans + deposits as above, perhaps less crap stuff sent into a bad bank type entity, reopen the (New) Greek banks as corporate entities which use Remnant Eurozone corporate accounts in lieu of central bank accounts for clearing. This needs a stop gap for liquidity, by either converting the deposits to term deposits (a soft form of capital controls arguably) or possibly finding bridge loans from external private entities. Given the entire deposit base is below €150 billion and may be much less by the time this scenario would unfold, and not all of it will move after an exit (too late), it should not be that hard to find hedgies to provide the financing.

The first variant brings a more generally interesting question: in a currency union, should financially weak regions have their own banks, or should they bank using the institutions from financially strong regions within the union? The answer is probably the latter, as happens in most centralised countries (e.g. most people in Cornwall do not bank with Cornish banks, but freeload on London banks, and quite rightly so; at an (ex-)country level the ex-GDR part of Germany has a weak indigenous banking sector and banks with West German banks, and quite rightly so).

What are the risks of Kosovoisation?

I may have missed something, but I don’t see many problems with this scenario, from Greece’s viewpoint. Long term, Greece would have no indigenous monetary policy, but they were never particularly good at it and monetary policy is of limited use anyway for a small country. They would loose access to EU structural funds, but then they save €400 billion of debt so net positive here surely. The main short term problem is if the Remnant Eurozone tries to cut private Greeks and private entities from their (non-overdraft) mainland Eurozone bank accounts. Possible but pretty hard, and mean. And hard to justify given all this would be triggered by the ECB pulling the plug in the first place.

Why this won’t happen

It should be obvious now that this won’t happen, precisely because it would probably be an okay deal for Greece, while costing the Eurosystem dearly both in nominal terms of treasury + ECB write-offs, in possibly collateral damage, and a very high risk of an associated cataclysm for the European project. The ECB will just not pull the plug unless Greeks do something really stupid (like printing their own unauthorised euros, they do have a print works I think).

It’s now a commonly held view to say that Greece would have been better off exiting the euro, returning to their own currency in 2009, let it devalue and restart from scratch.

picture of Greek Europa face watermark on a euro 10 banknote

Greek Europa watermark on new series euro banknotes (credit: ECB website)

Devaluation is no panacea

GDP and real incomes are down about 30% since the beginning of the crisis. It’s a lot, but how much it would have been down in real terms (in hard currency) with an exit? Even if we assume no redenomination costs (untangling contracts denominated in euros, etc) and no adoption issues (Greeks keeping using the euro for some of their daily usage because they didn’t trust the new currency, see below) the typical fall in such cases would be likely at least 50%. Then you would get a bounce in nominal drachmas but where would they be now in real terms? -30% maybe? The historical experience of other countries doing devaluations, say Argentina, does not show it as a certain path to unbridled prosperity.

It is likely that the numbers would have looked better at PPP (purchasing power parity) as all local services and goods go down in price in a devaluation. Greece is though a small country which is far from self-sufficiency and imports many goods, including energy, that are not produced locally, thus ensuring the impact of a devaluation would be felt by all.

So, while it’s not impossible that real GDP would have done a bit better with a devaluation, it’s certainly not a given.

Distributional impact of devaluation and Kosovo-isation risk

Perhaps the one advantage of the devaluation route is that it makes everyone with nominal incomes in the national currency poorer. This is sort of good for social equality — we’re all down together — although in the case of Greece it wouldn’t apply to shipping magnates or owners of tourist-oriented businesses (whose products are world-priced in competition with alternative destinations) so the one percent (or a section thereof) would have done okay either way.

For recipients of social transfers, it’s also not obvious which way is best. A pension halved but still in hard currency may buy more than a devalued one. The distribution is different (cheaper haircuts, higher cost energy) so who knows which is better.

One case where it would be worse for the poorest is the “Kosovo-isation” scenario, where people in employment or with any form of foreign income keep using the euro despite the introduction of a new currency, so the currency is only used by state employees and benefit recipients, who spend or exchange it as soon as they can to avoid it losing value. Some say the state collecting taxes in its own currency gives it value, but not necessarily: people can just convert from euros, or whatever the street currency is, to the tax currency the day before a tax payment is due. In this case the new currency may just go into a death spiral which is combining the disadvantage of a hard currency with those of a local one.

Tsipras is the Troika’s child

Creative destruction has a bad name, but it does, to an extent, work. A problem with everybody getting poorer together in a devaluation is that there are fewer reasons to change bad habits and people can just plod along in their mediocrity until the next round.

Greece had and may still have a dysfunctional state with poor tax collection and poor value for money when delivering services, that is not providing a well working framework for a modern economy. For example, clientelism is central to Greek politics which means people are given jobs they may not be qualified for or productive in as a reward for political support. This is not only a direct net cost to the Greek taxpayer (compared to employing productive people at market rates), but also an opportunity cost as these people may have otherwise found more productive use for their time. Even for the beneficiaries of state largesse, being stuck in dead end careers in comfy but meaningless jobs may not be that fulfilling.

The crisis has allowed Greece to make some progress on this, no doubt with some collateral damage. To know if the devaluation solution would have been better, we would need to know whether there are net benefits to the shock therapy, and how they compare with reforms possible, or not, under a devaluation scenario.

There may be more progress to come as Tspiras, being an outsider can break lots of allegiances that were untouchable for the incumbent. It is quite plausible that his government makes some progress that would have been impossible, or taken decades more, in a sleepy repeated devaluation cycle where a newcomer like Tsipras would have remained permanently unelectable. If Tsipras is the Greek Lula, and the euro crisis made him possible, it may not be a bad thing for Greece.

What now?

In any case, whether the benefits of devaluation then would have been real or imaginary, it’s a bit too late. Exit at this stage would probably be the worst of both worlds, by creating a real term depression at a moment where there are not many benefits left from it. Both Tsipras and the Greek electorate seem to be wise to that.

The main remaining open question is whether they obtain a satisfactory compromise on the large debt stock. Tsipras has new reforming powers to bring to the table. Many of his proposed reforms are compatible with fiscal responsibility (anything that attacks clientelism, or the economic privileges of the Orthodox church, or effective tax collection from the rich). Besides it seems they understand they need to keep the nominal debt untouched, which allows Northern governments to sell a deal to their own electorate more easily. What they need is lower outgoing cash flow for the next couple of years, which any combination of rescheduling, lower interest, or interest capitalisation can do. The situation further ahead can be dealt with later on. A partial (or total) conversion to GDP bonds would also be a good compromise: Greece pays if it does well (as it would with the current setup) and doesn’t if it doesn’t manage (in which case the current setup produces sooner or later a hard default).

The tricky point for the negotiation is perhaps whether they manage to isolate Greek banks from the Greek treasury. If Greek banks were either self standing, or taken over by a eurozone body (EFSB or whatever) then the Greek treasury could suspend, or threaten to suspend, official sector repayments without as such causing a disaster. They could be kicked out from the eurozone for that reason, though that would probably, ironically, require a treaty change and unanimity, that is it would be practically impossible unless they behave really really badly. And if everyone knows that, they’ll do a deal before we get there.

Maybe in 20 years time historians will see that the euro, somewhat inadvertently — or perhaps by design if we consider the euro as a federalist pre-commitment device — helped Greece extricate itself from its own failings. And perhaps save the EU from it own failings in the process too.

I’m adding a new category, divination, for predictions. Macro predictions are a mug game, of course, but I sometimes feel I make fair calls, so it’d be good to keep a public record, in order to prove scientifically that I’m actually as crap at it as everybody else.

Image of street performer looking at a crystal ball

Not your blogger (credit: Hadouken@Wikimedia)

Claim 1: new stock market peak before year end

So the prediction of the day is that the current market correction is not far from its bottom as the short term pessimism bubble reaches a peak. It wasn’t that big a correction anyway — stocks going back where they were 2 months ago, real yields crossing zero!, big deal all that — and the fundamental situation seems to be fairly OK. Monetary policy may not be optimal but it’s not too much in the way either, and the perceived dangers seem to be mostly storms in a teacups. Apart from that cyclical forces seem to be pushing up. To quantify the prediction, let’s say that the stock markets will touch May record highs again at least once before December.

Claim 2: Greek bottom in 2013 or 2014

I looked up my past predictions and have really only made one post with one previously, about Greece, in Febuary 2012 which was overall approximately correct. They even improved point #2 as the EU is now funding Greece through debt relief via accounting tricks (the buy backs last year, maturity rollovers, rate discounts, etc) which are actually an improved way to do what I was suggesting.

To make a new prediction for Greece I would say that nominal GDP will bottom this year or next (to be checked a couple of year afterwards, say end 2016), for similar reasons as the world markets bouncing back. At some point every body who has survived that long will probably keep going, the primary budget balance puts the Greek government in a better negotiating place, and with sentiment, at some point you can’t get much more desperate, and then the only way is up (however slowly).

Disclosure: long 17500/18000 December Nikkei call options spread, which is in part a play on the first claim; no position on Greece.