The European monetary crisis explained

Why each country of the eurozone will return to a local currency for its domestic affairs. Arguing for internal and external currencies. Foreseeing a future private international currency.
Free online accounting course by Andr Cabannes, PhD Stanford University, California, USA 10 July 2011

We explain why the money inside a country has nothing to do with and should not be the same as the one for external trade. We take the example of the Greek crisis and show that it is the consequence of the confusion between the two. Greece is only the first in a series of countries where the same problems will arise: Italy, Spain, Portugal, Ireland, France. We do not advocate the withdrawal of these countries from the euro, but the use by each country of two currencies: its local currency and the euro. We show that in recent decades China is the only country which applied the principle of separation of internal and external currencies. Finally we explain why we believe that a new private international currency will appear.

Table of contents data on Greece adoption of a common currency in Europe continued Greek budget and trade deficits, borrowing euros threat of default monetary straitjacket what will happen next? - a local currency the point of view of experts, lenders and European officials the case of Germany German and French debts are quite different what to think of the opinion of bankers? money is a spontaneous social phenomenon internal and external currencies the contribution of scholars arguing for a new monetary organization

how to handle a multiplicity of currencies Greece is not leaving the euro a "historical solution" to rescue Greece history repeats itself, let's remember Argentina Europe does what it reproached Greece for doing the case of China a realistic partial solution for Greece a new private international currency to go farther

Greece

2010

2011 (forecast in June 2011) -3,5 -9,5 6,7 -2,8 158 n.a. 15,2

2012 (forecast in June 2011) 1,1 -9,3 7,4 -1,8 166 n.a. 15,3

GDP (billion euros) Growth of GDP (%) Budget deficit (% of GDP) Interest on public debt (% of GDP) Budget deficit w/o interest on debt (% of GDP) Public debt (% of GDP) Current account deficit (% of GDP)

236 -4,5 -10,5 5,6 -4,9 143 -10

Unemployement rate (% of working 12,6 population) sources: European Commission, Eurostat, Bank of Greece

Adoption of a common currency in Europe The major European countries in the 1990's decided to have a common money. They set aside the currencies they each were using previously and instead dealt themselves euros. From then on Europe had a single currency. In the 2000's Greece and other countries joined the group to create some sort of European federation. The operation each time is the same: Greece relinquished its drachmas and received an equivalent amount of euros. Henceforth the country could buy goods and services anywhere in the eurozone with its euros. Let's see how it lead to the present monetary crisis, and what is likely to happen next.

Continued Greek budget and trade deficits, borrowing euros To understand the problem of Greece, we ought to distinguish monetary flows within the country from those across borders. They entail different accounting records, liabilities and problems. And within the country, let's focus on one very special economic agent, the government, the revenues of which normally come from taxes.

Within the country: the Greek government kept its economic policy which consisted in spending more than it received from taxes and minor state entrepreneurial activities, and, in the past, printing drachmas to make up for its budget deficits. It amounts to a fiscal and monetary policy where tax revenues are produced with the printing press. Some mediterranean or latin societies (Greece, Italy, Spain, Portugal, France, Argentina, etc.) prefer this system to price stability, which has other advantages and drawbacks. Across greek borders (1): The Greek government began to borrow euros mostly from foreign investors. Big European lenders (Socit Gnrale, Deutsche Bank, etc.) were happy to lend to Greece, because the interest rate was high, to take into account the risk, and at the same time they knew that Europe would refund them should Greece fail. These are euros flowing into the country and corresponding promises to pay back later including some interests (= bonds) flowing out. Private Greek agents too borrowed within the country as well as abroad. Across greek borders (2): in parallel to its budget deficits, Greece trade went into deep imbalance. Somehow the country indulged in a spending spree with its new money buying goods and services all over the world much more easily than with its previous drachma. Greece paid its imports in part with exports (tourism, textile, ore, food products, etc.), in part with promises, and in part with euros, which left the country.

Threat of default The Greek State is nearing defaulting on its foreign liabilities, and it is running out of euros for domestic expenses. The eurozone, feeling concerned, hesitates on what to do. Should we abide by the liberal credo. Let Greece go under - what does that mean about a sovereign State? -, let's buy the Parthenon like China all but did with the Piraeus. Or should the eurozone act as a community, taking temporary control of the government of Greece? Angela Merkel opposes extending Greece further loans from the ECB and prefers to reschedule current payments due. Nicolas Sarkozy favors new loans in euros from the ECB, IMF, private banks or funds, because France and its own alarming twin deficits is not far from the situation of Greece. Jean-Claude Trichet, the head of the ECB and de facto of the eurozone, opposes rescheduling payments to private banks because it would amount to defaulting and trigger the same process all over Europe. He prefers a formal solution from the IMF (which means not much more than SDR movement entries in books kept in Washington) or, in opposition to his staunch stance until may 2010, that the ECB print yet more euros recorded as a credit in

the liabilities of its balance sheet, or open new accounts in credit, to exchange with sovereign debt from a member of the eurozone, whose bonds would go as a debit in the assets of the ECB. Trichet buckled under the pressure of eurozone debtors. Notice that a bond purchase by the ECB, despite some medias sensational presentation, requires no particular effort from anyone in the eurozone. Yet it contributes to corrupting its money and prepares the ground for a monetary tsunami in Europe in not so distant a future. Monetary straitjacket Meanwhile, the Greek government began to reduce the salaries of civil servants, pensions of retirees and public spending. A growing number of Greeks don't have enough money for their everyday expenditures, and therefore shops and local producers suffer as well. The whole country is simply running out of the official money. What will happen next? - A local currency When in a community there is a dearth of monetary means (to facilitate production, exchange and consumption), however, we can simply create some new ones ex-nihilo. It becomes a "local money". States (or Europe in this case) disapprove strongly of this because money is one the pillars of State power, although one could say that it is none of their business to interfere with the way a local community organizes its internal exchanges (see for instance household money). The emergence of local money happened in many places, and the phenomenon is accelerating at the beginning of the XXIst century, mostly as a consequence of the computer revolution. We foresee that it will happen in Greece. The Greek government will begin to pay its civil servants and state pensioners in part with something that may be called a "temporary system of vouchers", and for convenience it may write on them whatever name they like, for instance "drachma" or "eurodrachma" (introduced with an exchange rate 1Dr = 1 with the euro). These will be usable to buy goods and services in Greece, and it will be forbidden to refuse them. And if the government doesn't do this, it is even conceivable that some private outfit do it. The point of view of experts, lenders and European officials

Experts are yelling: "Greece will leave the euro", "It's a catastrophe". They do not explain precisely why, and seem to prefer witnessing the economic activity of Greece decline, street riots burst and poverty set in, but in accordance with a strict budgetary and fiscal policy within the eurozone, to seeing the revival of the Greek economy with a monetary policy adapted to the situation. Lenders are worried, for good reasons: there is a risk that they lose money on risky loans; to be more explicit, there is a risk that the principle "your profits are yours, your losses will be taken care of by Europe" be no longer applied. And they are opposed to the introduction of a local money in Greece, officially "because we must pursue the construction of Europe,

etc.", in truth because this local money, which would restart the Greek economy, would make it even more doubtful that international investors be repaid fully their claims on the 350 billion public debt in euros. Hedge funds entered the game, buying second hand Greek debt at firesale price, betting that Europe will still give Greece the means to fulfill all its obligations.

Civil servants in Brussels and big countries are indignant: "We are unravelling the construction of Europe!". Generally speaking, they look at the future with intellectual frameworks of the past, in the same way in the 1920's the big powers desperately attempted to go back to the gold standard with the dire consequences of the 20's and 30's. For instance in 1925, Churchill, then Chancellor of the Exchequer, following the recommendation of experts, set the value of the pound sterling back to1 troy oz 11/12th = 3 17s 10d (the exchange rate set by Newton!) hurling Great-Britain into six years of depression. Likewise European officials are focussing on the construction of the United States of Europe and such likes, when, in our opinion, the future belongs to networks, on the model of families making up a city, of much smaller autonomous communities than present day heterogeneous nations inherited from the XIXth and XXth centuries. They would use a local currency, and one or several currencies for trade in higher level groups (see multiple currency monetary systems).

The case of Germany In 1990, West Germany reproduced with East Germany the same mistake Churchill made in 1925. After the reunification, Germany decided to set the value of one eastern mark to one Deutsche Mark (the western mark). This was equivalent to going back to the gold standard with the overvaluation of the pound sterling when it was set to the same value of gold it had before WWI. The consequences were the same: East Germany (five new lnder) went into a depression because its prices were suddenly to high. West Germany kept pouring money into its eastern part to try and compensate this phenomenon. To no avail: ex-East Germany is now a wonderfully equipped region with brand new freeways and other infrastructures but a weak industry. Germany spent more than a trillion euros in this pursuit, which explains a substantial part of its public debt. German and French debts are quite different It is tempting to compare the German and French debts (respectively 76% and 83% of GDP), but they have entirely different causes and structures. The French debt comes from a chronic fiscal deficit since at least the early 80's combined with a trade deficit for the last seven years, of the same nature as Greece's. Furthermore 2/3 of France's public debt is held by foreigners (without counting French banks financing itself borrowed from abroad), when Germany's public debt is more internal. And Germany on the other hand has had for years one of the world strongest trade surplus, which lead it to lend euros and dollars. France will experience the same problems as Greece, while Germany won't.

What to think of the opinion of bankers? Bankers will say that returning to local currencies is preposterous and impossible to implement, but let's not be overly impressed. Over the past few years, the same bankers created the so-called subprime loans, packaged them, sliced them, securitized them, and resold them to investors all over the world, and the latter finally incurred losses estimated by the Bank of International Settlements at four thousand billion dollars. Money is a spontaneous social phenomenon Those people forget that monetary phenomena are always and everywhere (to paraphrase a famous sentence) spontaneous social phenomena. Despite the scarcity of official monetary means, nothing can prevent the Greeks from organizing their production, exchanges and consumption somehow with a system of signs. That's what a money is. Why should Europe thwart it? Internal and external currencies The medium within a community to facilitate its internal operations has nothing to do with, and should not be the same as, the one for its external trade. Had human beings the possibility to easily give their blood to buy stuff, we would observe some people running out of blood and dying. Fortunately nature saw to it that it be impossible. The contribution of scholars Scholars did study something they christened an optimal currency area, and speculated whether the eurozone was one (or would become one). Suffices to say that Robert Mundell, who attached his name to the theory, successively explained that the euro was a good idea because the eurozone was an optimal currency area, and then that the euro would fail because the eurozone was not an optimal currency area. In the seventies, in Germany, a slogan making fun of the SPD went: "Like the SPD, be for and against nuclear power."

Arguing for a new monetary organization Communities forming a group should be left with the freedom to use at least two currencies: each community its own internal currency for domestic affairs, and the external currency of the group for exchanges between them. If you believe that this sounds intricate or strange, observe though that it is exactly what Europe did: for its internal affairs it created the euro, and for its external trade it is mostly using another currency, for the time being the dollar. To think of several currencies in one's purse may be disturbing. Notice however that most people would have only one: the local currency. The others would have currencies for trade which have no interference with the money regulating exchanges within the community to which they belong. How to handle a multiplicity of currencies At present, mid-2011, having in our purse different currencies for the various

communities to which we belong (city, region, state, eurozone, world) may seem intractable, and science fiction like. However when payments with our mobile telephones become generalized it will be very easy with modern database systems, managed by powerful organisations, to handle payments with a multiplicity of currencies by everyone (see multiple currency monetary systems). Greece is not leaving the euro Greece will still use the euro for its exchanges with other countries in the eurozone. But it is crazy to choke the domestic economy of Greece by imposing on the country the use, for its internal activities, of an external currency, the quantity of which owned by Greece decreases. And it is no less crazy to try and solve the local problem of Greece by corrupting the global money of the eurozone. * 22 July 2011 A "historical solution" to rescue Greece On July 21st, 2011, the heads of the seventeen eurozone countries after several heated meetings to decide what to do reached an agreement. They opted for a traditional solution: to grant a further 158 billion euros to Greece, coming after the 110 billions granted last year. They'd gotten their calculations wrong last year? The new package comprises IMF help, ECB purchases with euros wet from the printing press, payments rescheduling, new Greek debt guaranteed by the whole eurozone, etc. The finance ministers presented this as a historical solution to the Greek problem. In our opinion, it is everything but that. It is only costly window dressing to buy more time for a moribund system. All the fundamentals described in this note remain and will inescapably lead to a local currency. History repeats itself, let's remember Argentina A very similar scenario unfolded in Argentina in the 1990's: currency board with the dollar, budget deficits, flight of dollars from the country, ever increasing loans from the IMF and other foreign lenders, and swelling public debt. When the credit tap was eventually turned off Argentina defaulted on $103 billion of debt. It lead to a surge in poverty and riots at the end of 2001. It also wiped out the savings of many small investors worldwide who had trusted the country (and the IMF). In January 2002, Argentina finally unpegged its peso from the dollar, which is equivalent to going back to a local currency. In the present Greek scenario, we are at the stage of the ever increasing foreign loans. * *

8 August 2011 Europe does what it reproached Greece for doing After the latest declaration of the ECB's president saying that the central bank will

"reactivate its programme of purchases of sovereign bonds in order to avert a European monetary crisis" (now to purchase Spanish and Italian bonds), let's observe that Europe is doing precisely what it reproached Greece for doing: printing banknotes to finance internal expenditures higher than internal revenues. It is legitimate to think that JeanClaude Trichet, even if he will never publicly admit it, has accepted that the euro be scuttled, and eventually sink and disappear. As of August 15, 2011, the ECB has bought back 96 billion euros of sovereign bonds issued by Greece, Portugal, Ireland, Italy and Spain. * * *

The case of China In recent decades, China is the only country which understood and successfully applied the principle of separation of internal and external currencies. It used the dollar for its foreign trade and the yuan/renminbi for its internal affairs. It applied the separation principle in its strict version, taking measures to prevent the yuan/renminbi from becoming an international currency. After 1980, it became again a strong exporter (as it has been during most of history since Roman times). Its dollars were employed to import goods and services, to make foreign direct investments (in Africa for instance) and to buy foreign securities, mainly US Treasury bonds. Unfortunately these are likely to lose much value, and it is not a solution for the future. A realistic partial solution for Greece Greece still has euros, for its internal affairs as well as for foreign trade. The euros used for the domestic economy of Greece are a monetary nonsense. They can be transformed into "eurodrachma". The Greek government may decree authoritatively that all bank accounts of Greek citizens in are now bank accounts in Dr. The euros gained by the governement with this decision will be used to pay the interests on the foreign debt and begin to amortize it. It is also the solution France will be forced to implement, probably right after the presidential election which takes place in May 2012 (not to mention Italy, Spain, Portugal, etc.). A new private international currency We believe that in some future a new international currency privately managed by a firm (for instance Google) will be the trusted currency of the community of nations for their trade. The paradoxical situation, since Bretton Woods, of the dollar, being at the same time the sovereign currency of one country and the world international currency, will end. Like every monetary phenomena in history (with the exception of central banking in the XIXth century) the appearance of the new private currency will be inconspicuous, spontaneous, and overwhelming.

Andr Cabannes PhD Stanford University, California, USA