May 29, 2012
David R. Kotok
The drachma, the Greek currency name, is over 3000 years old. It was the most widely circulated coin in the world prior to the time of Alexander the Great. Readers may enjoy a few minutes of study about Alexander the Great. His was the Macedonian conquest of Greece and the rest of the ancient world. His education came from Aristotle who was his tutor. He changed the political geography of the Balkans and the Mediterranean. See a few notes at the very end of this commentary.
Back to the drachma.
Since reintroduction in 1832, all modern Grecian drachma forms have ended badly. The single exception WAS the exchange of the drachma for the euro in 2001. That chapter of Greek history is being re-written now.
The worst Greek hyperinflation was during World War 2. At its extreme, the Nazi-Fascist occupation Greek government inflated at rates similar to recent Zimbabwe or the infamous Weimar Republic. At one point Greece issued a 100,000,000,000-drachma note. Greek monetary history also includes one previous failure in a currency union (The pre-World War 1, Latin Currency Union).
After WW2, Greeks attempted to halt inflation with entry into the Bretton Woods fixed currency regime. They created a new version of the drachma by replacing the old one at a ratio of one new drachma for every 1000 old. When the Bretton Woods structure reached its demise in 1973, the then new version of the drachma declined in value. The post WW2, revalued drachma was 30 drachma to 1 US dollar at Bretton Woods entry (1954). The drachma reached about 400-to-1 US dollar prior to Greece joining the euro in 2001. In 2001, when Greece was admitted to the Eurozone, the official exchange rate was 340 drachma to 1 euro.
Will there be a “new” drachma? If yes, what will it look like?
Money has three basic characteristics. They are: (1) unit of account. This is how we enumerate a price or a debt. (2) Store of value. This is the issue of “trust.” Does money hold its value or does it lose the value to inflation. (3) Medium of exchange. This means acceptance, by others, of the money as a form of payment.
Nothing in modern Greek history suggests that a new drachma will qualify on any of these three measures. Modern Greek monetary history is one of default, inflation and destruction of wealth when the wealth preservation was entrusted to the government. Centuries of history support this statement.
Of course, any new Greek government can “force” its citizens to accept a new drachma as payment of obligations issued by that government. Greece may elect such a government on June 17. Argentina imposed force with the peso after it repudiated its governmental promise to maintain the peso at parity with the US dollar. In the Argentine case, the peso quickly went from one to the dollar to three to the dollar. Years later, Argentine citizens are still paying the price for their government’s monetary failure.
If Greece leaves the Eurozone and launches the new drachma, the internal outlook for a post-Greek exit of the euro is destruction of remaining Greek wealth, confiscation through taxation, high inflation and monetary turmoil. That is what would happen within the post-euro Greece. That is a repeat of Greek history.
The external (outside of Greece) outlook is worse. The private holders and investors in Greece have already been crushed and burned. They are no longer involved in the decision-making. They avoid any Greek obligations. They function on a cash basis only or with secured or hedged letters of credit. The Greek stock market has been decimated; its percentage decline exceeds the losses of American markets during the Great Depression.
The Greeks owe several hundred billion Euros to European and international institutions. That debt cannot be paid. The Greeks do not have the money. Holders of those obligations are mostly governmental institutions now. Those institutions can hold obligations for a long time and can negotiate political changes in the structure of those obligations. Meanwhile the related institutions can also defer the default impact by postponing recognition of it while they negotiate. In sum, we are not worried about losses on Greek debt by the ECB, IMF or others.
If Greece were to leave the Eurozone unilaterally, we expect that the post-euro Greece will have no market access for years. Greeks, with a new drachma, would function on a mostly cash basis in making their external payments.
Were Greece to exit, other European commercial and banking holders of Greek obligations would have to take more losses. They already know these exist in principal. They would need to mark-to-market. That means they will have charges against their capital and may need infusions of new capital. The equity owners of those commercial institutions will suffer losses. Many already have lost as the markets are adjusting prices to reflect this risk. These losers are the banks in Europe, the insurance companies in Europe and others who are involved in the finance of the Eurozone.
The last element in this litany applies to contagion risk. We already see contagion at work in Portugal. Credit spreads are telling us that Portugal is the next Greece. It remains to be seen if the market is right or the market is overreacting. We also see contagion signs of trouble in Spanish spreads, in Italian spreads and even slightly with France. The French benchmark 10-year bond now trades over 100 basis points wider than the 10-year German benchmark “bund.” The lessons of losses from holding Greek sovereign debt are fresh. Bondholders of the other countries’ debt fear repetition with good reason.
No one knows if Greece will leave the Eurozone. Many are privately and contingently preparing for it, while publicly saying they do not want it to happen. Electoral outcomes are unpredictable, even though polling results influence markets. In the end, Greece has already lost. Europe has lost but can still cut further losses if it acts with congruence. We do not expect that to happen in any pro-active way. It is not in the nature of Europe’s political leaders to reach consensus pro-actively. They do so when forced by market events. We must think of European leaders as reactive, not proactive.
“When you’re in a hole, stop digging.” 1989 U.S. News & World Report, 23 Jan. CVI. iii. 46 (headline).
The Eurozone leaders had the chance to stop digging when the Greeks restated their macro numbers after they entered the Eurozone. Those leaders were publicly silent, privately enraged as I heard with my own ears, but publicly silent.
Eurozone leaders had another opportunity to stop digging when the Greek government lost its high credit rating. Instead, they bent the rules and permitted Greece to maintain its collateral standing. Eurozone leaders had repeated chances to stop digging as the last two years have unfolded. Eurozone leaders have failed at pro-active decision-making.
They have another chance right now but, so far, they have failed to act decisively. Eurozone leaders continue to extend credit to Greece. The present form is the expansion of the Emergency Liquidity Assistance in Greece. Europeans fear a contagion from bank runs that would collapse the Greek banking system. Meanwhile the ELA is only expanding the liability for the rest of the Eurozone as it waits. At Cumberland, we are tracking the ELA continuously. It is telling a story of accelerated deterioration.
Europe’s contagion risk is high and rising. Banking runs in weaker Eurozone countries are likely to continue. Why would any sane depositor keep her euro in a weak bank while she can move it to a safer bank in another country?
My colleague and Cumberland’s Chief Global Economist, Bill Witherell, is in Europe and just finished several days at the GIC meetings, which included eight central bankers. Greece and the other periphery were an ongoing topic of discussion.
Bill emailed me his conclusion. “The decision for Greece exiting is really up to Greece. There is no provision in EC law for kicking a country out. It could be done with a unanimous decision by the EC heads of state. The problem is that Greece wants to stay in but the majority appears not to be willing to follow through with the austerity commitments already made. They will not be able to meet their financing needs without further funds from their creditors. The latter will be quite unwilling to continue to help if Greece refuses to keep its commitments. Is it possible we could see a messy restructuring/default but with Greece remaining in the Eurozone? Portugal Is not Greece no matter what the bond vigilantes may think. I think the Eurozone members, the ECB and the Portugal government will do whatever it takes to see Portugal through a difficult period. The same goes for Spain and Italy. Incidentally, in the Sat. FT there was an article saying over a long time period, half the time Greece was in a default/restructuring situation.”
Thank you to Bill, who responded to my email between airports in Cracow and Paris. Bill will have more to say about Europe in the coming days.
So, when you’re in a hole, stop digging. If you are not in a hole, don’t go there.
At Cumberland, we have avoided the “hole.” We do not own peripheral Europe. We have underweighted total Europe but do own some exposure in the north. We are now worried that France can weaken so we do not own France’s ETF. We are more worried about Italy, the world’s third largest debtor. We remain concerned about the outcome in Spain. We fear a reprise of Greek tragedy in Portugal although our base case is that it won’t end in a Portugal default. In any case, we do not own, Greece, Italy, Portugal or Spain and currently are avoiding France.
As for the new drachma, it is not a panacea.
Some Notes follow:
(1) The word panacea has its roots in the Greek word panakeia, which means all healing. Such is the irony of language.
(2) Ancient Macedonia is not to be confused with the present day Republic of Macedonia, a part of the former Yugoslavia.
(3) Macedonian King Philip II, the father of Alexander the Great, united ancient Macedonia with successful military campaigns. He created the platform for his son to conquer the world. Philip’s success 24 centuries ago had two elements that were new to warfare at this time in antiquity. He expanded the use of heavy cavalry. Ancient Macedonia had the ability to support horses in larger numbers than more southern Greek agricultural states. Philip incorporated heavily protected horses in the construction of his Phalanxes. The phalanx is the name of the battle formation used in ancient times. Philip added a long spear (sarissa) to the front lines of the phalanx. It required two hands to hold it and was about 18 feet long. That allowed the first five rows of the phalanx to hold spears as they marched to face the oncoming phalanx. Shorter spears meant only the first two rows of men could use spears to penetrate the opposition.
(4) The island of Delos is famous in Greek mythology. It is also the original seat of the early Greek monetary authority. After the Persian wars, the island became the natural meeting-ground for the Delian League, founded in 478 BC. Those congresses were held in the temple. The Delian League’s treasury was kept on Delos until 454 BC when Pericles moved it to Athens. Thus, we surmise that the original Greek monetary policy was determined on Delos. It must have been successful since the drachma was universally accepted at that time.
David R. Kotok, Chairman and Chief Investment Officer