Tuesday, May 29, 2012

Old-fashioned remedy for the euro disease

The economic situation in Spain worsens by the hour. Today we learn that retail sales dropped by 10% in April, compared to same month last year. Banks are virtually bankrupt, unemployment reaches 25%. The Spanish economy risks a complete collapse.
Spain may of course hope for external help from Brussels and the ECB, but there are chances that such help will amount to too little, too late. Spain needs to do something, although the range of actions it can take seems rather limited.
One thing it could do, as aearlier post advocated, is take liberties with the euro. This post gets back to the subject and examines a concrete example of how it could proceed.

Spain would emit promissory notes (IOUs) in order to relieve its economy in two ways:
  • Inject liquidity in an economy paralyzed by a credit-crunch.
  • Help finance a budget deficit that amounted to 8.9% in 2011, and that Spain would be supposed to reduce to 5.9% in 2012. If it tries to do so, additional austerity measures will aggravate the recession (and possibly trigger the collapse), if it does not, it will face prohibitive rates and won't be able to get the money from the markets.
One thing those notes would not achieve however is restore Spanish competitiveness through devaluation (which would happen with an overnight switch to the peseta).
There are certainly many ways in which a promissory note scheme may be designed. Let's see what it could look like:

  • The Spanish government discloses in advance all details of its scheme (because promissory notes, just like money, require confidence, and thus transparency).
  • Notes (IOUs) entitle the holder to receive a payment in euros on June 1st, 2015.
  • Each month, the government emits notes for a maximum nominal amount of 4 billion euros, for a limited period of two years. That's roughly half the deficit, and 10% of the budget.
  • IOUs are issued in notes of 1, 10, 100 or more euros and printed on paper. They are directly used to pay for the domestic expenses of the state, according to a given ratio (a civil-servant making 1,600 euros a month would receive 1,400 euros and 200 "notes" to be withdrawn at a post-office). 
  • The notes bear no interest. Technically, this means that the beneficiary of the note offers a discount to the Spanish government. With 3-year market rates at 5%, notes are worth about 86% of their face value at the moment of emission.
  • One the face of it, not much different from money
  • Banks are allowed to open current accounts for notes. They can offer short-term loans in notes, and exchange euros for notes, or conversely, at market rate.
  • In addition to the scheme, the government implements reforms for improving competitiveness (and having a more flexible labor market). 
Several questions must be positively answered for the system to work:
  • Would civil servants accept to be partially paid in notes ? This is highly likely. In the example above, the civil-servant would abandon 1.75% of its salary, a decrease that would remain mostly virtual if the the civil servant is able to buy things with the notes.
  • Would merchants then accept the notes ? This is again quite likely. In the depressed state of the Spanish economy, they would rather be glad to sell anything at all. In which proportion they accept notes, or whether they accept them at face value, may in fact soon become key selling points.
  • How would react the international financial markets ? This is a more debatable question, but it not unreasonable to think that markets would welcome the scheme, and that the rates on Spanish Government Bonds would return to affordable levels. What we've seen in the crisis so far is that the markets are wary of Brussels inaction, but react favorably to anything that looks like a solution, even a partial or temporary one (markets have been quite keynesian so far, in showing some distrust of austerity - dig Krugman's blog for evidence).
More liquidity, less fiscal pressure. Would that be enough to restore growth? Maybe, maybe not, but at least it would help. And apart from growth, it should also have a positive side effect on banks.
People won't exchange their notes for euros. They will as much as possible do the opposite, spend notes and save euros (Gresham's law: bad money chases out good), lowering the pressure on the balance sheet of banks.

The scheme displays additional tactical advantages:
  • It puts pressure on Brussels and the ECB. As they might not like the scheme, they will have more incentives in coming with their own solution.
  • It provides Banca de España with the possibility of becoming lender of last resort for commercial banks (in notes). Although such a possibility should be clearly announced at the start of the scheme.
  • Should the events turn nasty elsewhere in Europe (and that can happen any day), Spain could make its scheme more aggressive.
Suppose now that after a couple of years growth returns (thanks to the scheme or for whatever reason). Spain would balance its budget, and rates would reflect the confidence of the markets. Spain would be in position of repaying its notes as intended and ending the scheme.
Or it could renew it and use it as a monetary tool to place in the hands of Banca de España rather than those of the ECB. Since such a tool would work both ways, it would help prevent the next housing bubble.
And if growth does not return, Spain could more easily decide to exit the euro and switch to the peseta, since the transition would have been facilitated by the existence of the notes. By the way, that's a reason why notes should not be called pesetas in the first place (although they are technically not much different). If the initial intent is not an euro-exit, people should not be made to believe it.

It must be noted that such a scheme is more promising if the debt level is low, the government credible, and the economy structurally healthy. Spain displays all three conditions, Greece none of them. It is however quite likely, and most unfortunate, that Greece will have to experiment IOUs first.

Such a dual currency system is neither odd, nor creative one. It is old-fashioned. We now increasingly hear that the euro replicates the gold standard. But the euro rather replicates gold itself. Under the gold standard, national economies had national currencies pegged to gold. In the eurozone, national economies use a common currency, in the same way as they did with gold before the 20th century. When those economies progressively issued bank notes (with a promise to repay in gold) in the 18th and 19th centuries, they created their own currencies. Gold (and other metals) remained in use until the gold standard was abandoned in the 30's. The difference between the euro and gold is that the ECB can increase the supply of euros at will, while no one ever had the power to create gold out of nothing. But if the ECB does not make enough use of its power, that difference is of little use for troubled European economies.


  1. Tel qu'il est présenté le schéma n'est pas en "dual currency", mais il laisse au gouvernement une option assez dérangeante du point de vue du créancier qui se voit remettre la reconnaissance de dette. Si le titre est explicitement libellé en euro, il ne se distingue pas de la dette existante et on voit mal en quoi l'Espagne trouve un avantage à les émettre. Si sa dénomination est vague ou susceptible d'être révisée, de nombreux prestataires les refuseront ou chercheront à les convertir au plus vite. Les imposer, même partiellement, aux fonctionnaires, constituerait une inégalité de traitement inacceptable pour les syndicats. Si les créances ne sont pas imposées mais émises par adjudication comme les obligations actuelles, les investisseurs réclameront vraisemblablement une prime de risque par rapport à la dette existante en raison de l'option de re-dénomination ou de reconduction du programme proposée en cas de scénario défavorable. Au mieux, la prime de risque sera équivalente.

    En outre, l'instrument semble inadéquat pour recapitaliser les banques, dont les engagements sont formulés en euros. La BCE refusera probablement ces titres dans le cadre de ses opérations de prises en pensions en raison de leur caractère optionnel (reconduction de la reconnaissance de dette, incertitude sur la dénomination à la maturité). En outre, le schéma n'est évidemment pas compatible avec la réglementation bancaire internationale. Les banques espagnoles resteront des parias...

    Le tour de passe-passe proposé n'apporte pas de solution à la faillite virtuelle du secteur bancaire. Une certaine dose d'austérité semble inévitable et il faudra bien trouver le courage de liquider certaines banques en ruinant définitivement les actionnaires et en appauvrissant les créanciers obligataires... mais cela implique de tels problèmes systémiques pour la zone euro que les détenteurs de dettes bancaires ont été épargnés jusqu'ici. Le FMI et la BCE s'y sont opposés alors que le gouvernement irlandais souhaitait le faire... Les Islandais ont pu appliquer cette recette tranquillement dans leur coin en vertu de leur caractère non systémique !

  2. Those reservations may look more sensible than the proposed scheme, but they don't fully account for the exceptional situation Spain is in.
    - Yes, the notes add to the global Spanish debt, but they add to the internal debt, not the foreign one. More importantly, they don't bear interest. Those are two big advantages for Spain. The question is how the international markets will weight those advantages against the debt increase (... and they've been keynesian lately).
    - Spanish local and national governments are sharply reducing the number of civil servants and their salaries (resulting in less healthcare, less education). Civil servants will take the notes (there would be no nominal wage decrease, and only a 1.75% real decrease).
    - The scheme is not intended for saving Spanish banks, but for stopping negative growth. If it can achieve that, it would do a lot of good to the banks (provided they can wait that long).
    - What additional austerity would achieve? They tried it, and things keep on getting worse. Maybe there is something flawed in this promissory note scheme, but I still haven't heard any other suggestion about what Spain could do, apart from hoping that Ms Merkel changes her mind.