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Monday, February 20, 2012 1:49 AM


Why Greece Must Exit the Eurozone, How it Will Happen (and Why Portugal and Spain Will Follow); Does the Euro Act Like a Gold Standard?


Several people have asked me about statements I have made that "Greece is in a hopeless situation until it exits the Eurozone."

Actually Greece is in a horrific condition whether or not it exits the Eurozone as the Troika literally destroyed Greece (perhaps purposely to protect French and German banks), by dragging this mess out the way they have.

A Primer on the Euro Break-Up

To understand why Greece (then Spain and Portugal and perhaps even Italy) must exit the Eurozone, one must first understand the flaws of the European Monetary Union.

In general terms, the question at hand is "what makes good and bad currency unions?" The best answer I have seen written anywhere is also in the same article that explains in depth how sovereign defaults and currency devaluations happen.

Please consider some pertinent snips from A Primer on the Euro Break-Up by Jonathan Tepper of Variant Perception.

THE NEED TO EXIT: A ONE SIZE FITS ALL MONETARY POLICY

Europe exemplifies a situation unfavourable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe.

Professor Milton Friedman, The Times, November 19, 1997

Before the euro was created, Robert Mundell wrote about what made an optimal currency area. It is a groundbreaking work that won him a Nobel Prize. He wrote that a currency area is optimal when it has:

1. Mobility of capital and labor – Money and people have to be willing and able to move from one part of the currency area to another.
2. Flexibility of wages and prices – Prices need to be able to move downwards, not just upwards.
3. Similar business cycles – Countries should experience expansions and recessions at the same time (technically this is referred to as “symmetry” of economic shocks).
4. Fiscal transfers to cushion the blows of recession to any region – If one part of the currency area is doing poorly, the central government can step in and transfer money from other regions.

Europe has almost none of these characteristics. Very bluntly, that means it is not a good currency area.

The United States is a good currency union. It has the same coins and money in Alaska as it does in Florida and the same in California as it does in Maine. If you look at economic shocks, the United States absorbs them pretty well. If someone was unemployed in southern California in the early 1990s after the end of the Cold War defense cutbacks, or in Texas in the early 1980s after the oil boom turned to bust, they could pack their bags and go to a state that is growing. That is exactly what happened.

This doesn’t happen in Europe. Greeks don’t pack up and move to Finland. Greeks don’t speak Finnish. And if Americans had stayed in California or Texas, they would have received fiscal transfers from the central government to cushion the blow. There is no central European government that can make fiscal transfers. So the United States works because it has mobility of labor and capital, as well as fiscal shock absorbers.

The fundamental flaw of the euro is that it provides one monetary policy for the entire euro area. This has led towards wildly divergent real effective exchange rates and has produced asset bubbles. ...
Does the Euro Act Like a Gold Standard?

Here are a few more snips that caught my attention.
EURO AS A MODERN DAY GOLD STANDARD: SIMILARITIES AND DIFFERENCES

In truth, the gold standard is already a barbarous relic. All of us, from the Governor of the Bank of England downwards, are now primarily interested in preserving the stability of business, prices, and employment, and are not likely, when the choice is forced on us, deliberately to sacrifice these to outworn dogma... Advocates of the ancient standard do not observe how remote it now is from the spirit and the requirements of the age.
John Maynard Keynes, 1932, in "A Retrospective on the Classical Gold Standard, 1821-1931" and in Monetary Reform (1924), p. 172

The modern euro is like a gold standard. Obviously, the euro isn’t exchangeable for gold, but it is similar in many important ways. Like the gold standard, the euro forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionary bias. Under a gold standard, the burden of adjustment is always placed on the weak-currency country, not on the strong countries. All the burden of the coming economic adjustment will fall on the periphery.

Under a classical gold standard, countries that experience downward pressure on the value of their currency are forced to contract their economies, which typically raises unemployment because wages don’t fall fast enough to deal with reduced demand. Interestingly, the gold standard doesn’t work the other way. It doesn’t impose any adjustment burden on countries seeing upward market pressure on currency values. This one-way adjustment mechanism creates a deflationary bias for countries in a recession.

What modern day implications can one draw from the gold standard-like characteristics of the euro?

Barry Eichengreen, arguably one of the great experts on the gold standard and writer of the tour de force Golden Fetters, argues that sticking to the gold standard was a major factor in preventing governments from fighting the Great Depression. Sticking to the gold standard turned what could have been a minor recession following the crash of 1929 into the Great Depression. Countries that were not on the gold standard in 1929 or that quickly abandoned it escaped the Great Depression with far less drawdown of economic output.

It is odd then that Eichengreen and most economists today encourage peripheral countries to stay inside the euro as a proper policy recommendation when they would have encouraged countries in the 1930s to leave the gold standard.
Barbarous Relic - Not

Anyone quoting Keynes in a positive manner is going to elicit a negative reaction from me.

Gold is hardly a barbarous relic. Nearly all of the problems cited with a gold standard have little to do with gold per se, but everything to do with fractional reserve lending, the rampant expansion of credit, and arrogant central bank planners who think they (and not the markets), know how to set interest rates.

Russia Central Planners vs. Central Banks

By trying to prevent recessions and bail out banks every time they got into trouble, The Greenspan Fed, followed by the Bernanke Fed spawned the biggest housing and credit bubbles in the history of the world.

Can someone, anyone tell me why economists correctly railed against communist Russia central planners, yet openly praise complete fools at the Fed who think they can plan where interest rates ought to be?

Setting interest rates by central planning committee cannot be done, and the results speak for themselves. Indeed, history has proven that central bank malfeasance spawns boom-and-bust cycles of increasing amplitude over time. 

It's high time we stop blaming the gold standard for problems and instead lay the blame where it squarely belongs, on fractional reserve lending, central banks, and government interference in the free markets.

Currency Controls, Bank Holidays, and PIIGS to the Slaughter

The above section constitutes my main complaint in an otherwise brilliant article, packed full of historical examples as to how sovereign defaults occur.

It's 53 pages long and well worth a read in entirety.

Ideal Breakup

The ideally, Greece, Portugal, Ireland, and Spain should all drop out of the Eurozone at once, but it's far more likely this will drag out over time. If so, Portugal is on deck, followed by Spain.

In spite of recent praise of Portugal by German Finance Minister Wolfgang Schäuble, it would be foolish for anyone to trust what he or chancellor Merkel says. Like Greece, the situation in Portugal and Spain is hopeless, just not far enough progressed yet.

Fate was sealed on February 7, with Merkel's Official Denial "I will have no part in forcing Greece out of the euro"; Schäuble Starts Salami Tactics on German Participation, Calls for Vote.

Note carefully how the "I"s are being dotted and the "T"s crossed: Germany Draws Up Plans for Greece to Leave Euro; Athens Rehearses the Nightmare of Default; Merkel's Denial Rings Hollow

Look for Greek CDS to Trigger in March possibly with preceding bank holiday ahead of the March 20 bond due date.

The weekend of March 11-12 or 18-19 look like ideal candidates for a bank holiday and Greece exit of the Eurozone.

If you have money in Greek banks, get it out now!

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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