Greece, the Eurozone, and Canada

I have been following the story about Greece. Like some other Eurozone countries, Greece has high deficit/GDP and debt/GDP ratios. Unlike Canada, but like Canadian provinces, Greece cannot print money. Eurozone countries are like Canadian provinces, as I argued in here back in January. But the Eurozone, unlike Canada, lacks a federal fiscal authority. The Eurozone is what Canada would be if we abolished the federal government, except for the Bank of Canada.

I rather stuck my neck out in that January post. I had "poster's regret" soon after. But now I'm looking a lot more prescient than I felt at the time. (Which proves it would be sheer luck, even if I do turn out to be right).

Here's what I said:

"4. As a last resort, perhaps at the cost of abandoning the inflation target, the Canadian Federal government can always print money to pay the national debt. The Eurozone "provincial" governments cannot, and would be forced to default. If there were a "run" on Canadian government bonds, similar to a bank run, where bond-holders refused to roll over the maturing debt, the Bank of Canada could act as lender of last resort to the Federal Government, just as it would to a commercial bank. The Eurozone "provincial" governments have no such lender of last resort facility at the ECB. It is as if their debt were denominated in foreign currency, which they cannot print. This is very worrying, because without a lender of last resort, the Diamond-Dybvig model of bank runs shows us that expectations of runs can be self-fulfilling. This same model could be applied to any short-term debt. Even if they can solve the coordination problem, some Eurozone provincial governments would fear a "run" on their bonds if they adopted an expansionary fiscal policy. (Presumably the Federal government would act as lender of last resort to a Canadian province facing a similar "run"?)"

And:

"Let me stick my neck out further. Unlike Willem Buiter, who makes a well-reasoned case against any country leaving the Euro, I think this is possible, maybe even likely. Financial crises are especially dangerous where the fiscal authorities cannot coordinate with the monetary authority. Argentina under the US dollar is one example. A Eurozone "provincial" government facing a liquidity crisis due to a "run" on its debt will be forced to understand these dangers, and will deeply regret not having its own lender of last resort printing press. It may then issue emergency scrip. After a very messy period when the scrip circulates alongside Euro currency (the banks will be closed), that scrip may become the new national currency.

Why couldn't a Eurozone country do an Argentina?"

Dunno. Let's see what happens. But I am very glad that Canada didn't join in a common currency with the US, Mexico, or anywhere else, even though Canada's fiscal situation is much better than Greece's.

Comments

[Stephen Gordon]

And indeed 'doing an Argentina' would involve repudiating much of the existing debt, which is denominated in euros. Foreign bondholders would want payments to be made in euros - a currency that would still exist - and not in the new Greek currency. (Of course, a Greek government could force Greek bondholders to accept payment in the new currency.)

[Adam P]

and of course, economically this is not any different than just monetizing the debt.

[Mark_dowling]

Countries *joining* the EU are obligated to begin the process towards the Euro (as opposed to UK/Denmark/Sweden) so it is as much a political article of faith as an economic one (although like Sweden it's possible to simply contrive to not meet the economic criteria).

Leaving the Euro might be legally feasible but the Eurocrats would probably like to hinder it if possible.

[Mark_dowling]

Also, why would leaving the Euro involve repudiating debt? It just becomes foreign currency debt surely?

[Stephen Gordon]

You're right. OTOH, its size would jump significantly after the new Greek currency devalued.

[Andrew F]

Isn't this what California tried/is trying with their USD bonds?

[Nick Rowe]

Mark: "Leaving the Euro might be legally feasible but the Eurocrats would probably like to hinder it if possible."

But if Greece was unable to pay its debts, then I'm not sure what the Eurocrats could do to stop it happening, unless they do a bailout. They might do a bailout, but I could see it being very politically unpopular in Germany, and other countries.

Andrew: yes, the cases are similar. Maybe California has less sovereignty than Greece? Maybe Californians are too accustomed to the US dollar? Dunno.

[JP Koning]

Technically, the Bank of Canada can act as lender of last resort to the provinces. Certain dusty old rules allow it to print money to a) buy provincial debt from provinces or b) to lend to provinces on the security of provincial debt.

But to the best of my knowledge, the BoC has never used these powers. Not sure how this compares to the ECB. My understanding is that the ECB rules are quite strict about the use of national debt in open market ops or as collateral for central bank loans.

[zanon]

Nick: California's IOUs were never accepted for (state) taxes. But in many ways, their situation is similar to Greece, or a Canadian Province.

Also worth contrasting this situation with the US$ swap lines Bernanke opened with the rest of the world about a year ago. They're being wound down now, but it's the only way they could roll over $. Since Bernanke cannot lend euros, he cannot do the same for Greece.

[Nick Rowe]

JP: "Technically, the Bank of Canada can act as lender of last resort to the provinces. Certain dusty old rules allow it to print money to a) buy provincial debt from provinces or b) to lend to provinces on the security of provincial debt."

That is important. I didn't know that (how come you know, or can find out, all these dusty old rules?). Even if they have never been used, the fact that the BoC *can* use them is what matters, and probably prevents them needing to be used.

zanon: "California's IOUs were never accepted for (state) taxes"
That might be an important difference.

[JP Koning]

Dusty old rules from here: http://laws.justice.gc.ca/PDF/Statute/B/B-2.pdf.

Section 18.j says that the BoC may... "make loans to the Government of Canada or the government of any province, but such loans outstanding at any one time shall not, in the case of the Government of Canada, exceed one-third of the estimated revenue of the Government of Canada for its fiscal year,
and shall not, in the case of a provincial government, exceed one-fourth of that government’s estimated revenue for its fiscal year, and such loans shall be repaid before the end of the first quarter after the end of the fiscal year of the government that has contracted the loan"

Section 18.i is also relevant.

Mind you, would this be politically feasible? Could you imagine the hoopla if Ontario got central bank loans but Quebec didn't?

"how come you know, or can find out, all these dusty old rules?"

A good internet connection and way too much time on my hands ;)

[Don the libertarian Democrat]

I also raised a similar issue with Edward Hugh about Spain:

http://fistfulofeuros.net/afoe/economics-country-briefings/two-graphs-that-tell-it-all-on-spain/#comments

"# Don the libertarian Democrat Says:
March 27th, 2009 at 5:20 pm

Doesn’t this argue for either more subsidies from the other countries or, sad to say, Spain having its own currency?"

He replied:

"@ Don,

I hope, in passing, I have answered your question. Basically, getting its own curerncy back wouldn’t help at this point, since all the debts would need to be repaid in another currency, or you default, and become a cross between Argentina, Cuba and Serbia.

Flat broke, and no one willing to lend you any money."

And me:

"# Don the libertarian Democrat Says:
March 28th, 2009 at 8:56 pm

Edward,

Thank you. I understand. Still, it’s an interesting question to consider going forward.

Thanks,

Don"

I think that this problem is now evidenced with respect to Greece.

[Adam P]

"Since Bernanke cannot lend euros, he cannot do the same for Greece."

But suppose Bernanke lent them dollars, why wouldn't that work just as well?

[zanon]

Adam P: Greece's debts are euro denominated. They need euros, not $. The US could open a swap line again with the ECB, I guess, get euros, and give them to Greece, but it really makes more sense for the ECB to do this directly.

When Fed opened $ swap lines earlier in the year it was essentially lending uncollateralized.

This is also why Spain getting its own currency will not help, its debts are euro denominated.

[Adam P]

zanon, you've completely missed my point, if Greece gets dollars from the fed they can use those to buy Euros without materially changing the Euro/dollar fx rate. If Greece introduces their own currency, explicitly to pay of Euro denominated debt that they otherwise can't afford then it's a fair bet that the value of this currency on the fx market will drop so much so fast that they'll still have to default.

So, the fed can bail them out as effectively as the IMF or ECB if it wants too. Leaving the Euro will accomplish little for them (except of course if having an independent monetary policy increases Greek output so much that they can pay the debt in real terms, but this is an entirely seperate issue and if it were true they should be leaving the Euro regardless their debt situation).

[Andrew F]

Why would the Fed bail out Greece? That just creates a moral hazard for other small countries to be profligate with their fiscal policy.

[Adam P]

Andrew F, I was reacting only to this statement: "Since Bernanke cannot lend euros, he cannot do the same for Greece."

The reason Bernanke doesn't bail out Greece is because it's not his job, not because he can't. The statement seemed to imply he couldn't.

The swap lines Bernanke opened with the worlds central banks were for liquidity provision, not to bail anyone out, so the example is completely irrelevant to the discussion.

[zanon]

Adam P: If Greece introduces its own currency and forces conversion of euro debt to its own currency debt, that is default for sure. New currency would not be worth much on the market, although it could work OK for Greece (I don't know how much Greece imports). A swap like this may also be very bad for the Euro, as more countries might start to exit the currency union. Greece certainly is not the only player under pressure. Also, to the extent that Europeans flee Euros for $s, this might make things worse too.

There are complications with how euros work in their banking system. So, if you buy Euros, do you hold them in a euro country central bank, or at the ECB? In the US, you really don't care what State the bank is in where you deposit your $. Might people in some countries prefer holding cash (ie. money outside the reserve system) to holding it in their own country's banks? This will all show up in spreads between euro debt issues by country banks vs ECB. You can see this is wide in Greece now.

The reason why a straight US bailout will not work the way the swap lines did earlier is because they demonstrate that the ECB cannot effectively integrate across eurozone countries. We both agree that it makes more sense for the ECB to bail out Greece. And yet the US has to step in and do it. There's a risk that other countries would effectively decouple from the eurozone as they need similar help as Greece.

[Adam P]

"If Greece introduces its own currency and forces conversion of euro debt to its own currency debt"

yes that is a default and is equivalent to repudiating the debt but above the guys (Stephen and Mark Dowling) seemed to be talking about a situation where the debt remains denominated in Euros in which case having their own currency accomplishes nothing, as we've agreed.

"The reason why a straight US bailout will not work the way the swap lines did earlier is because they demonstrate that the ECB cannot effectively integrate across eurozone countries."

I don't understand your point here, in principle if Bernanke could legally lend to the Greek government and was willing to do it then what difference does it make what this demonstrates about the ECB?

My point was anyway more basic, Greece needs a loan who's real value covers the coupon payments. Whether the loan comes in USD, CAD or Rubles is irrelevant as long as it's enough to aquire the needed Euros.

[zanon]

Adam P: I understand your point. I also agree that the US could probably swap dollars (or something) for euros and give that to the Greeks.

My point is that it is more complicated, as there is a real question about the integrity of the eurozone. There really shouldn't be any difference in the spread between euro denominated debt at the ECB and any eurozone country. After all, it's meant to be all euros, not greek euros, that are different from french euros, etc. If the ECB cannot connect these markets, then the zone is at real risk of breaking down.

The closest US analogy I can think of is the overnight interbank lending market. This is a mechanism to set interest rates, and credit considerations should not be important. You get a bank run when members single out a bank not to lend to, effectively squeezing them out of the reserve market. In a very real sense, they cease to be a bank. This also means there is no longer "a" FFR, as the interbank lending market rate starts to depend on counterparties.

If the Fed cannot restore that banks reserve account through lending directly (which it did) then the banking system has broken down.

in Euro terms, it would mean that even if Greece decided to stay in the eurozone, it could get pushed out by other countries unless the ECB opened a direct line itself. The US could rollover Greece's debt, but then Greece is out of the eurozone and now the Greek Euro is different from the regular euro and is some kind of dollar pegged currency (or something). Might this be temporary and they be let back in? Mebbe. Might this trigger a run on Eurozone? Mebbe. Worth taking risk? Probably not. Will US stepping in solve this run problem? No, sadly it will trigger it.

[zanon]

Adam P: Finally, re: Bernanke and swap lines. The difference between liquidity provision and bailing someone out is whether you get paid back! LOL!

If Mexico had taken dollars and said to Bernanke "OK, you take pesos we swapped for you" then it would rightly and openly be seen as bail out. He took a risk opening himself to this possibility. There's a reason some countries got unlimited swap lines and others were capped.

[Doc merlin]

This will teach me to buy a greek shipping stock, sigh. I was hoping it was gonna be an early 2010 play, but it looks more and more like late 2010 or 2011 at this rate.

[Too Much Fed]

Nick said: "Why couldn't a Eurozone country do an Argentina?"

Dunno. Let's see what happens. But I am very glad that Canada didn't join in a common currency with the US, Mexico, or anywhere else, even though Canada's fiscal situation is much better than Greece's."

Is it more like will the USA someday pull an Argentina?

[Too Much Fed]

Nick's post said: "That is important. I didn't know that (how come you know, or can find out, all these dusty old rules?). Even if they have never been used, the fact that the BoC *can* use them is what matters, and probably prevents them needing to be used."

Do you really want to sound like hank paulson?

[Nick Rowe]

Too much Fed: "Is it more like will the USA someday pull an Argentina?" Certainly not in this recession. The US prints its own money. It does not promise to convert its money into any foreign money. It does not borrow in foreign money.

[Too Much Fed]

Those three points are true, but what will the so called "people" in Congress do to make the interest payments?

Will Congress seize pension funds? Will they cut Social Security, Medicare, and Medicaid just to satisfy what I consider to be worthless bondholders (especially foreign) to address the budget deficit? Sound like Argentina (or the IMF)?

If the USA is ever forced to print currency to give to the bondholders to prevent currency denominated debt defaults, how will Congress and the fed attempt to keep the dollar from tanking so that foreigners won't demand debt denominated in a currency other than the dollar?

Even for the USA, a trade deficit and budget deficit can only be run for so long without payment problems. And those problems usually get inflicted on the lower and middle class.