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Would the breakup of the euro put us on the path to the end of paper money?
06/08/2012 8:30 am EST
Money has been around for a while and it’s not terribly complicated.
The key element is trust. That was true when all money was actually a piece of metal that you could bite or bounce. And now that money is just a piece of paper, it’s even truer. Today’s money is nothing but trust.
Which is why the euro crisis is so bizarre. The euro is, in theory, one of the world’s great currencies. And yet, as this crisis has demonstrated, nobody actually stands behind it. There is no lender of last resort. There is no “full faith and credit.” There’s nobody on the other end of the promise.
And it’s as if the leaders of the EuroZone wanted to go out of their way to prove it. They’ve taken us up to the velvet curtain and then themselves, with a self-satisfied smile, pulled it aside to show us that there is no Great Oz.
And in the process they’ve done major and perhaps irretrievable damage to their own currency and to the very idea of money in our time.
Maybe nobody ever grasped the idea of money more clearly than the Byzantine Empire, the great Roman Empire of the East. From the time that Constantine the Great minted the first gold solidus in 312 until the final issue of that coin was struck by Basil II, the Bulgar Slayer, around 1020, the solidus was minted at a steady rate of 72 coins to a Roman pound of gold, or 4.48 grams of gold per coin. When coins came back to the Imperial treasury—all taxes had to be paid in solidi—they were melted down and re-struck. No wonder most Byzantine emperors were proud to put their own image on the solidus.
And it’s clear that the Byzantine emperors understood the power that owning a trusted currency gave them in the world. One of the first acts of the empire after recovering from the chaos of caused by the attacks of the Seljuk Turks in Asia Minor and the Normans in Italy in the 11th century was to reverse the debasement of the currency begun in 1042. By 1080 the solidus was down to 10% gold as embattled emperors melted down older coins, diluted the gold with silver, and then attempted to pay their mercenaries in cheaper money. The empire’s own troops, however, refused to accept the solidus, once the most respected coin and the medium of exchange from India to the Baltic, as payment. In 1092, once order was finally restored in the empire, Emperor Alexios I Komnenos replaced the debased coins with the hyperpyron, a new coin of 20.5-carat gold. The new coins contained 4.45 grams of gold.
That’s a steady currency. A drop of 0.03 grams of gold per coin in roughly 800 years.
Contrast that to the euro.
The currency was created as if it would be a monument of stability. That’s why there are no provisions in the treaties that created the euro for a country to leave the monetary union and go back to its own currency.
But the reality is that the euro is way more leveraged than the debased solidus ever was. After all even the debased solidus still contained 10% gold.
Start with the European Central Bank. The bank has official equity capital of just 6.5 billion euros. That tiny bit of capital supports a balance sheet that now totals 3 trillion euros.
How is this possible? Because the European Central Bank is essentially owned by the national central banks of Europe. They have contributed the bank’s capital in exchange for an ownership stake in the bank. Through that structure the European Central Bank has a claim on these national central banks. It you think of it structurally, each national central bank owns a share of the European Central Bank’s balance sheet. All those Spanish, Greek, and Italian government bonds, all those mortgage-backed assets, all those loans to French and Germany corporations that European banks have used as collateral for loans from the European Central Bank ultimately belong, for better or worse, to national central banks.
And that’s not the end of the European Central Bank’s liabilities. There’s also something called the Target2 Balance. (Target stands for Trans-European Automated Real-Time Gross Settlement Express Transfer System. Apparently the “s” in “settlement” is silent.) Target2 handles payments among banks in the EuroZone and imbalances among EuroZone members. (Membership in Target2 is mandatory for countries in the EuroZone. Membership is open to European Union members that don’t use the euro. Six non-EuroZone central banks use Target2.)
On one level Target2 is just a settlement system. On this level the system works like this: European banks maintain accounts with their national central banks. When, say, a Spanish importer places an order with a German exporter and asks its bank to pay that Germany exporter, the importer’s Spanish bank transfers money to the German bank account of the exporter. The Target2 system debits the Spanish bank’s account at the Spanish central bank, the Banco de Espana, and credits the receiving German bank at Germany’s central bank, the Bundesbank. The Spanish and German companies settle their credits and debits with their respective banks, which then settle with their respective national central banks. The two central banks settle their accounts, not by transferring actual assets (cash, for instance) but through liabilities and credits in the Target2 system. The Banco de Espana winds up with the liability and the Bundesbank winds up with a credit.
But on another level Target2 is an automatic funding system designed to cover trade imbalances among EuroZone members. If a country, say Spain again, is importing more than it’s exporting, it winds up with a big and growing liability on the Target2 system—but it doesn’t have to transfer cash or other assets to the Bundesbank to settle those liabilities. It, in essence, winds up owing the Target2 system, which has, in turn, created a liability that is ultimately due to the Bundesbank but that in the short-term is actually being funded by the Target2 system.
I think you can guess what has happened in recent years to Target2 liabilities and credits as the EuroZone’s weaker economies lost competitiveness and imported much more than they exported to the stronger economies in the EuroZone. The Target2 liabilities for the EuroZone’s peripheral economies from Greece to Italy to Spain to Portugal to Ireland climbed by 150 billion euros in April to 770 billion euros. I don’t have exactly comparable figures for the credits run up in the Target2 system by the EuroZone’s stronger exporters but in February the Bundesbank showed a credit balance of 576 billion euros in the system.
There’s nothing magical about any of these numbers. There’s no reason that a 1.9 trillion euro balance sheet—the size of the European Central Bank balance sheet a year ago—should be supportable and a 3 trillion balance sheet shouldn’t be, or that a 620 billion euro Target2 liability should be supportable and a 770 billion euro liability shouldn’t be.
It all does finally come down to trust. If that Byzantine mercenary had been willing to accept the debased solidus in 1050 as good money, the fact that it was only 10% gold wouldn’t have mattered. If the national central banks of Europe, are willing to backstop the European Central Bank and, most importantly, if everybody in the financial markets is willing to trust that willingness, then the fact that the European Central Bank has just 6.5 billion euros in capital is irrelevant. If banks and everybody in the financial markets believe that the Bundesbank and other Target2 creditors are willing to keep letting other central banks run up their liabilities, then the Target2 system is as good as gold.
But only if the trust in the system is there.
And it’s here that the leaders of the EuroZone have done real damage to their “money” in the way that they’ve handled this crisis.
Take a look at the Greek debt haircut, for example. As part of the rescue package that Greece negotiated with the International Monetary Fund, the European Commission, and the European Central Bank, Greece forced its private sector creditors into a voluntary 70% write down on the value of their bonds. The deal might have been necessary in order for European leaders to agree to funding a Greek bailout package, but it had several “trust busting” elements, which were pointed out by critics of the deal at the time. First, the haircut imposed an ex post facto change of the rules for the majority of Greek bonds in order to make more bond holders sign on to the deal. If you hold the debt of other national governments, you’re entitled to wonder how the terms of your bonds might change in a crisis. Second, the haircut was imposed only on the private sector investors in Greek bonds. The European Central Bank, on the other hand, did not have to write off the value of its significant portfolio of Greek bonds. Bond holders were left worrying who might be jumped ahead of them in the line for payouts in any future crisis. And, third, by imposing a write down, the European Central Bank and its partners created the question of when it might happen again. The deal certainly raised the risk of holding sovereign debt in the EuroZone.
Allowing the Greek crisis to go to the stage where a Greek exit from the euro is a real possibility has had a similar but even more profoundly negative effect on trust. Suddenly analysts are digging into the details of how the euro system works. Quite frankly, you no more want to know how a modern paper currency is made than you want to know what goes into a cheap hotdog. Analysts and economists digging into the euro system have been shocked, shocked, in tones that echo Casablanca’s Captain Renault, to discover leverage and risk in the system.
And once you head down that path, well, the scenery gets mighty gothic mighty quickly. We wind up with economists saying things like “In a euro breakup Germany will lose 20% of its GDP when debtors renege on their Target2 liabilities” or “The official sector [read the European Central Bank and the International Monetary Fund] are owed 290 billion euros by Greece. Of that 120 billion represents Target2 liabilities.”
These are only real issues if 1) the euro does break up, and 2) levels of trust sink to such low levels that, like Byzantine mercenaries, no party in Europe is willing to trust the currency or its bookkeeping systems. Even in a the event of a euro break up the Bundesbank could simply print money or write itself a check, in the words of University College Dublin economics professor Karl Whelan, to cover what it’s owned. That would seem a reasonable alternative to trying to extract 576 billion euros (or whatevers) from German taxpayers to cover what is, from one perspective, a bookkeeping entry.
Of course, you can only do things like print money or write yourself a check (and then not cash it, of course) if trust in the system hasn’t vanished. As the slow runs on Spanish banks (and the not so slow runs on Greek banks) demonstrate, though, there’s not exactly a lot of trust to spare in the EuroZone financial system.
And I think we’re only a resentful and shortsighted Greek election result—and a ham-handed political reaction from the German, Finnish, Austrian, and Dutch governments—away from a decisive erosion in trust in the euro. The European Central Bank has already made it clear that it is not prepared to be a Federal-Reserve-style lender of last resort. Well, then, who exactly does stand behind the euro? Not EuroZone governments it’s clear—they can’t agree to issue joint Eurobonds. Not the Bundesbank, the strongest of the national central banks, which has made it clear it thinks it has done enough.
So who then thinks the euro is worth defending and who would spend some tens or hundreds of billions on defense if that were what it took?
And if the euro can dissolve, if the EuroZone can go back to Deutschmarks and drachmas, then why should we have faith in any paper currency? The breakup of the euro won’t mean the breakup of the dollar or the yen or the real, but it sure would accelerate the already ongoing search for a more secure depository of value than paper money. Even one that proclaims “In God we trust.”
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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