Saturday, 12 November 2011

Leaving the Euro

I remember when they were first elaborating what eventually became the Euro. There was a competition to name the new currency. My own thoughts tended towards some kind of derivative of "Mark". Not only was that the name of Europe's strongest currency, there were also antecedents in British history — indeed, much of Europe employed "marks" of one kind or another as units of value.

Another of my favourites was "ecu": there was of course an ECU (European Currency Unit) at that very time, in a kind of virtual foreshadowing of the common currency. There had also been several ├ęcu coins in French history, the first one as long ago as 1266. The word is related to Portuguese escudo, ultimately from Latin "scutum" (a shield) and has a long history in the realm of currency.

"Just as long as they don't call it the 'Euro'," I thought, cringing at the very idea (I did, I swear it, I was that psychic person), "that would be so horribly self-important and bureaucratic." Perhaps I meant "beurocratic". But when I thought of how those sophisticated European elites would sneer if the Americans ever decided to rename the Dollar the 'Americo', I realised that our clever EC politicians would never do anything so hopelessly gauche.



There's much speculation at the moment as to whether one or more nations might leave the Euro in the near future, and if they did, how exactly that might happen. The modalities, as the French say. A few clarifying considerations might be in order.

Firstly, what is a Euro? Unfortunately I don't have one in front of me, but I do have twenty pounds, and we shall have to be content with that. If you look at the top of the front of a twenty pound note you will see the words "I promise to pay the bearer the sum of twenty pounds". The same idea is true of all our modern currencies, they are promises to pay. To pay what? For that, we need to remember a little history.

Nowadays when we think of currency we tend to think of coins and notes as being more or less the same thing, one perhaps a bit heavier and bulkier than the other. Historically though, they were very different things. Coins were essentially lumps of valuable metal: gold, silver, and for the cheap seats, copper, bashed flat and stamped with the mark (there it is again) of a reputable treasury to guarantee its weight and purity. Notes on the other hand were originally bankers' receipts, handed out when traders deposited their bags of coins with them. They were promises to (re)pay the coins. It was the coins that were valuable. The notes, insofar as they had value, had it because they guaranteed that you could convert them into coins.

Notes of course were a lot more convenient for trading with than coins, especially for large transactions. So despite the fact that there was what we nowadays call "credit risk" associated with them (if the banker went bust and couldn't give you the coins, the notes would then be worthless) they caught on. They were also freely tradeable: if I gave a twenty pound note to my butcher, he could take it to the bank and receive his twenty gold coins without having to prove either his identity or mine. That makes them bearer instruments and further increases their fungibility with coinage.

It's sometimes surprising to remember that this system remained essentially intact up until the early 1970s, when Nixon unilaterally revoked the convertibility of the dollar into gold. What was especially clever about this was that he did it in the context of the then prevailing Bretton Woods System, which defined the dollar as the currency that other currencies were valued against, thus more or less legally obliging everyone else to go along with it, much to the fury of some of the European contingents.

That's really the point when everything changed. Instead of having to redeem their notes in precious metals, central bankers were now able to take your twenty pound note off you and replace it with ... another twenty pound note! Since they were no longer bound by the necessity of converting their essentially worthless paper back into gold, they could print as much of it as they wished, and this, in very large part, they promptly did (neatly illustrating the tension between a currency's dual functions as a unit of exchange and a store of value).

It's no accident that at the very same time as this happened, nations all over the world quietly retired their silver and copper coins and replaced them with almost-worthless substitutes. After all, you can't have twenty shillings being worth more than a pound note can you? You can't have arbitrage between the various components of one currency, can you? If you look at the Royal Mint today you'll see that they are selling a coin with a two pound face value for nine hundred and ninety five of the paper equivalents. That's the scale of the arbitrage that would now be available!

The point
Yes, now to the point of this post. Which is that even today, even inside the Eurozone, there is something that is remarkably similar to the old, national currency note. It's a government-backed promise to pay, that's freely tradeable between third parties. They are issued by country governments sovereignly, and the worth of each government's issue floats freely against all the others. I'm referring, of course, to the currency note's "big brothers", the T-bills and government bonds.

It's remarkable indeed, that in the context of the various European governments' eagerness to remove the ability of financial markets to arbitrage between them, of their eagerness to hide the effective international wealth transfers that were so cruelly exposed in the bad old days of fixed exchange rates, when the richer European countries had to repeatedly intervene in markets to prop up the currencies of their poorer neighbours, that they neglected to remove the one class of instrument that allowed markets to see exactly that, and to do exactly that.

So, in a sense, there still are independent national pseudo-"currencies" within Europe, and I wonder if more could be made of them, in order to relieve the pressure that a common currency creates? For example, Governments could legislate that their bonds could be used to pay taxes. Ok, that's not really a winner: of all parties to a transaction, governments are the most likely not to want to be paid in something as worthless as their own paper. But as a means of retiring their issuance, possibly at a discount, it might be considered. Or how about legislating to make a government's bonds legal tender for the settlement of all transactions in its territory that are over, say, 100,000 Euros? And of course, once you can force people to take your worthless bonds, you may as well make them irredeemable — "consols" as they are called.

In just such a way, by just such a series of steps (and more), European governments could surreptitiously introduce something that was more and more like a freely-floating, national currency, without ever quite leaving the Euro. A way of effectively letting off some steam, without losing face.

The other thing they could do of course, is to say to international bond markets what they said to their own populations in 1971: that the only thing they will redeem their notes for is more of the same. That's effectively what they've been doing for decades anyway, by consistently rolling their debt over from one year to the next — a sure sign, for any student of history, that the next step would be bankruptcy. That would be much more likely to provoke an outcry from the markets than the creeping speciation of bonds, but maybe people really are that stupid.

2 comments:

  1. Replies
    1. Turns out to be prescient too, at least the paragraph pointing out that the survival of government bonds allow markets to differentiate between economies; that's precisely what Hollande et al. are targetting with their idea of common eurozone bonds that the individual eurozone nations would be jointly and severally liable for.

      Insofar as that would translate to me giving all the people in my postcode the right to write checks on my bank account, the solvent countries would be mad to accede to it.

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