There is a theory running through financial circles that claims to offer Greece a get-out-of-jail-free card to its current problems and avoid the country being forced out of the single currency. The idea is fairly simple: Greece needs to launch a parallel currency alongside the euro so that it has the money to get its unemployed citizens back to work.
There’s only one problem — it’s bound to fail.
To understand why you need to look at what launching a parallel currency would actually mean in practice. Here’s Wolfgang Münchau in the Financial Times today (emphasis added):
I would advise against a cold turkey switch into a new currency regime — one that would replace the euro with a new drachma. I doubt this is logically feasible or economically desirable. I would opt for a transitory regime, a smoke-and-mirrors version where nobody knows precisely whether Greece is in or out.
My preferred choice would be a parallel currency that acts as a medium of exchange but not necessarily as a store of value or unit of account. Its denomination would be the euro. This pseudo-currency would not be legal tender. Its success would depend on whether people accepted it. Its sole function initially would be to provide temporary liquidity if the country were to be cut off from central bank funding.
As Münchau admits, though launching a fully independent currency (or “new drachma”) may not itself trigger an exit, it would send a strong signal to financial markets that the government in Athens was preparing the way for Greece to slide out of the euro.
Financial markets, wary of the country defaulting on its euro-denominated debts in the event, would start pulling out as many euros as they could and external creditors would likely refuse to roll over their loans on fear that they would not be able to be paid back. For a country that is still heavily reliant on outside financing to stay afloat such a scenario would necessary inflict a huge amount of pain on an already beleaguered populace who can ill-afford yet more setbacks.
As such, launching a new currency can be an option only if the Greek authorities are set on a euro exit.
Not everyone agrees…
Despite Münchau’s caution, he raises the prospect that there may yet be a way for Greece to both have its proverbial cake and eat it.
Supporters of this idea propose something less drastic than the picture painted above. Instead of issuing a wholly new currency, they suggest that Greece launch a euro-lite that would allow the country to remain within the single currency. Under this system the government issues IOUs to the private sector, backed by future tax payments, that promise to pay the bearer a fixed exchange rate against the euro at some point in the future.
As a 2013 paper by Wolfgang Richter, Carlos Abadi & Rafael de Arce Borda argued (emphasis added):
We suggest re-denomination at par, i.e. one unit of the parallel currency represents one euro. The principle is that all the claims before cut-off date stay in euro so as to not be expropriatory. If the basis for the performance is initiated after the cutoff date, then the claim/liability is re-denominated. However, the creditor should be entitled to compensation by the local Central Bank if the creditor is faced with long-term contracts which cannot be terminated early and the creditor receives consideration in parallel currency.
This would allow existing euro debts to be maintained and allow Greece to undergo currency devaluation in the short term in order to boost competitiveness and, through that, kick-start the economy sufficiently to get the people working again… in theory.
For sure, if the underlying Greek economy could grow its way out of its current debt burden through weakening its currency alone then why not give it a go? In effect creditors would be asked simply to suspend their euro claims on Greece while it reorientates itself towards export-led growth and then wait to be repaid in full after the successful readjustment.
There are some big holes in this theory, however.
Firstly, it requires that people accept the new currency. That requires trust. If the currency is sharply devalued against the euro there is an open question as to whether shopkeepers, or goods and services providers would actually accept it as a medium of exchange, let alone a short-term store of value, necessary for a currency to be viable.
This problem is exacerbated if the currency is seen as a stepping stone back to the euro rather than a step towards an exit. If people will soon no longer be able to use euros, they have a reason to assign at least some value to holding the new currency as it would likely be the official medium of exchange following a Grexit — giving people a strong incentive to trade with it now.
Yet if it’s just a temporary measure then businesses and individuals both within and outside of Greece would have an overwhelming preference to trade in euros to avoid being hit by devaluation. This would not only limit the impact of the scheme but also mean that people would quickly attempt to convert any cash they hold in new drachmas back into euros, driving down the value of the currency still further and threatening a hyper-inflationary outcome (for an example of this, imagine the recent ruble crash without Russia’s ability to bail out the currency with its huge foreign currency reserves).
Secondly, the number of years that Greece has had to endure high unemployment and recession strongly indicates that the country has suffered permanent damage to its potential growth. As such trying to use a new currency as a way of (ultimately) paying back the full amount of pre-crisis debt will still impose a strong headwind to growth even if it were successful. Again, the baggage of euro-denominated debt could make it almost impossible to find a fair value for the new drachma.
And lastly, any guarantee to exchange the new currency one-for-one with euros at some point in the future imposes a significant liability on the Greek state. If it fails to hit its growth targets or if its tax revenues disappoint then it is unclear how the central bank could plug the gap without either pegging the amount of notes in circulation to available euro and/or gold reserves (making the programme effectively pointless) or printing more of the new currency, forcing down its value still further and risking hyperinflation.
So is a parallel currency another false dawn?
To combat these problems former Deutsche Bank chief economist Thomas Mayer suggested creating the “Geuro” that would only be convertible in one direction (from euros into Geuros) and therefore only operate as a domestic currency. This would be achieved by the Greek government issuing zero coupon bonds — effectively IOUs that resemble cash — which could then be used to make payments within the country.
Assuming that the Greek government is unable to quickly balance its primary budget, a plausible response of the government to the shortage of euro cash as a result of the end of financial transfers would be to issue debtor notes (IoUs) to its creditors, promising payment as soon as fresh euro cash would become available. As creditors lacking euro cash would have to use the IoUs to settle their own bills, these instruments would assume the role of a parallel currency.
Hey presto, problem solved!
Except, of course, that such a plan still requires a eurosystem takeover of Greek banks in order to cover the capital shortfall between devalued Geuro revenues and euro obligations. In other words, Greece would still need the permission of the institutions formerly known as Troika to undertake the programme. That’s never going to happen.
Oh, and those creditors accepting the IOUs would still have to keep faith in the government. The success of the Geuro idea relies on the conviction of creditors in the ability of the state to meet its future (euro-denominated) debt commitments and the effectiveness of its institutions in managing the transition.
Yet as years of problems with tax collection and corruption have made abundantly clear, this belief is sorely lacking in Greece.
Münchau writes: “A parallel currency is thus no soft option, but still less risky than the alternative. It may pave a way back into the eurozone for Greece. At worst, it would be a transitional regime towards a more orderly exit.”
I’m not so sure. Although a dual currency would be a necessary step towards Grexit, this is not what the Greek people voted for, which was to stay in the euro without having to take on the full burden of rebalancing the region’s economy.
Moreover, using it as a means to devalue within the single currency amounts to a huge gamble on the credibility of the Greek state — a bet that is garnering fewer and fewer takers right now.
Supporters of the plan frequently point to the experience of California, which used IOUs to paper over its budget gap in 2009, but they miss the crucial factor that made it possible: America’s fiscal union. Without the explicit backing of other member states it is highly unlikely that a parallel currency strategy could work to keep Greece in the euro.
Instead the discussion of such a measure speaks to the increasing desperation of people to find the least-worst option for Athens. This, sadly, isn’t it.