Merk Commentary
Greece: High Flying Drachma

Axel Merk
Merk Hard Currency Fund
Nov 22, 2011

The worst-case scenario for Greece, should it be unable to secure further bailouts, might be that it would have to live within its means. Presently, spending only the money coming in is considered unbearably brutal. If Greece could only leave the euro, it could install its own printing press, inflating its sorrows away. Any economist will object: it’s complicated. But it isn’t: Greece could introduce a high-flying New Drachma, quite literally.

First, please note that any country may default on its debt. The trouble is that the day after a default it might be difficult or impossible to obtain a loan at palatable terms. As such, any country considering a default must conduct a risk / benefit analysis. A country that has a primary deficit, i.e. a budget deficit before paying interest expenses, faces the challenge that such deficit would be eliminated overnight (because the deficit could no longer be funded), causing a massive shock to the economy as government spending would come to an abrupt holt. To mitigate such a shock, it is usually the lesser evil to beg for leniency from creditors, in return for austerity measures. It is in Greece’s interest to promise the stars to get yet another loan. In contrast, once a primary surplus has been achieved, Greece may well find a default attractive to cut its overall debt burden; the shock from being shunned from the credit markets would then mostly be a shock to the creditors.

It’s because of these dynamics that countries tend to default only after an agonizing period trying to cut expenditures. Some succeed: look at Ireland. The country appears to be regaining the confidence of the markets. However, political realities may make it difficult for Greece to ever get on a sustainable fiscal path.

However, if a country defaults without first eliminating its primary deficit, policy makers may be tempted to repeatedly default without ever getting the house in order. If creditors are dumb enough to provide another lifeline, good luck to them ever being repaid. In such a situation, credit is more typically provided through the countries’ own printing press, in the case of Greece by introducing a new currency.

Introducing a new currency in a debt-laden country that has been unable to eliminate its primary deficit may be doomed for failure, but since when has bad policy stopped politicians from trying to implement it? There are logistical and legal challenges, such as what obligations would remain euro denominated and what obligations will now be New Drachma obligations. More importantly, if Greece were to introduce its own currency, odds are that those that can, would reject it; as a result, the euro would remain the default currency for business.

In contrast, pensioners and government employees might have no choice but to accept the New Drachma as payment. Quite likely, these groups would cry foul that their new currency is worthless, demanding to be paid more. Not long thereafter, and with a media friendly Greek drama playing out on the streets, the government might relent, printing more money to appease the protestors. Inflation and hyperinflation may well take hold, in turn relegating the New Drachma to the history books.

Some policy makers may suggest capital controls and a variety of oppressive tools to force the adoption of the New Drachma. Unfortunately, the little money left in Greek banks may evaporate faster than policy makers can act, as savers would likely take their money abroad. While it may cause a complete collapse of what little public infrastructure is left, the upside of a dysfunctional government is that the black market may fill the void. After all, it’s only money we are talking about, and some ingenious entrepreneurs will always find a way to keep life moving along. Anarchy, however, might well be used to describe the situation if things turn sour.

Optimists that we are, we believe it doesn’t have to be that way. No, we do not expect the Greek to learn German and adopt their habits. But Greece might have an opportunity to turn the crisis into an opportunity. The government should embrace reality and recognize that swapping the euro for the New Drachma in some forceful fashion would be a non-starter.

How about introducing a currency in parallel to the euro? A currency irresistible because of its benefits? All those in favor of the gold standard, please close your eyes and ears! How about a currency that offers value, yet is inflatable? In our opinion, the euro is about as close to a gold standard that investors can obtain these days, as individual member nations cannot print their own money and – so far at least – the European Central Bank (ECB) has only printed a fraction of what the Federal Reserve (Fed) has. We are not suggesting such a currency for the strong countries, but for Greece, it might provide them with a lifeline, one that’s only for Greeks to lose. The currency idea we have in mind is directly borrowed from the airlines: a frequent flier program – let’s call it the “Drachma Program.”

The Greek Government would have the exclusive authority to issue Drachma Points (DPs). In order to get government services, DPs would have to be paid. The government would set the price of government services in DPs. The government would, in turn, estimate what portion of the typical government employee’s and pensioner’s consumption is comprised of government services. That portion would have to be paid in DPs; remaining expenses would continue to be paid in euro, until DPs receive wider acceptance.

The government should make DPs transferable. As such, a market would be created that creates an exchange rate between euros and DPs.

We know that, without a doubt, benefits of government employees and pensioners will have to be cut to be sustainable. Rather than forcing almost the entire economy into an underground economy, the rest of the economy could continue to embrace the euro, while the public sector would embrace DPs.

If a Greek government were to introduce price controls, shortages would be created. By limiting DPs to the public sector, should the DPs be mismanaged, there would be a shortage of public sector services. That, in turn, may not be the worst outcome, as the private sector would then have an opportunity to make up the shortfall.

A way to balance income and expenses may be for the government to collect revenue in (strong) euros and pay expenses in (weak) DPs. Government employees and pensioners can be paid partially in DPs, but creditors should be paid in euros (possibly after what is becoming a customary “haircut”) – at least until DPs are well established in the marketplace.

So, would this idea work? It ultimately depends on how exactly it is implemented. Odds are that Greece would inflate this new currency away anyway, just as it is likely to do with a New Drachma. However, if Greece wants to leave the euro, the new currency should be introduced while still allowing business to be conducted in euros; the banking system could accept both euros and DPs. With a gradual introduction and the currency value linked to government services (rather than nothing as is the case with a fiat currency, or gold as in the gold standard), such a transition may be feasible.

Ultimately, holders of Greek debt have a choice: accept a restructuring with a 60% “haircut” or accept a New Drachma that’s worth only 40% of the euro (or less)? Either way, losses will have to be taken by creditors. Moreover, any short-term loss may simply be a first step towards further losses down the road if Greece cannot devise a sustainable budget.

While we ponder about Greece, the market has obviously moved on to worry about bigger economies. Greece’s policy makers may dream about the benefits of their new high-flying mileage program and how to market it to the people, but policy makers in the rest of Europe should focus on the health of their banking systems. We cannot prevent sovereigns from defaulting on their obligations, but they can make banks strong enough to stomach potential losses. Governments should get used to the idea, as supporting banks may cost them dearly, including their ratings.

The alternative for governments is to go down the road of doling out frequent flier points. It might just work – being the first in line for having accumulated more points than your peers may make them appear priceless; until you notice that the premier status lines are just as long as the lines for everyone else. Thought of from an American perspective: if you are a good citizen accumulating DPs, you get to skip the line at the DMV!

Subscribe to Merk Insights to be informed of our analysis as this crisis evolves. We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com.

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Nov 22, 2011
Axel Merk

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Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.

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