How Greece Can Quietly Exit the Euro

On the radio this morning a journalist from the New York Times confidently asserted that Greece would soon leave the Euro and issue Drachma. Both the new Drachma and the resulting Euro were both likely to plunge as a result and therefore it’s a good time to book an August vacation to Greece (meanwhile German vacationers are avoiding Greece in droves, no doubt wary of an unwelcome reception). While the journalist’s confident forecast of a Greek exit may be right, her analysis of subsequent market reaction (unburdened as it is by the requirement to invest other people’s savings in a commensurate fashion) is subject to the interpretation of the markets. However things turn out, one can be reasonably assured that a Greek exit isn’t going to surprise many people.

For some time we’ve felt that a short Euro represented an attractive hedge on long equity market risk.  Most of the bad things that could derail equities would either start in the EU or hurt the EU harder (such as an Israeli attack on Iran’s nuclear facilities, a concern earlier this year). But now that the focus has moved back to Europe, and we are once again contemplating the previously unthinkable, we think there’s less protection in such a position. The Euro isn’t a good investment, but its current price is more likely an accurate reflection of the balance of risks and as such doesn’t provide much of a hedge any more.

Every time we approach what seems to be a fork in the road, a third option seemingly appears. Such is the case now, with the apparently binary option between Eurobonds and no Eurobonds now joined by a European Redemption Fund, a sort of halfway house between today’s single-issuer bonds and Eurobonds jointly and severally guaranteed by Eurozone members.

But another thought occurred to me. What’s to stop the Greek government from paying its bills with IOUs rather than Euros? It may in any case be an unavoidable choice if lenders refuse to provide additional cash to allow the Greek government to continue operating. The IOU would promise payment in the future (say, 3 years) at whatever is the prevailing currency as determined by the Greek government. These IOUs would presumably trade at a discount, but over time as more of them went into circulation they could start to function as an alternative currency. Not an immediate replacement for the Euro, but a parallel currency that could represent a softer alternative to the shock of a Euro exit. These IOUs might ultimately become New Drachma. No doubt there would be many technical challenges with such a move, but given the large part of Greek GDP represented by the government before long these IOUs could represent a substantial part of the Greek economy. Such a path might offer a more measured form of exit and devaluation, preferable to the chaos of an immediate exit. Countries in the past have operated with two currencies, although typically the US$ has taken hold following a loss of confidence in the local currency. California has even issued IOUs when its disfunctional government has failed to approve a budget.

New Drachma IOUs reverses the sequence, but might offer a less time-pressured solution to the current crisis.