Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

A Tale of Two Currencies

Friday, February 13, 2015


January 19, 2015

This is a tale of two currencies, the Swiss franc is a real currency and the Greek drachma is a virtual currency. The price of the Swiss franc increased by more than twenty percent last week and the price of the virtual drachma also declined by thirty to forty percent.

The virtual drachma will become transformed into a real currency when the banks in Athens run out of euro currency notes in response to a run prompted by the anticipation that Syriza will gain more votes than any of the other parties in the parliamentary elections on Sunday January 27.

The take away that some observers have from both experiences is that a system of currency parities won’t work, and that a floating currency arrangement would be preferable. And that would be the wrong conclusion.

The dominant feature in the market for currencies is time-consistency between the anticipated price of a currency, the current spot price of the currency, and domestic and foreign interest rates. If the annualized percentage difference between the anticipated spot price and the current spot price differs significantly from the difference in the two interest rates, investors have an incentive to change the currency composition of their portfolios to profit from the anticipated change in the price of the currency.

Greece joined the European Monetary Union under somewhat cloudy circumstances on January 1, 2001. The price of the Euro was 340.750 Greek drachmas. At the time, the government declared that its inflation rate was 1 percent. The ratio of government debt to its GDP was disguised by a swap that temporarily took government debt off the balance sheet (which meant that the commitment of the Greek government to deliver cash to the bank or banks that sold the swap was not recognized as a liability of the government.)

Once Greece was a member of the European Monetary Union, the banks in northern Europe financed even larger deficits of the Greek government, which enabled it to hire more employees. When the banks woke up to the precarious state of government finances, the Government of Greece had a massive primary fiscal deficit and only a modest amount of cash to finance the deficit. Brussels and Frankfurt agreed to finance the deficit in exchange for promises about reducing the fiscal deficit.

Since the beginning of austerity, employment in the public sector in Greece has declined from 869 thousand to 723 thousand, or by about twenty-five percent. Employment in the private sector has fallen from 3.74 million to 2.78 million, or by twenty percent. If the decline in public sector employment is considered autonomous then the multiplier is 6.6 –which seems extraordinarily high for a small open economy. Greece has received $70 billion in loans a year–or about $6,000 for each of the 11 million Greeks.

Greece is like Argentina. A poor country with a lot of rich people. Everyone–okay nearly everyone–is trying to rip off the public sector. Politics is a family business.

Brussels and the ECB in Frankfort and the IMF in Washington have misdiagnosed the source of the Greek problem. Greece has a structural deficit in its balance of payments because the price of the Euro in terms of the costs and prices is much too high.
Prices and costs were too high when Greece joined the Euro, that is, given its prices and costs in 2001, the price of the drachma should have been 420 to 450 GD to the Euro. After Greece joined, easy access to euros meant that the prices and costs and government employed surged.

Lots of people in Athens and Thessaloniki are thinking that if Syriza wins big, the country and the government will run out of Euros. Individuals will go to their ATMs and the Euros won’t be there; the banks that own the ATMs will not have the notes that they need to re-supply the machines. The government won’t be able to pay its bills. Hence the run has begun and there is little that can be done to stop the run. The virtual drachma will morph into a real drachma

When Greece leaves the Euro, Cyprus will leave the Euro. There will be negative impacts on other producers of olive oil and tourist services.

The lesson is not that the implicit commitment to a parity for Greece didn’t work, but that Greece went into the monetary union at a price for the drachma that was much too high. The tragedy is that the reforms demanded during the austerity program were too severe; the schoolteachers in Brussels forgot that reforms are easier to introduce when an economy is growing.

One of the marvels of Switzerland is that the country is highly decentralized into 26 cantons–formerly nation states– and yet there is a strong sense of the commons. Switzerland has been more successful than any other country in achieving a low inflation rate. In 1970, the price of the U.S. dollar was 4.20 SF?? The average annual rate of increase in the price of the Swiss franc has averaged more than two percent.

The Swiss problem is that the foreign purchases of Swiss francs as stores of value weaken the competitiveness of the Swiss exports of engineering products and tourism. The finance economy in Switzerland is important, especially in three or four of the cantons; the real economy is important in 26 of the cantons.

The gain to Switzerland of allowing an investment inflow to lead to a higher price for the Swiss franc and a loss of net exports probably is negative in the short run, especially if the investment inflow is cyclical.

Investors have been net buyers of Swiss francs since the onset of the global 2008 crisis. the Swiss adopted a ceiling on the price of the franc, and they held the ceiling for three years, which led to ballooning of the balance sheet of the Swiss National Bank. At some stage the Swiss decided to take the hit in the currency rather than in the price level.

There is a lot of excess capacity in the curozone countries, and very little excess capacity in Switzerland, which has the lowest unemployment rate in the world. A decline in the price of the swiss franc would lead to excess demand and contribute to a higher inflation rate.

What insights can be taken from the Swiss franc? The first is that a small successfully managed economy has no obligation to take in dirty foreign laundry. The second is that the Swiss need an additional financial instrument to deter investment inflows.

Currency markets seem likely to be volatile during the coming weeks.