Author: David Kotok, Post Date: May 29, 2012

The drachma, the Greek currency, is over 3000 years old.  It was the most widely circulated coin in the world prior to the time of Alexander the Great.

Market Commentary - Cumberland Advisors - Greek Drachma

Readers may enjoy a few minutes of study about Alexander the Great.  His Macedonian army conquered Persia and much of the rest of the ancient world.  His education came from Aristotle, his tutor up to the age of 16.  He changed the political geography of the Balkans and the Mediterranean. See a few notes at the very end of this commentary.


Back to the drachma.


Since its reintroduction in 1832, all modern forms of the drachma have ended badly.  The single exception was the exchange of the drachma for the euro in 2001. That chapter of Greek history is being rewritten now.


The worst Greek hyperinflation was during World War II.  At its extreme, the Nazi-Italian occupation Greek government inflated at rates similar to those in latter-day Zimbabwe or the infamous Weimar Republic.  At one point Greece issued a 100,000,000,000-drachma note.  Greek monetary history also includes one previous failure in a currency union (the pre-World War I Latin Currency Union).


After WWII, Greece attempted to halt inflation by entry into the Bretton Woods fixed-currency regime.  They created a new version of the drachma by replacing the old one at a ratio of one new drachma for every 1000 old.  When the Bretton Woods structure suffered its demise in 1973, the new drachma declined in value.  It had been valued at 30 drachma to 1 US dollar at Bretton Woods entry (1954), but reached about 400 to 1 US dollar in the years prior to Greece joining the euro.  In 2001, when Greece was admitted to the Eurozone, the official exchange rate was 340 drachma to a euro.


Will there now be another new drachma?  If yes, what will it look like?


Money has three basic characteristics.  They are: (1) unit of account.  This is how we enumerate a price or a debt.  (2) Store of value.  This is the issue of “trust.”  Does money hold its value or does it lose value to inflation?  (3)  Medium of exchange.  This means acceptance, by others, of the money as a form of payment.


Nothing in Greek history suggests that the new drachma would qualify on any of these three measures.  Greek monetary history is one of default, inflation, and destruction of wealth when wealth preservation was entrusted to the government.  I have centuries of history on my side when I make this statement.


Of course, a new Greek government can try to force its citizens to accept a new drachma as payment of obligations issued by that government.  Greece may elect such a government on June 17.  Argentina used force to prop up the peso after it repudiated its governmental promise to maintain the peso at parity with the US dollar.  In the Argentine case, the peso quickly went from one to the dollar to three to the dollar.  Argentine citizens are still paying the price for their government’s monetary failure.


If Greece leaves the Eurozone and launches the new drachma, the internal outlook is for destruction of remaining Greek wealth, confiscation through taxation, high inflation, and monetary turmoil.  That is, a repeat of Greek history.


The () outlook outside of Greece is even worse.  Private holders of Greek debt have already been crushed and burned.  They are no longer involved in the decision making.  They avoid any Greek obligations and function on a cash-only basis or with secured or hedged letters of credit.  The Greek stock market has been decimated; its percentage decline exceeds the losses of American markets during the Great Depression.


The Greeks owe several hundred billion euros to European and international institutions.  That debt cannot be paid.  Holders of those obligations are mostly governmental institutions now.  Those institutions can hold obligations for a long time and can negotiate political changes in their structure.  Meanwhile, they can also defer the impact of default by postponing recognition of it while they negotiate.  In short, we are not worried about losses on Greek debt by the ECB, IMF, or others.


If Greece were to leave the Eurozone unilaterally, we expect that the post-euro Greece would have no market access for years.  With a new drachma, Greeks would function on a mostly cash-only basis in making their external payments.


Were Greece to exit, other European commercial and banking holders of Greek obligations would have to take more losses.  They already know these exist, in principle.  They would need to mark to market.  That means they will have charges against their capital and may need infusions of new capital.  The equity owners of those commercial institutions will suffer losses.  Many have already lost as the markets go on adjusting prices to reflect this risk.  These losers are the banks and insurance companies of Europe and others who are involved in the finance of the Eurozone.


The last element in this litany applies to contagion risk.  We already see contagion at work in Portugal.  Credit spreads are telling us that Portugal is the next Greece.  It remains to be seen whether the market is right or the market is overreacting.   We also see budding signs of trouble in Spanish and Italian spreads and even slightly with France.  The French benchmark 10-year bond now trades over 100 basis points wider than the 10-year German benchmark “bund.”  The lessons of losses from holding Greek sovereign debt are fresh.  Bondholders of the other countries fear repetition, with good reason.


No one knows whether Greece will actually leave the Eurozone.  Many are privately and contingently preparing for it while publicly saying they do not want it to happen.  Electoral outcomes are unpredictable, even though polling results influence markets.  In the end, Greece has already lost.  Europe has also lost but can still minimize further losses if it acts with congruence.  We do not expect that to happen.  It is not in the nature of Europe’s political leaders to reach consensus proactively. They do so when forced by market events.  We must think of European leaders as reactive, not proactive.


“When you’re in a hole, stop digging.”  Cite: U.S. News & World Report, 23 Jan. 1989. CVI. iii. 46 (headline).


The Eurozone’s leaders had the chance to stop digging when the Greeks restated their macro numbers after they entered the Eurozone.  Those leaders were publicly silent –privately enraged, as I heard with my own ears, but publicly silent.


Eurozone leaders had another opportunity to stop digging when the Greek government lost its high credit rating.  Instead they bent the rules and permitted Greece to maintain its collateral standing.   Eurozone leaders had repeated chances to stop digging, as the last two years unfolded.  Eurozone leaders have failed at proactive decision making.


They have another chance right now, but  they have so far failed to act decisively.  They continue to extend credit to Greece.  The present form is through the expansion of “emergency liquidity assistance” (ELA) by the Greek central bank, with the secret approval of the ECB.  Europeans fear contagion from bank runs that would collapse the Greek banking system.  Meanwhile, the ELA is only expanding the liability for the rest of the Eurozone, as it waits. At Cumberland, we are tracking the ELA continuously.  It is telling a story of accelerated deterioration.


Contagion risk is high and rising.  Banking runs in weaker Eurozone countries are likely to continue.  Why would any sane depositor keep her euros in a weak bank, when she could move them to a safer bank in another country?


My colleague and Cumberland’s Chief Global Economist, Bill Witherell, is in Europe and just finished several days at the GIC meetings, which included eight central bankers.  Greece and the other peripheral countries were an ongoing topic of discussion.


Bill emailed me his conclusion: “The decision for Greece exiting is really up to Greece. There is no provision in EC law for kicking a country out. It could be done with a unanimous decision by the EC heads of state.  The problem is that Greece wants to stay in, but the majority appears not to be willing to follow through with the austerity commitments already made.  They will not be able to meet their financing needs without further funds from their creditors.   The latter will be quite unwilling to continue to help if Greece refuses to keep its commitments.


“Is it possible we could see a messy restructuring/default but with Greece remaining in the Eurozone?  Portugal Is not Greece, no matter what the bond vigilantes may think. I think the Eurozone members, the ECB, and the Portuguese government will do whatever it takes to see Portugal through a difficult period. The same goes for Spain and Italy.  Incidentally, in the Sat. FT there was an article saying that over a long time period, half the time Greece was in a default/restructuring situation.”


Thank you to Bill, who responded to my email between airports in Cracow and Paris.  Bill will have more to say about Europe in the next few days.


So, when you’re in a hole, stop digging.  If you are not in a hole, don’t go there.


At Cumberland, we have avoided the “hole.”  We do not own peripheral Europe.  We have underweighted total Europe but do own some exposure in the north.  We are now worried that France can weaken, so we do not own France’s ETF.  We are more worried about Italy, the world’s third-largest debtor.  We remain concerned about the outcome in Spain.  We certainly fear a reprise of Greek tragedy in Portugal, although our base case is that it won’t end in a Portuguese default.  In any case we do not own Greece, Italy, Portugal, or Spain and are currently avoiding France.


As for the new drachma, it is not a panacea.


Some notes follow:

(1) The word panacea has its roots in the Greek word panakeia, which means “all healing.”  Such is the irony of language.

(2) Ancient Macedonia is not to be confused with the present day Republic of Macedonia, a part of the former Yugoslavia.

(3) Macedonian King Philip II, the father of Alexander the Great, united ancient Macedonia with successful military campaigns.  He created the platform for his son to conquer the world.  Philip’s success 24 centuries ago had two elements that were new to warfare at this time in antiquity.  He expanded the use of heavy cavalry.  Ancient Macedonia had the ability to support horses in larger numbers than more southern Greek agricultural states.  Philip incorporated heavily protected horses in the construction of his phalanxes (the battle formation used in ancient times).  Philip also added a long spear (sarissa) to the front lines of the phalanx.  It required two hands to hold and was about 18 feet long.  That allowed the first five rows of the phalanx to hold spears as they marched to face the oncoming phalanx, whose shorter spears meant only the first two rows of men could penetrate the opposition.

(4) The island of Delos is famous in Greek mythology.  It is also the original seat of the early Greek monetary authority.  After the Persian wars, the island became the natural meeting ground for the Delian League, founded in 478 BC.  Those congresses were held in the temple.  The Delian League’s treasury was kept on Delos until 454 BC, when Pericles removed it to Athens.  Thus, we surmise that the original Greek monetary policy was determined on Delos. It must have been successful, since the drachma was universally accepted at that time.

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