There's still time - just - for an orderly Greek exit from the Euro

So, austerity is not working (big surprise) and my earlier plan for a Greek exit from the Euro is also now unworkable. The reason is that I think it is now impossible for the Greek government to get a hold of enough gold to make the plan workable. This was in fact already somewhat dubious before, but now it definitely isn't possible.

However there is still time to exit the Euro without consigning the Greek economy to the metaphorical basket. Unfortunately in this case the solution is only partially free market. I'm sorry, Greeks, it's the best I could think of.

What many people expect must ultimately happen is that Greece must create its own currency and replace all Euros in Greece with this new currency. This is a terrible plan (and yes, I know the alternatives are worse) because inevitably it will result in bank runs, people having their savings partially wiped out or, if hyperinflaion results, which is extremely likely, all of their savings.

My solution is a partial default. Tada.

It's obvious to everyone that this is what must happen, the only question is how. I believe my solution can provide bond holders with some confidence, protects the Greek people's savings, restores Greece's currency sovereignty and gives the lowest chance of hyperinflation. It also doesn't require any bank holidays

Brief outline:

The purpose of stage 1 is to prepare the world and Greece for the changes.
1. a) Announce debt repudiation. Redenominate all outstanding bonds in new Drachma currency at 1:1 Euro.
1. b) Announce low tax liability for transactions or income involving new Drachma.
1. c) Establish new Drachma as sovereign fiat currency receivable in taxes.
1. d) Announce no additional bond issuance by Greek government.

The purpose of stage two is to make the necessary changes to bring about a prosperous Greece.
2. a) Pay off bonds when due with newly printed Drachma.
2. b) Establish limiting of Drachma supply (to ultimate ceiling of total Drachma bond liabilities) to prevent hyperinflation.
2. c) Rapidly but smoothly reduce governent spending to near 0.

The purpose of stage three is to prevent the same from occurring ever again.
3. a) End fractional reserve banking and eliminate most legislation.
3. b) Create a new constitution.
3. c) Establish citizenry as the first line of policing and defence.

The first stage of this plan is to hit the bond holders with the default. Announce that all outstanding Greek bonds will be redenominated in the new currency, which I will call Drachma. This will not be popular, but it is necessary and bond holders will prefer it to alternatives, because they will be the first reipients of the new currency.

A parallel announcement will be made in Greece that the new currency will attract a consumption tax of say 10% and no other taxes of any kind. This is in order to drive demand for the Drachma over the Euro in Greece itself. If the tax for Euros is high and for Drachmas is low, people will start to prefer it. This is how the Drachma is monetised in Greece. At this point no Drachma are in the possession of any Greek. The Euro and Drachma will be parallel currencies until the Euro is effectively demonetised. Both will be acceptable for tax liabilities.

Stage two is to print new Drachma to pay off the bonds denominated in Drachma. The new money will be fully sovereign currency - in other words, no bonds will be required to expand the money supply. The size of the money supply will be determined by the Greek government, but an excellent practice would be to only print all money necessary to pay off the existing bonds, and then only print such money as is needed to replace worn out currency. The money supply will be constant. There will be no need for a central bank as such, only a government printer replacing worn out notes and a mint to coin the lower denominations. Constant money supply will make it an exceedingly safe currency and increase its trust and money value in the eyes of trading partners and the Greek people themselves. It makes hyperinflation an extremely remote scenario.

Fractional reserve banking would end.

The era of Greek government bonds would have to end - only a balanced budget would be possible going forward. This will be an economic shock, for sure, but people will be heartened by the low taxes in their near future. Investors might well find Greece an attractive place to do business if they are confident that business could be conducted in a currency that attracted minimal taxes. This would be a big boost to confidence in Greece itself and prevent the depression from spiralling too far. Once Drachma started to circulate back to the government it would be time to redenominate certain avenues of government spending in Drachma. What is clear is that with Drachma taxes so low Greek government spending will also need to decrease drastically. The shock of this, as stated before, will be partially offset by dramatic increases in investment funds flooding the newly liberalised Greek economy and low priced labour. Even so, great care would be taken to make sure that people relying on the State for their livelihood are not suddenly dumped. Pensioners and the old are particularly vulnerable, so might be worthy recipients of newly printed Drachma themselves. They might be considered a secondary vehicle for the monetisation of the Drachma, however this is not really necessary. The 10% consumption tax will soon provide adequate funds to give state dependents a living income if they have no other sources, however entitlements will have to be the same for all recipients and anyone with an amount of Euro savings would not be eligible. All previously contracted pension obligations would have to be reneged on. All government employees would have to gradually be given the sack and join the real economy which hopefully will begin to boom because of the influx of investment.

Two major exceptions are police and military. In the mean time the police and military would be responsible for maintaining law and order and preventing foreign invasion, respectively. To aid law enforcement all Greek adults would be encouraged to buy and carry firearms that may be used to deter unauthorised access to one's property. However this will not be a free for all in murder because the police would still treat any death as a potential murder case. Citizens should be encouraged to use non-lethal force except in cases of imminent threat to life. The number of police and military personnel could thus be greatly reduced, leaving the state's main spending to the old who cannot adapt to the new situation, and the small number of law enforcement and judicial officials. It is clear that only the most basic laws could be handled under this reduced judicial system. No fraud, no theft, no rape, no murder would pretty much be the scope. In such severe times all other regulations are an unacceptable burden. What remains of the government should focus on creating a new constitution that enumerates the constant money supply condition, a common law framework, and otherwise establishes the Greek people as the master of their government, not the other way around.

In the long run, whatever happens Greece will eventually recover. The purpose of this plan is to make that transition as fast and painless as possible - for Greece and the rest of Europe. It requires a radical rollback of the Greek state and a radical plan for monetising a new currency, but when the situation is unique the solutions must be also. I only hope that whatever happens is as kind or kinder to all parties than my proposal.

This plan may begin implemetation at any time, under almost any conditions as long as the government sitll exists and has some clout. It goes without saying, however, that sooner is better. Between the beginning of stage one and the end of the whole process would be about two years, so time is of the essence. I greatly fear that no such plan will be used and the Greek people and other Europeans of modest means will continue to suffer under the heavy yoke of poor growth and high taxes. If that happens things could become violent, and no one wants that.

A fresh look at Austrian business cycle theory

I recently read a very interesting critique of the Austrian business cycle theory (ABC), and I just couldn't resist adding a few of my thoughts. Here follows my comment on the piece.

1,2,3) If a lot of capital goods turned out to be in the wrong use at the same time then a large investment in labour would be required to convert them. Capital conversion is thus a natural part of the economy but would spike at certain times - namely some time during a recession. The same applies to labour itself because retraining takes time of course, and when a person studies he is investing intellectually in that career path.

4,5) Any unnatural change in the money supply will cause a shock, it is just that those shocks are of a different kind. Gradually falling prices are no problem if the money supply is not contracting in a sudden unnatural way. Austrians, I think rightly, blame the fact that such a deflation shock can occur at all on the prior inflation. Once the money supply has been unnaturally (through fiat inflation, FRB expansion, take your pick) increased price stability becomes impossible, because as that additional money filters through the economy and increases the price level the only way to put a halt to that price increase is to actually reduce the money supply. The severity of this will be decided by what level of inflation is considered acceptable. Thus I think that it is the central bank's desire to prevent the price inflation that causes much of the "downside" problem. It would be a much better policy to refuse to change the supply in any way and allow prices to stabilise at a higher level.

6,7,8) I think it is reasonable to say that Austrians discount risk in the interest rate issue. The question then becomes, is it that lower interest rates will decrease savings because of poor returns or increase them because of lower perceived risk? I think this is at the core of what causes the business cycle, because low interest rates will cause low yield investments to become more populous while at the saver end the average man will save less because the perceived risk in a bank is usually close to 0, and thus the interest rate is very much a supply/demand. Personally I think that at very low interest rates (say, less than 3%) the savings rate is inelastic because those savings are prudential rather than an investment.
So if we assume that time preference is the wrong way to look at it and we instead consider risk perception, we need to understand why perception changes suddenly. I believe that the injection of cash into the investment sector will gradually cause the prices of capital goods to rise and at some tipping point it will become evident that some enterprises will not be profitable under the current price levels and expected future prices (for capital goods). These higher prices will thus conceivably cause a crash in the demand for capital goods as the contageon spreads. The demand crash causes unemployment from those unprofitable companies, causing a demand crash in the consumer goods sector as well, further exascerbating the unemployment problems.
As a result of these demand crashes only the highly profitable producer companies will be able to keep trading. From their perspective it is better if the money supply remains constant because then the price inflation will allow them to pay off their creditors through higher numerical revenue despite decreased sales. If the central bank elects to focus on inflation and raises interest rates these companies will face reduced revenue and higher interest rates, likely making many of them insolvent as well. I believe this is a very plausible explanation for the Great Depression, since we know deflation occurred. In a sense the motivations for deflation are immaterial - it will cause a bust proportionate to the deflation. The magnitude of the impact of the previous inflation is then a function of how far deflation is allowed to continue - if it goes to the money supply before the boom then it will be as mild as the boom, if allowed or forced all the way down to the monetary base then you could have a truly catastrophic contraction unless the boom started when the money supply was already at the monetary base.
The Austrians do have the cause of producer goods price rises correct, I believe: that low interest rates cause real savings to be lower than real investment, thereby eventually causing increased competition between consumers and producers for raw materials.
So to summarise: deflation is bad because it causes naturally profitable enterprises to go bust, inflation is bad because it causes naturally unprofitable enterprises to be started. There's a pleasing symmetry there, isn't there?

10,11,12) I agree with most of what you said here. Under my construction the idea of a malinvestment is in a sense not there. The investments are all profitable when investment is high and prices are still low. So it's not that the entrepreneurs make a mistake at the time given the conditions, it's that later price increases are unforseen and reveal those investments as unprofitable. The difference, in real terms, between a profitable and unprofitable enterprise is that the former uses fewer real goods than are given up by people when they save, and the latter uses more. The problem with a boom is that it reduces the real resources available to those enterprises on the margin and makes many otherwise profitable ventures fail when the bust comes.

Any way you cut it some companies will have to fail. There are only three options: Deflation, which destroys profitable companies; constant money, which I believe is the cure; and inflation which, in order to prevent the failure of those companies that used real resources not "saved" by consumers would have to constantly increase until the result was hyperinflation. That's the only way to get the necessary "forced saving" and hyperinflation will be inevitable as people realise their money is losing value, since by definition they will be forced to give up more real goods than they actually want to.

All of this suggests what I have been thinking about for a while: the best monetary policy is one where the central bank does not alter the money supply at all. I really need to do some analysis to find out if this theory is borne out by the facts but that is for another time. Look for future posts on this topic.

EDIT: I realised after this that the central bank can continue to inflate even at high levels without this causing hyperinflation (which as I define it is not to be thought of as a threshold level of price rises) because the economy can adjust to permanent money supply increases. It all depends on the psychology of the people and whether they are willing to accept the situation. If they do accept it then through the general ignorance of the effects of inflation real wealth will be transferred to those otherwise unprofitable enterprises.