Sunday, July 10, 2011

A Very "Nonstrategic" Exit Plan

Because all I've been doing is reading economic history for the last three months, I felt it was time to start putting some tangential thoughts I've been having onto paper. Plus, there is nothing like trying to peak reader's interests by writing about events that happened nearly a century ago. The time we want to venture back to is the fall of 1932. The place is Nevada. Just like most other parts of the country, the Nevada banking system had been severely weakened, as the Great Depression had inflicted three years of economic destruction. Unfortunately, a new run on a major chain of banks started up in November. The Governor opted to use a novel tool, not yet deployed in the crisis, to stem the tide of depositor anxiety, the bank holiday. A bank holiday suspends convertibility of demand deposits into cash, while allowing the bank to carry on most other operations, such as making commercial loans, certifying checks from other banks etc. By suspending any withdrawals, consumer anxiety can cool down, and depositors will hopefully come to their senses, preventing a bank run from spreading.

This idea had worked well in the past, however, during the heightened anxiety of the Depression, it ultimately proved to be a beggar-thy-neighbor policy. Once states started to call banking holidays, the citizens of contiguous states would start freaking out, thinking that their state was next on the list. A self-fulfilling prophecy would occur. Citizens would begin fearing a bank holiday was going to occur and rationally respond by trying to get their money out before the cashier's windows closed. The effect of everyone doing this collectively proved counterproductive as runs started intensifying, forcing a banking holiday to slow things down.

How is this relevant to today seems an apt question? The current debates over the debt situation in the EU seem to be missing out on this distinction. The contagion effect of investors, banks, and currency speculators from Greek default has been well-documented. There is little doubt these people will pull money out of not only Greece, but other troubled countries, such as Portugal and Spain. Many commentators have noted that since a currency run is inevitable, the Greeks might as well get ahead of the storm by creating the crisis themselves and strategically exiting from the Euro. This point misses the distinction between a currency flight occurring because of investor worry versus a self-inflicted policy of a government. The contagion effect of a Greek government decision to exit the Euro would seem to weigh heavily on consumer and business decisions in other EU states.

While it is true that the Greek situation is untenable and a restructuring of their debt will be inevitable, it does not hold much water than an exit from the EU is inevitable. And the argument that a "strategic" exit is possible is truly barren. Any sort of exit would have to be proceeded by a bank holiday of sorts, as the Greek banking system would be forced to shut down convertibility of euros as a national shift to a new currency occurs. With that occurring there seems no way to hold the EU together. Citizens and investors in countries reeling economically such as Spain and Portugal would start recalculating just as those citizens in contiguous states in the Great Depression began recalculating. There is a chance that other well-off states could be brought down as citizens start taking out euros fearing for the liquidity of their bank accounts. The thought that there exists some short-cut out of the debt crisis is wrong. The road will be long and bumpy, and unfortunately with only one route to future prosperity.

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