Why do people assume that Greece has to stop using the Euro if it leaves the Euro-zone?

"Economist" Andrew Lilico* appeared on Channel 4 News yesterday evening, and he was reading from the same script as Allister Heath, i.e. if Greece leaves the Euro-zone then basically it would have to introduce a new currency which would devalue against the Euro by seventy or eighty per cent, there will be 'capital flight' and 'bank runs', molten lava will start raining from the sky etc etc. And as we know, the feeble minded have always insisted that Greece has no control over the currency it uses because it can't print Euros and can't set its own interest rates.

Now, this is all arrant nonsense, so let me try and unpick the web of self-supporting lies and prejudices and set a few matters straight...

1. Countries do not need to have their own currencies

It is traditional for most countries to have their own currency, but there's no absolute and over-riding reason why this should be.

Basically, very small countries just don't bother, because the convenience of using the same currency as your main trading partners far outweighs any marginal advantage of being able to set your own interest rates etc. Liechtenstein uses the Swiss Frank; the Channel Islands use sterling; a lot of shops in the German part of Switzerland were happy to accept Deutschmarks (and now probably accept Euros); Monte Carlo used to use the French Franc; Luxembourg used to use the Belgian Franc; Andorra used to use the Spanish Peseta; The Vatican and San Marino used to use the Italian Lira (these all now use the Euro); and so on.

Even in pre-Euro days, Germany, Benelux and Austria used to have very stable exchange rates and would co-ordinate their central bank interest rate policies, they have been a currency bloc for fifty years. It is also true that there are plenty of huge global corporations which have total income/expenditure far larger than the income/expenditure of smaller countries. None of these corporations have their own currency as such, they just use whatever the local currency is wherever they operate.

2. Any country can print any amount of any currency it likes - provided people are prepared to accept it in payment

In fact, anybody can do this. Remember: money does not exist in and of itself, it is a case of 'splitting the zero' and when you print money, you create an asset (the notes or coins or IOU) and a liability on yourself to redeem or honour them.

To give an example, when you apply for a mortgage, you actually print money, by writing a big number on a bit of paper and trotting round the various banks to see whether any will accept your 'currency'. The banks then decide whether you will be able to repay it out of your future income; you then choose the bank which gives you the best credit rating, i.e. which offers you the lowest interest rate. A UK buyer will print sterling, an American buyer will print US dollars and a Euro-zone buyer will print Euros.

The bank in turn prints its own sterling, dollar, Euro and gives that to the person who sold you the house. Their deposit is backed by the bank's assets, and the banks assets in turn consist of your ability and willingness to repay; and the seller/depositor can withdraw that money over time and spend it on goods and services which you produce; and you take that money and use it to repay the mortgage. So his deposit melts away as your mortgage is repaid. In reality you are getting a house now in return for providing the seller with goods and services in future, it's just that the whole system works better with standardised units rather than with face-to-face barter.

The point here is that governments only need to print money if their expenses exceeds their income (to which see 4).

3. Greece would not need to stop using the Euro as its functional currency even if it left the Euro-zone

This overlaps with 1. above.

I can imagine it's a bit of a hassle introducing a new currency, but that all assumes that Greece has to stop using Euro as its functional currency, even if it does leave the Euro-zone or do a partial default, but who says they do?

Whether the government defaults on part of its debts or not has nothing to do with which currency it uses thereafter (Did Russia stop using the Rouble after its partial default in the late 1990s? Methinks not), in the same way as a lot of companies have gone into and out of administration or done debt-for-equity swaps and still continue using the same currency as before.

(The most recent example I can think of when a country scrapped its old currency and introduced a completely new one was West Germany in 1948, but that was not announced in advance. They just did it overnight, every adult was given DM 40 and told to get on with it, the old Reichsmark were just so much waste paper. Older Germans can still remember that as soon as the Deutschmark was introduced, there were jobs to be had, the shops were full of things to buy and so on, different topic, this was more about wiping out the ill gotten gains of the old Nazis who had hoarded Reichsmark).

Real Greek people and businesses can use any currency they like, in the same way as some Swiss shops used to accept Deutschmarks and now accept Euros. Most governments, for convenience, tend to use one currency only, and there's another fairly modern tradition that taxes are collected in 'money' rather than in kind, but this is only a convention, and there's no over-riding reason why this should be the case (to which see 5).

Now, a government doesn't earn money in the traditional sense, it raises taxes, but as long as the Greek government can collect taxes - which it can and does, it collects 39% of its GDP in taxes, mainly via swingeing VAT - it has no problem as long as it keeps state spending to 39% of GDP. It doesn't of course, but that is a separate issue (to which see 4).

4. Governments only need to print money if they are running deficits. Governments CAN set their own interest rates, even if they use a foreign currency. Government CANNOT set their own interest rates, just because they are using their own currency

If a government matches income and expenditure, it does not need to print or create money at all, or at least, it creates and destroys money at the same rate, so by the end of each month it all squares out again (see 5).

It is only when a government is running a deficit that it needs to 'print money' and the amount they can print depends on its credit worthiness, i.e. the ratio of its overall debt to its current surplus, just like with my mortgage example in 2. Our hero who earns £50,000 has no problem printing an IOU for £150,000 and being accepted by a bank, but very few banks would accept an IOU from him for £500,000.

There is a grey area of course, if our hero wants to borrow £100,000 he'll get a much better interest rate than if he wants to borrow £200,000, and once we get past £300,000 or so, only one or two banks will be willing to lend to him and at very high interest rates, and if he wants to print £500,000 no bank will accept him (i.e. no bank will give him such a mortgage, i.e. the interest rate charged is infinity). Thus the interest rate that the mortgage borrower has to pay depends largely on how much he wants to borrow relative to his income.

I did some charts a while back that show exactly the same rule applies to countries who all use the Euro. The Dutch government pays next to nothing on its government debt because it hardly has any and runs a surplus, Greece and Italy pay the highest rates because their debts are so huge and they run deficits. Quite how the UK government - which is just as indebted as either and runs similar deficits gets away with the derisory interest rates it pays, I simply do not know.

So if the Greek government wants to pay lower interest rates, all it has to do is to run a surplus and pay off its national debt, which can be done surprisingly quickly if a country puts its mind to it, i.e. over ten years or so.

Conversely, let's imagine Greece were to reintroduce the Drachma, re-denominate its debts and start collecting taxes and paying for pensions and salaries in Drachma. Investors would look at the overall ratio between total stock of debt; current tax receipts; and current surplus/deficit and that dictates the interest rate. It's not as if the Zimbabwean government could arbitrarily choose to pay any old interest rate it liked until it scrapped Zim dollars and started using US dollars, is it? That particular experiment seems to have worked, so why should we assume that Greece can achieve a positive outcome by doing the opposite and going from a stable, major currency back to a tin-pot currency?

5. Governments do not need to use any particular currency for tax and spending purposes, because whatever units they choose becomes a currency in its own right

Let's take a simple example and assume that a government runs neither a deficit nor a surplus, so it collects exactly as much as it pays out; or more to the point, it pays out as much as it collects. As Modern Monetary Theory teaches us, the order is unimportant.

It could use green plastic tokens if it wished (provided they are very hard to forge) and decide that pensioners get a hundred plastic tokens a week, teachers and nurses get two hundred a week, policemen get three hundred and doctors five hundred. It then works out that it needs to issue three billion plastic tokens a month, so it has to claim back those three billion plastic tokens in tax. It then decides a simple tax system, where the tax on one litre of petrol or a bottle of wine is one plastic token; the tax on a house is a hundred plastic tokens a week, and so on, as long as the numbers balance somehow.

So a pensioner receives and has to pay a hundred a week and is indifferent. A teacher has a surplus of a hundred tokens and can sell them to anybody who needs to pay their house tax, fill their car with petrol, buy booze, for whatever the going rate is. Or a teacher can take his two hundred tokens, pay his house tax, buy fifty litres of petrol and buy fifty bottles of wine (if he so wishes, not that this 'blog approves of drinking and driving).

Those green plastic tokens have value because people need to get hold of them to pay their house tax or petrol tax or booze tax. Quite how much one token is worth in £-s-d depends entirely on people's marginal preferences between being a teacher/ nurse or working in the private sector; between buying booze, driving a car or having a house to themselves (if five people share a house, the tax is only twenty tokens each per week), and no doubt an exchange rate would be established so that you can go down to the bank and buy or sell tokens for a fairly stable amount in £-s-d, it may be 57p per token, it may be £1.23, the free markets will sort this out.

* He's not an "economist" at all, if you ask me, he is a "commentator on economic matters". By analogy, a sports reporter is not an athlete.
--------------------------------------------------
UPDATE: He has emailed me a spirited defence with some links to his research work, which you can peruse at your leisure and make up your own mind:

http://www.jti.com/file.axd?pointerID=8e10b02017a843cd920459089c544088

http://cesifo.oxfordjournals.org/content/56/2/141.abstract

http://www.econstor.eu/bitstream/10419/26648/1/597827478.PDF

http://stakeholders.ofcom.org.uk/binaries/consultations/823069/responses/Europe_Economics_report.pdf

http://www.policyexchange.org.uk/images/publications/pdfs/Controlling_Public_Spending_-_Nov_09.pdf

http://www.europarl.europa.eu/document/activities/cont/201108/20110818ATT25094/20110818ATT25094EN.pdf

http://www.fsa.gov.uk/pubs/international/mifid_impact.pdf (Annex 2)

http://www.europe-economics.com/publications/bc_rs_thefutureofbankingregulation.pdf

Also worth a look is his excellent summary of the whys and hows of debt for equity swaps.