I have been totally wrong recently. First I thought that continued growth in the US would mean rising corporate earnings and that equities could well grind upwards, and that the problems of Europe were on hold. Then I thought that the recent sell-off was mainly about Spain, and that fears about that country were overdone. I did not see the Greek election causing the chaos it has done — I rather assumed that PASOK and ND would scrape a majority and that the austerity programme would basically continue.
I think about equities as depending on trailing earnings and credit spreads. The latest Greek problem has led to a widening of credit spreads, while I expected credit spreads to narrow, giving an extra boost to the equity market.
As a result of being wrong, I have lost money, roughly cutting in half my return for the year to date. This is better than the alternative, which is being wrong and failing to lose money. If you don’t lose money when you are wrong, you will not make money when you are right.
My main mistake has been to misjudge which developments would be most salient. Assessing salience is the most important art of the discretionary macro trader. I did not focus on the risks in Greece or on what could happen if a government could not be formed — although recent events were probably impossible to predict. More significantly, once the Greek election had happened, I was too slow to see the danger it posed. This was the big mistake.
I also chased a view — and I am not sure if this was right or wrong. In late January I was inclined to be long equities, but did not get in (I don’t just buy any old time — that is a sure fire way to lose money — I wait for a buying opportunity). In response, I modified my trading method to allow me to get into a rally that had already begun. But I waited too long, and I think there was an element, in my recent purchase of the S&P 500, of chasing returns for a call that was right but which I failed to trade. On the other hand, I was well aware of the risk of this, and thought it over carefully. Was I blind to the risks? I did, after all, only take half a position. Or was I basically right, in that, had the Greek election edged the other way, equities would have continued upwards? I am not sure. Not every loser is a mistake. I will keep mulling over the extent to which my recent losses have been mistakes.
What is the right way to think about Greece? For years, I have argued that the advance of an undemocratic, federal Europe would provoke revulsion or even violence in the individual member states, once local populations realised that they had no democratic outlet for whatever frustrations they happened to feel at the time. Actually, Greece has not reached the stage I envisaged, in which the achievement of change through the ballot box would be impossible (this is still the direction in which Europe is heading). But is had reached the stage at which change could not be achieved through normal politics. In response, voters gave the two parties that represent normal politics only 32% of the vote in the election.
Was this in line with my expectation? The problem is, it was a long-term expectation. I think that austerity will not work, and I think if austerity is pursued vigorously and indefinitely then local populations will eventually reject it. But at any given time, it is more likely that the moment for that is “later” rather than “now”. That is what I assumed this time. Further, polls showed, and continue to show, a majority of Greeks in favour of remaining in the euro — but perhaps the connection between that and the state of the economy has always been too complicated for voters to understand. Their opinion on the cause of their troubles is irrelevant if they decisively reject the effect.
It is very difficult to reconcile long-term and short-term views on this; but I suppose I should have been watching like a hawk for evidence that the revulsion stage had been reached.
Leaving the Euro?
What does it mean to say that Greece could be forced out of the Eurozone? What it means is that the next tranches of aid to Greece might be cut off, so that the country defaulted on its bonds; as a result, the ECB might stop accepting Greek bonds as collateral and refuse to allow any further emergency liquidity assistance from the Bank of Greece to Greek banks. Together with a likely acceleration in the “jog” on the banks that is happening at present into a full-blown run, this would bankrupt the Greek banking system. (At the same time, the government would have no sources of external capital and likely no ability to borrow domestically and would therefore have to balance its budget at once, which would mean continued fiscal contraction. Greece’s GDP, already down 20% from its peak, would collapse still further.)
I wonder whether it is inevitable that the Bank of Greece would have to be ejected from the Eurosystem in this situation. I do not see why this has to be so. If the Bank of Greece stayed in, then the creditors of the Greek banks (including depositors) would have a claim on those banks’ reserves at the Bank of Greece (including, probably, the Bank of Greece itself — presumably the fact that the collateral it held against loans to Greek banks had become worthless would mean it became a general creditor?). The fact that the capital of the Bank of Greece had been wiped out would not matter, because the losses would be borne by the whole Eurosystem. It would presumably take some time for creditors to get their hands on these reserve balances. On the other hand, if the Bank of Greece were ejected, its liabilities would become something other than euros — but since they would not be accessible to anyone (the banks having gone bankrupt) it would be hard to argue that Greece would in fact have a new currency. A country has a currency only to the extent that it has a banking system.
What would be the currency, then? Whether the Bank of Greece stayed in the Eurosystem or not, the deposits of the Greek population in Greek banks would be wiped out. But euro notes and coins would continue to circulate. Some Greeks would have euro deposits abroad, and they could continue to use these to purchase goods and services from other Greeks with foreign bank accounts (and foreign banks with branches in Greece would presumably continue to operate). The value of a euro would not change, but the number of euros in Greece would fall dramatically; the Greek population would become a lot poorer relative to the rest of Europe; the lack of euros and the demand for hard currency would likely mean sharp deflation. Greece would become very poor, and would effectively use the euro without being “in” the euro (as Kosovo and Macedonia do, and in the same way that Panama and Ecuador use the US dollar).
What would happen next? If the Bank of Greece remained in the Eurosystem, then a new national banking system could eventually created along the same lines as the old one. If it was ejected from the Eurosystem, or if a political decision were taken to pull out of the euro, then either Greece could remain “euroised”, with no currency of its own, or a new currency could be created.
I suppose the point of all this is that the creation of a new currency is a matter of political decision and bureaucratic organisation. A chaotic exit from the euro of the kind described above does not lead quickly to the creation of a new currency; it leads to the “euroisation” of the economy. I think it unlikely, in such a chaotic situation, that a government could be formed that could organise the transition to a new currency. If it ever happened, it would be, at least, some months after the initial collapse.