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Tuesday, 21 June 2011

Default And A Single Currency

While some in the Fourth Estate work themselves into a panic over events in Greece, amid talk that a Eurozone country might default on its debts, very few have realised that a rather larger economy within a single currency area has already done this, and that the single currency concerned has not merely survived, but its integrity has not even been threatened.

Before the advent of the Euro, the premier single currency, and single currency area, was that of the USA. The Greenback was also acknowledged in many other countries as a reliable means of exchange. And within the USA, individual states enjoyed considerable autonomy in revenue raising powers – maybe not to the extent of nation states within the EU, but autonomy nevertheless.

Moreover, the reality of a single currency, along with a single interest rate and single source of control via the Federal Reserve was unquestioned, even though the outcomes swung from prosperity along the north-east corridor from Boston to DC, to widespread poverty close by in West Virginia. And recent years have brought other strains on this single currency area.

As the first decade of the new century came to a close, the state of California was effectively bust: the shortfall ran into tens of billions of dollars. So then-Governor Arnold Schwarzenegger devised a cunning plan, involving a bond issue. This raised much needed revenue and kept the state solvent. And then holders of those bonds began to think about cashing them in.

But when the bonds were traded, nobody wanted to give 100 cents on the Dollar for them, so sellers had to take whatever they could get, if they wanted to realise some cash. And here there was, effectively, a partial default, if only by proxy: California bonds making around 70 cents on the Dollar meant that securities in that single currency had been written down.

So what happened to the single currency? Well, the US Dollar went on very much as before. There was no market panic, no upheaval, no flight of capital, even though, were California a stand alone economy, it would be the world’s eighth largest. The state had effectively forced creditors to take a haircut (on top of an extended repayment schedule) without the kind of collapse that some are predicting for the Eurozone.

That’s something to think about when reading the various horror stories about Greece and what will happen if there is some kind of default. I’ll look at the potential for a haircut, and who might be affected, later.

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