Tuesday, March 26, 2013

Financial Medieval: Hard currency hypothesis and Risk-free assets revised.

It has not been a very long time (at all) since I begun my undergraduate studies in economics and from what I remember there were only a few (conventionally) risk free assets: cash, government bonds, deposits. At this moment we really need to focus on the Euro-zone. Government bonds, i.e. debt issued by government, although involving some risk this is low- currently a little higher; cash is the bills and coins in circulation and is totally riskless, unless in cases of over-inflation; and deposits which... used to be risk-free. That is because European Commission is thinking of de jure haircutting savings when the firm that accommodates them is at stake. If that is approved, Euro will never be much of a hard currency and hence there is no point at all calling upon low inflation exclusively. 

In addition, we have to start thinking of our deposits as risky and, as a matter of fact, the probability that we lose a given fraction of our deposits equals the probability of bank failure times this given fractions. That is to say that think we have secured our future income and welfare, rather we "sold" CDS for free.

Currently, the probability of recording losses in the value of your bank deposits in Euro-zone has sharply risen forcing you to re-examine your options. You cannot turn to sovereign debt because you may feel unsecured and you might be more of a risk-averse personality as well. Most likely, your preferences shift towards cash. Thus, you might be considering at the moment withdrawing some of your deposits, if not all, or have them moved at another location such as Switzerland, the USA, GB etc. ECB and European authorities will have to respond to these actions of yours by imposing capital movement restrictions and, probably, by selling foreign exchange reserves in order to restrain the depreciation momentum. 

If all the above are combined, they form a scenery from some decades ago; from Bretton Woods system to the first half of Wasington Consensus (the Middle Ages of finance). We failed to maintain a balance between regulation and complete deregulation and we may start oscillating from the one to the other instead. We also failed to maintain a constrained state essential for the enhancement of entrepreneurship and we imposed heavy taxation instead. We failed to take some precautions in order to allow for fiscal soundness before being too late and we expect immediate actions and immediate results from structural reforms instead. In other words, while the markets were left unregulated and unbounded at any cost in the name of efficiency and the subsequent prosperity developing more and more sophisticated tools we just end up back from where we had started.

If you are not convinced, as yet, that the price of a hard Euro have been the recent years of feeble recovery within the EMU member states, nor that we paid that price in order to finally go a few decades back consider this: does it worth it to pursue a hard currency at such a cost?