'Imagine a depositor in the US state of Arizona being permitted to withdraw only small amounts of cash weekly and facing restrictions on how much money he or she could wire to a bank account in California. Such capital controls, if they ever came about, would spell the end of the dollar as a single currency, because such constraints are utterly incompatible with a monetary union. https://www.project-syndicate.org/commentary/greece-dual-currency-regime-by-yanis-varoufakis-2016-01#Lhm32CE5g1edaVbx.99
Suppose Arizona has just one bank. It is insolvent. The Fed could agree with the Receivers of the insolvent Bank, that small transactions can go through because they will net out in a predictable manner but that large transactions or cash withdrawals will not be permitted. Clearly, this is a stop gap measure of a type familiar to Insolvency practitioners. In the long term, Arizonan depositors will take a haircut whose size depends on relevant Deposit insurance provisions. Shareholders are likely to be wiped out and different classes of creditors will settle for cents on the dollar. There is no implication for 'monetary union'. True, there may be an Arizonan political party which demands secession from the Union and the refinancing of the troubled Bank through the establishment of a new currency. If Arizona does a lot of trade with the rest of America or receives net transfers, this course of action would be suicidal even if it were politically or militarily feasible. Why? Creditors in other States would be able to get Court orders to distrain assets owned by, or remittances to, relevant Arizonan counter-parties so as to satisfy their own claims. Those Arizonans with positive net assets or transfers with respect to the rest of America will have to be coerced to accept the new currency or the intermediation of the re-financed Arizonan Bank. If this is not done, then the new 'funny money' will rapidly inflate away into toilet paper.
Varoufakis thinks otherwise. Why? Turns out he's been doing a bit of Mathematics. Let us see how good he is at multiplying and subtracting.
Greece today (and Cyprus before it) offers a case study of how capital controls bifurcate a currency and distort business incentives. The process is straightforward. Once euro deposits are imprisoned within a national banking system, the currency essentially splits in two: bank euros (BE) and paper, or free, euros (FE). Suddenly, an informal exchange rate between the two currencies emerges.
Urm...Capital Controls lead to Currency Black Markets and/or 'Multiple Exchange Rates'- everybody knows this. If Tax evasion and money laundering are going on there is already going to be an effective 'Black' exchange rate depending on the level of risk and size of the transaction involved. A guy running a kebab shop in Kensal Green who launders his money through Cyprus is probably paying about a 7 to 15 percent premium. If VAT goes up along with stricter enforcement and hence detection rates, the premium goes up (unless there is a compensating Supply shock). If VAT falls, the premium falls because demand decreases.
Consider a Greek depositor keen to convert a large sum of BE into FE (say, to pay for medical expenses abroad, or to repay a company debt to a non-Greek entity). Assuming such depositors find FE holders willing to purchase their BE, a substantial BE-FE exchange rate emerges, varying with the size of the transaction, BE holders’ relative impatience, and the expected duration of capital controls.
On August 18, 2015, a few weeks after pulling the plug from Greece’s banks (thus making capital controls inevitable), the European Central Bank and its Greek branch, the Bank of Greece, actually formalized a dual-currency currency regime. A government decree stated that “Transfer of the early, partial, or total prepayment of a loan in a credit institution is prohibited, excluding repayment by cash or remittance from abroad.”
Actually, what happened was this. Varoufakis was Finance Minister when the Banks closed. A couple of weeks after he resigned they reopened with stringent limits on withdrawals. The decree he mentions came into effect at that time- i.e. 20th July- two weeks after he resigned. It was the Government of Greece, led by Tsipras (with whom Varoufakis had not yet broken ties) who passed this law. Incidentally, the Bank of Greece is not a branch of the ECB. Its Governor is the Greek economist who invited Varoufakis to take up a Professorship at Athens University.
The eurozone authorities thus permitted Greek banks to deny their customers the right to repay loans or mortgages in BE, thereby boosting the effective BE-FE exchange rate. And, by continuing to allow payments of tax arrears to be made in BE, while prescribing FE as a separate, harder currency uniquely able to extinguish commercial bank debt, Europe’s authorities acknowledged that Greece now has two euros.
The Eurozone authorities did not have the power to prevent Greece passing the law Varoufakis complains about. Europe's authorities 'acknowledged' nothing. They did not say 'our Banks will only accept Euro transactions emanating from Greece if they are of a particular sort'. No rules were changed by Eurozone authorities. The Greeks had made certain sorts of transactions illegal and this had consequences for Banks dealing with Greece no matter where they were registered.
The real effects of the dual-currency regime on Greece’s economy and society can be gleaned only from the pernicious interaction between the capital controls and the “reforms” (essentially tax hikes, pension reductions, and other contractionary measures) imposed on the country by the eurozone authorities. Consider the following beguiling example.
Greece’s companies fall roughly into two categories. In one category are a large number of small firms asphyxiating under the tax office’s demand that they pay in advance, and immediately, 100% of next year’s corporate tax (as estimated by the tax authorities). The second group comprises listed companies whose depressed turnover jeopardizes their already diminished share value and their standing with banks, suppliers, and potential customers (all of which are reluctant to sign long-term contracts with an underperforming company).
The coexistence, in the same depressed economy, of these two types of businesses gives rise to unexpected opportunities for shadowy trades without which countless businesses might close their doors permanently. One widespread practice involves two such firms, say, Micro (a small family firm facing a large advance tax payment) and Macro (a publicly traded limited liability company that needs to demonstrate higher turnover than it has).
Macro agrees to issue invoices for (non-existent) goods or services rendered to Micro, up to, say, €20,000 ($22,000). Micro agrees to pay €24,600 into Macro’s bank account (the price plus 23% value-added tax) on the understanding that Macro will reimburse the €20,000 to Micro. This way, at a cost of €4,600, Micro reduces its taxable revenue by €24,600, while Macro boosts its turnover figure by €20,000.
Alas, due to capital controls, Macro cannot reimburse Micro in FE, nor can it wire €20,000 to Micro’s BE bank account (lest they be found out by the authorities). So, to seal the deal, Micro and Macro approach a cash-rich vendor. This is usually a gas-station owner who is flush with cash at the end of each day and who, for security reasons and in order to pay for his fuel supplies, is obliged to deposit his cash daily at his bank, turning valuable FEs into less valuable BEs. The mutually beneficial deal is completed when Macro wires €20,000 in BE to the gas-station owner, who then hands over a smaller sum of FE (cash) to Micro’s owner, pocketing the difference.
The fact that this informal deal benefits all sides exposes the terrible inefficiency of current fiscal policy (namely, punitive business taxes) and how capital controls magnify it. The state collects additional VAT from Micro (at a loss of corporate taxes that Micro cannot pay anyway); Macro enjoys the benefits of seemingly higher turnover; and the gas-station owner reduces his losses from converting FE into BE. The downside is that economic activity is overstated and, more important, that reform becomes even harder as entrepreneurs internalize the necessity to find new, creative ways of bending the rules.
So, Varoufakis thinks 'Micro' will want to escape the 26 percent Corporation Tax by committing a crime which involves paying 23 percent VAT! What's more, Macro- a big company- and this cash rich petrol station owner will also be willing to commit crimes just to get a share of the 3 percent difference between the VAT rate and the Corporation Tax rate! Are Greek business men crazy? Who in their right mind will commit a crime for just a one percent margin? Suppose Greek business men really are like the utility maximizers of Game Theory. Will 'Micro' be any better off? No. He paid his Corporation Tax in advance. The assessment is based on previous earnings. The sudden appearance of an invoice for services from 'Macro' won't get him a refund but it may get him an audit. The immediate effect of Micro's action is that he first pays Advance Corporation Tax and then pays VAT on a bogus transaction, so as to reclaim some of that tax, but then, because Tax authorities assume people are rational and if their Cost of Sales went up, so must their profits, ends up either paying double or else getting caught and ends up paying a huge fine or going to jail. At no point does Micro end up with more money in his pocket than he would have if he had stayed honest.
What about 'Macro'? By issuing the bogus invoice, he has to hand over not just VAT but also Advance Corporation Tax on his profit from the supposed sale. Suppose his net profit is ten percent. Though, Revenue and Cost of Sales went up equally- by 20,000- Net Profit will be predicted to rise by 2000. The Advance Corporation Tax liability, at 26 percent, will be 520. So, to chase a one percent illegal profit of 200 Euros, 'Macro' incurs an immediate Advance Corporation Tax liability equal to 520 Euros! What's more, sooner or later, he can look forward to a Tax audit and a big fine and a cozy jail term.
What about the Garage owner? He has cash Euros which he wants to deposit outside Greece (only a nutter would put his money into Greek banks after what happened last year). Many Greek businesses are re-locating to Bulgaria. They have a proven business model but need working capital which is costly for them to acquire because foreigners don't know them and will charge a premium. Clearly, this is an arbitrage opportunity of a sort which Greeks have been successfully exploiting since the the time of Homer! I don't know off hand what the cost of laundering 'Petrol Garage' Euros is but it can't be higher than what the local West London doner kebab king is paying because British enforcement is tougher than anything that yet obtains in Greece.
Varoufakis thinks the Garage owner will invoice Macro for 20,000- incurring God knows how much VAT and fuel tax liabilities in addition to the Advance Corporation Tax on the supposed profit from this transaction- in order to get a wire transfer of 'BE'. Why on earth would he be crazy enough to do this? If he is so patriotic as to want to keep his money in a Greek Bank, he can do so at zero risk and less than one percent cash collection cost rather than getting in bed with Macro and Micro. If he wants to get into the Currency black market- handing out paper packages of 20,000 euro notes to guys he's never met- he should do so without getting involved in a paper trail. In any case, the guy needs to be super-liquid to pay his suppliers. He's the last person on earth who wants to be caught currency poor if the Banks close again.
The sole purpose of the capital controls imposed on Greece last summer was to force the country’s rebellious government to capitulate to the eurozone’s failed policies. But an unintended consequence was the formalization of two parallel (euro-denominated) currencies. Combined with the punitive taxation caused by Europe’s refusal to recognize the unsustainability of Greek public debt, the dual-currency regime produces unforeseen incentives for informal transactions in a country that desperately needs to defeat informality.
The reality of Greece’s two currencies is the most vivid demonstration yet of the fragmentation of Europe’s monetary “union.” In comparison, Arizona has never looked so good.
The Greek Government, not the ECB, passed the law Varoufakis complains off. Exchange Control was never demanded by the Eurogroup. The Greek Government, of course, is perfectly at liberty to introduce 'FE' auctions, or formalize a multiple exchange regime, like other IMF defaulters. The course they have taken is that of least resistance. However, it must be said, Varoufakis's own plan would have been significantly worse.
Last August he wrote as follows-
The phenomenon is both the cause and consequence of delayed tax payments to the state, reinforcing the cycle of generalised illiquidity.
To address this problem, our simple idea was to allow the multilateral cancellation of arrears between the state and the private sector using the tax office’s existing payments platform. Taxpayers, whether individuals or organisations, would be able to create reserve accounts that would be credited with arrears owed to them by the state. They would then be able to transfer credits from their reserve account either to the state (in lieu of tax payments) or to any other reserve account.
Suppose, for example, Company A is owed €1m by the state; and it owes €30,000 to an employee — plus another €500,000 to Company B, which provided it with goods and services. The employee and Company B also owe, respectively, €10,000 and €200,000 in taxes to the state. In this case the proposed system would allow for the immediate cancellation of at least €210,000 in arrears.
Okay, lets try this. My cousin Vivekides Iyeromogolou pays 100 Euros cash in bribes to get a Govt. contract to supply 100,000 of worthless rubbish- profits to be split according to the time honored formula such that all relevant wheels are greased.
Currently, since the ECB won't play ball, Vivekides gets nothing because the Govt. has no funds to disburse - which discourages him from such activity.
Under Varoufakis's scheme, however, he can immediately- no questions asked- trade this notional 100,000 to some guy who genuinely owes that much in taxes. Vivekides can now proceed to pay off the Greek Bank Accounts of the other crooks involved such that it appears that the worthless rubbish has been delivered and found to be of acceptable quality. Currently, Vivekides's conter-party is paying the Greek Treasury in Euros using his domestic Bank account because that Bank might go bust anyway. Under Varoufakis's new scheme, however, he can have his cake and eat it too. Vivekides will trade his 100,000 for a fraction of the counter-party's Bank Balance. The Govt. gets stuck with 100,000 of worthless rubbish and also loses whatever Vivekide's share of Greek Bank Euros could otherwise have legitimately purchased.
But the game doesn't stop there. Essentially you now have the possibility for a complicated deal whereby a criminal with some 'black Euros' can get a 10,000 credit in his Bank account so as to create a 'legal' front for his criminal gang, by paying Vivekides 1000 Euros cash down in return for which Vivekides hands over his 100,000 credit for worthless rubbish. This 100,000 credit eventually finds its way to a genuine tax payer- a, perhaps, not over scrupulous businessman holding 'blue Euros' (on an analogy with the Argentinian blue dollar, which functions like an unofficial foreign exchange auction) arising from off the books, or falsely invoiced, transactions by exporters, who now settles with the Greek Treasury at a much smaller sacrifice of Internationally accepted fungible assets than would otherwise be the case. Everybody wins- except the Greek Treasury which gets stuck with its own worthless scrip. Varoufakis just fucked over his own Govt.- again!
Currently, since the ECB won't play ball, Vivekides gets nothing because the Govt. has no funds to disburse - which discourages him from such activity.
Under Varoufakis's scheme, however, he can immediately- no questions asked- trade this notional 100,000 to some guy who genuinely owes that much in taxes. Vivekides can now proceed to pay off the Greek Bank Accounts of the other crooks involved such that it appears that the worthless rubbish has been delivered and found to be of acceptable quality. Currently, Vivekides's conter-party is paying the Greek Treasury in Euros using his domestic Bank account because that Bank might go bust anyway. Under Varoufakis's new scheme, however, he can have his cake and eat it too. Vivekides will trade his 100,000 for a fraction of the counter-party's Bank Balance. The Govt. gets stuck with 100,000 of worthless rubbish and also loses whatever Vivekide's share of Greek Bank Euros could otherwise have legitimately purchased.
But the game doesn't stop there. Essentially you now have the possibility for a complicated deal whereby a criminal with some 'black Euros' can get a 10,000 credit in his Bank account so as to create a 'legal' front for his criminal gang, by paying Vivekides 1000 Euros cash down in return for which Vivekides hands over his 100,000 credit for worthless rubbish. This 100,000 credit eventually finds its way to a genuine tax payer- a, perhaps, not over scrupulous businessman holding 'blue Euros' (on an analogy with the Argentinian blue dollar, which functions like an unofficial foreign exchange auction) arising from off the books, or falsely invoiced, transactions by exporters, who now settles with the Greek Treasury at a much smaller sacrifice of Internationally accepted fungible assets than would otherwise be the case. Everybody wins- except the Greek Treasury which gets stuck with its own worthless scrip. Varoufakis just fucked over his own Govt.- again!
Suddenly, an economy such as Greece’s would acquire important degrees of freedom within the existing European monetary union. In a second phase of development, which we did not have time to consider properly, the system would be made accessible through smartphone apps and identity cards, guaranteeing that it would be widely adopted.
In other words all current tax payers with access to black or blue Euros would immediately be able to buy 'tax Euros' for pennies. The Treasury gets worthless 'tax Euros' which no one will be willing to receive for the supply of stuff which aint worthless simply. Govt. can't buy anything. It can't raise any revenue. The State has withered away- thanks to Varoufakis's genius. No doubt, as a former President of the Black Student's Alliance at Essex university circa 1978, Varoufakis will be declared President for Life by the grateful Greek people whose desire to adhere to the 'Europeanist' project actually meant joining Zimambwe and Somalia and Sudan as IMF defaulters because as Varoufakis said 'Greeks are the Blacks of Europe'.
What is your verdict on Varoufakis as Mathematician? Yes he can multiply 20,000 by the VAT rate and get the right answer which is 4,600. He says that a total of 24,600 can be deducted by 'Micro' from his taxable revenue. This isn't true. It is a bogus transaction bound to attract an audit unless Greek tax authorities are incompetent- in which case the simpler and safer method is simply to lie to them ab ovo.
Moreover, since Greece is moving to 100 percent Advance Corporation Tax, this does not mean Micro gets any money back today. It seems, Varoufakis can multiply all right but if he does so then he can't subtract properly.
Moreover Micro has to pay a commission to the Garage Owner. Thus he is losing more than 4600 today in order to avoid paying 5200 at a later date and committing a crime in the process. Assuming even purely computerized checking by the Tax authority- the increase in his Cost of Sales by 20,000 will actually cause him to receive a demand for as much as 10,400 extra Euros (assuming typical Gross Profit mark ups for micro enterprises) ! Of course, if the Greek Tax authorities are utterly worthless, this may not happen- but in that case why not just under-report Profits in the first place? Even if this were not the case, would any sane person sacrifice liquidity at this time for so paltry and problematic a reward?
What about the counter-party- the big firm 'Macro'? Varoufakis correctly calculates that they have to pay 4,600 in VAT at the end of the quarter. But he forgets to add the Advance Corporation Tax on the profit from this transaction. Furthermore, he neglects the role of the external auditor (Macro, presumably, is a public quoted company).
Assume Macro's net profit margin is ten percent- then it has incurred 520 in immediate tax liability purely on the basis of increased turnover. However, because of its bogus transaction with the Garage owner- which boosts Cost of Sales and thus projected Gross Profit (unless the two transactions are set off against each other- which would immediately raise red flags and give the game away) the total expected net contribution from the bogus transaction (because fixed costs remain unchanged) will look double that of genuine transactions- i.e. it will be close to the VAT rate. This happens even if the payment to the Garage owner isn't shown as 'above the line' (i.e part of Gross mark up) but appears to be directly related to boosting contribution to fixed costs. Since the relevant marginal contribution on novel below the line items must be high- otherwise the external auditor objects- the net profit rate appears to have increased. The more 'Macro' indulges in this sort of bogus transaction, the more it looks as though its net profit margin is actually much higher than what it really is- viz. eleven percent of which ten percent is legal and one percent illegal- and that it is hiding money. This means, sooner or later (assuming Greek Tax authorities are competent) Macro gets a huge tax bill based on total turnover but computed at this new, purely fictitious, net profit rate. Of course, if tax authorities aren't competent, everybody would just pretend to be making a loss to avoid Corporation tax altogether. In either case, rational agents (even the artificial sort who figure in Game Theory) will never act in the manner Varoufakis suggests. Unless, that is, they are equally stupid and ignorant.
Assume Macro's net profit margin is ten percent- then it has incurred 520 in immediate tax liability purely on the basis of increased turnover. However, because of its bogus transaction with the Garage owner- which boosts Cost of Sales and thus projected Gross Profit (unless the two transactions are set off against each other- which would immediately raise red flags and give the game away) the total expected net contribution from the bogus transaction (because fixed costs remain unchanged) will look double that of genuine transactions- i.e. it will be close to the VAT rate. This happens even if the payment to the Garage owner isn't shown as 'above the line' (i.e part of Gross mark up) but appears to be directly related to boosting contribution to fixed costs. Since the relevant marginal contribution on novel below the line items must be high- otherwise the external auditor objects- the net profit rate appears to have increased. The more 'Macro' indulges in this sort of bogus transaction, the more it looks as though its net profit margin is actually much higher than what it really is- viz. eleven percent of which ten percent is legal and one percent illegal- and that it is hiding money. This means, sooner or later (assuming Greek Tax authorities are competent) Macro gets a huge tax bill based on total turnover but computed at this new, purely fictitious, net profit rate. Of course, if tax authorities aren't competent, everybody would just pretend to be making a loss to avoid Corporation tax altogether. In either case, rational agents (even the artificial sort who figure in Game Theory) will never act in the manner Varoufakis suggests. Unless, that is, they are equally stupid and ignorant.
What is our conclusion? Varoufakis can multiply correctly but if he does so he then loses the ability to add or subtract relevant totals. Essex University gave this guy a Degree- a lower Second admittedly- in Mathematical Economics. They must be so proud.
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