Wednesday, May 16, 2012

Greek explosion imminent, I swear

I’ve called it prematurely for over two years, but now I am pretty sure that Greece is about to go under. This is for two reasons: (1) the run on Greek banks is accelerating; and (2) the ECB has reportedly begun to turn off the liquidity spigot for a number of Greek banks because they are hopelessly insolvent.

When the lender of last resort cuts off a bank facing a run, the bank is dead and will shortly default on its deposits. While the Greek central bank and the Greek government will do whatever they can to prevent bank failures, the remorseless arithmetic is decisive, because neither Greece nor its central bank can print euros. It appears that the ECB is now playing the game of chicken with the EU: If you want us to prevent a Greek collapse, then recapitalize its banking system with EU money.

I’m sure that the EU wants to prevent a Greek collapse, but I don’t see where they can get the money to recap Greek banks. That is a fiscal job for the government, not a liquidity job for the ECB. The Greek government isn’t going to get an open line of credit until it implements the austerity plan already agreed to. And it can’t implement the austerity plan because there won’t be a Greek government until a month from now, if then.

So unless the EU blinks, Greece won’t be able bail out its own banks, and they will have to close their doors. Once one Greek bank defaults on its deposits, all banks will be subject to massive wholesale and retail runs. This means that Greece will have to impose a deposit freeze pretty quickly. But the only way to reopen the banking system is with a currency Greece can create, which means leaving the eurozone. (This decision will have to be made by an unelected government without a parliamentary majority; how convenient for Greek politicians.)

Leaving the eurozone will necessitate not only redenomination but also default upon all external debts denominated in euro, which Greece can’t pay. Greece has the choice of repudiating its foreign debt or denominating it in drachma at par, and then paying it off Zimbabwe-style. Either way, it will totally screw the ECB and the rest of the eurozone. Their collapse will cost Europe something between EUR 500 and 900 billion. A small country, but a big price tag.

Greece is facing a “hard constraint”: bank insolvency and illiquidity. This is not a problem that can be resolved by negotiation, riot, or military coup. It can only be resolved by leaving the eurozone and massive external default.

I have to assume that the focus of attention in Brussels and Frankfurt now is deciding whether to push Portugal off this same cliff, since it is inevitable, and maybe Ireland too. They have to build a firewall around Spain because Spain is too big to fail. The Spanish firewall will have to involve the ECB, because only the ECB has unlimited resources in euro. The EU can help to recapitalize Spanish banks, but it can’t stem deposit outflows; only the ECB can do that. This will require an endless three-way conference call between Paris (Hollande), Berlin (Merkel) and Frankfurt (Draghi and the ECB board).

This crisis comes at an awkward time for France, which has taken its first step down the Greek anti-austerity road.  The people of France have voted against austerity and in favor of growth. They are going to get austerity.

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