Wednesday, July 8, 2015

What Grexit? Just keep calm and carry on ... and keep Greece in the Eurozone.

Remember the battle cries before the Greek referendum?  The Greek government has let the last opportunity for a final deal go by, and a “no” on Sunday, July 5th, will invariably mean a “Grexit”, an exit of Greece from the Euro currency zone.  It will mean that the world for Greece will come crashing down and that excruciating disaster will strike.  
Well, the Greeks voted “no” anyhow.  Now, there is yet another deadline on Sunday, July 12th, for a final, final deal, or else a “Grexit” will invariably follow.  Or perhaps the endgame truly arrives on July 20th, when Greece has to repay 3.5 billion Euros to the ECB. Yes, this is getting tiresome.  
Now, granted, it is possible that the exit scenario will finally come to pass on July 21st, if no deal is struck on Sunday, July 12 and Greece then defaults on the ECB on July 20th.  This is what most observers predict, this is what the threatening voices from the ECB suggest.  So let me raise another possibility.  I will argue that there may be no Grexit at all.  Yes, there will be haggling.  Yes, there will be chaos in Greece (no kidding, things haven’t been great there as of late).  Eventually, in a few years, everything will be humming along ok. Indeed, if the cooler heads prevail, on both sides and in particular at the ECB, this scenario looks to me more likely.  How so?
Let me start with a hypothetical scenario.  Suppose, Merkel and Co. would have offered in June that all Greek sovereign debt is going to be wiped out and forgiven, at the price of no further lending to Greece by other governments or European funds in the future.  No other conditions: no “austerity”, no demands of cuts in pension, nothing else.  What would Tsipras have done?  He would have driven home to a victory parade.  He and his government would have been celebrated through the night by huge cheering crowds for this major triumph.  They would have considered building him a huge statue on the Parthenon.  And all talk of a Grexit would have stopped.
Take the current situation.  And suppose, the Greek government simply does not make any further payments on its old debt.  Suppose that otherwise, everybody carries on with whatever they would have done in that hypothetical scenario above.  Sure: the IMF, the ECB and the other European governments will not be happy.  But if they, essentially, act rather similarly as if the debt had been forgiven in that scenario above, the difference to that scenario will be small indeed.  And: no Grexit. 
But, you may say, why should the IMF, the ECB, the other European governments act the same way?   So, let’s ask, what can they do about the Greek default?  What are they prepared to do?  And: what is it, that they really want? 
There is a lot of noise by many that Greece should be punished for its intransigence by kicking it out of the Eurozone.  But there really is no procedure for doing that.  The Maastricht treaty does not say, that the ECB and the other European governments can liberally bail out each other, against the promise of debt repayment and the threat of having to leave the Eurozone otherwise. On the contrary: the whole legal framework had been designed explicitly with the stipulation of “no bailout” and no financing of governments by the ECB.  It takes two to Tango.  You lent money to Greece?  You shouldn’t have.  You are mad that you are not getting your money back?  I get that.  But, unfortunately, there is no legal basis for you to somehow now punish Greece by kicking it out of the Eurozone.  Sorry.
The somewhat more elegant version is the argument that Greece should finally, really decide whether they want to be part of the European Monetary Union and play by its rules, or not.  The mischievous hope here somehow seems to be that Greece throws in the towel on its own.  It probably could indeed somehow exit the European Union, and thereby exit the EMU as well.  And there are even a number of economists who argue, that the introduction of a Drachma and a subsequent devaluation would revive the situation in Greece and restore order to its banking system.  But guess what!  The Greeks like the Euro.  So far, they have no intention of leaving the EMU on their own.  They probably think that a Grexit and the reintroduction of a Drachma would do more harm than good: incidentally, so do I.  It seems unlikely, therefore, that the Greeks will leave on their own: certainly, for a while.
The key issue to all this is the ECB and the Greek banks.  We have all seen the dramatic pictures of people in Greece lining up at banks, trying to withdraw cash, of which the Greek banks now have very little.  But as in any bank run, banks run out of liquidity pretty quickly.  It is then the task of the lender of last resort to step in and lend to solvent, but illiquid banks against good collateral at penalty rates, as Bagehot has taught us.  And that is exactly what the ECB claims it has done.  It has provided emergency liquidity assistance or ELA, via the Bank of Greece to Greek banks to the tune of nearly 90 billion Euro, vastly exceeding the --- by comparison --- rather minor amounts that were the subject of negotiation between the Greek government and the other European countries in June. 
What happened to those 90 billion?   They are no longer in the banks.  If they are not abroad, they are now in circulation in Greece.  They are under mattresses.  They are in envelopes and suitcases, which get handed over, whenever a large transaction needs to take place.  The next plot by Barclay’s research puts it into a nice perspective: Greece is increasingly becoming a cash economy. For every Euro withdrawn from Greek banks, about 40 cent increase domestic cash circulating.
How much, really, could the Greek depositors still withdraw, if the ECB would be so generous and lift the limit entirely?  It turns out: a lot less than it used to be.  Check the plot of the private sector deposits in Greece.  They once stood at 240 billion Euro at the end of 2009.  They fell dramatically: the latest number from the Bank of Greece for May states it as 130 billion.  Surely, it is even lower now.  So, one half or more of what has been on the bank accounts has been withdrawn already.  There is lots of cash in Greece.  It just isn’t in the cash machines or at the banks.  Good luck with converting all that cash into Drachma.
The ECB has felt increasingly uncomfortable with extending so much ELA.  There are increasingly stronger voices which argue that the ECB has gone too far already and should withdraw this support.  ELA was meant for the plain-vanilla bank-run: for solvent, but illiquid banks, the national central bank provides cash against collateral, at a haircut, unless the ECB vetoes that.  Should any losses occur, the national government will have to pony up.  But this here is a system-wide run on the Greek banks.  And the Greek government does not seem inclined to pay for any losses to any non-Greek entity.  With the deep recession in Greece, the ECB may finally judge that the collateral isn’t worth the cash lent against it and may judge the banks to be insolvent, rather than illiquid, and stop the ELA entirely, rather than just keeping it at the current 90 billion Euros.  Many think that a default by Greece on the ECB on July 20th will trigger that, though there is really no logical reason to link the two.  This is all about a judgement call, how much the collateral is worth, how solvent the banks are, and how much one should value the fiscal backstop for those losses that result.
So let us examine the scenario of ELA withdrawal.  At that point, the ECB could ask for the ELA to be repaid --- an impossibility at this point --- or seize the collateral, pushing the banks into bankruptcy.  Does that now automatically mean a Grexit, because somehow the Greek government would be pushed into printing Drachma to repay the remaining depositors?  There are lots of other possibilities.  One is: split the banks into a part that has liabilities vis-a-vis the Bank of Greece and the other parts, which have a viable network of branches, cash machines and customer base.  Sell the latter to the foreign banks: they will be valuable; they will be open for business as soon as the deal gets done.  What about the former?  For that, gradually sell the assets that have been pledged as collateral: perhaps, they were really worth as much as has been claimed all along and the banks were really solvent, in which case these parts will be profitable too and the remaining deposits can be paid off.  Or perhaps losses occur, which need to be covered somehow, perhaps with a mix of haircuts on the remaining deposits, government IOUs and a reinjection of capital by the Greek government.  The Syriza government, after all, is not averse against making payments to its own citizens, and there would be considerable national pressure to solve this issue.  Does it beat receiving Drachmas instead?  I think so.  It probably beats it by a mile.  Moreover, a number of Greek banks are already part of the single resolution mechanism of the European Monetary Union, which guarantees European funds as a backstop, should national backstops fail.  It is entirely possible that the end of ELA and an inability or unwillingness by the Greek government to pay triggers European clauses, providing considerable payouts and deposit guarantees to Greek depositors.  That will be fascinating to watch.
Finally, it is interesting, what Merkel, what Hollande, what Draghi are saying.  They claim that their objective is to keep Greece in the Eurozone.  They really do not hope for a Grexit.  Not only would it be a huge black spot on their record, it also would make any repayment of existing Greek debt even less likely.  The Greeks do not want out either.  So, the wisest course of action may be for the ECB to simply sit really still on its ELA claim on the Greek national bank.  Some of the Greek banks will have to be broken up, as described above, to get the functionality of the financial system back on track.  The Greek government will need to make sure to keep collecting taxes from the now somewhat further reduced activity at home.  It is close to a zero primary deficit, and should be able to keep making payments at home with the taxes it collects.  There will be occasional financial flow mismatches or perhaps there will be a bit of a primary deficit: perhaps then, the Greek government will pay a small portion of its salaries, pensions or obligations with IOUs.  These may then circulate: perhaps at a discount or perhaps not (for example, if they can be used for paying taxes). Is this a Grexit?  If the majority of the transactions happen in Euros, if all the accounting is still done in Euros, we shouldn’t call it that.  IOUs are used elsewhere too. 
So, perhaps the best thing for everyone is to table the whole issue of debt repayments for now.  We really do not need more final, final, final, final deadlines and hectic negotiations.  There are more important things to do.  Let’s put these issues and the outstanding ELA amounts on ice for a while, and let the Greeks struggle along, on their own.  In a year or two, let’s calmly restart the discussion on what to do about it all.  With that, things may turn out to be much more benign, than the doomsday sayers have been preaching.  Indeed, this may not be a disastrous “Grimbo”, as some have argued, but a new beginning.  After a somewhat painful adjustment phase, which Greece is in the middle of already, there will be a return to some reasonable normality.  Things will be ok. And Greece may even be willing to repay a good portion of its debt, at that point.
So, just keep calm and carry on and keep Greece in the Eurozone.

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