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Wednesday, June 17, 2015

Greek Crisis To Interfere With Eurocrats' Vacations?

The Greek crisis is heating up again, with the Bank of Greece releasing a hysterical monetary policy report. Apparently all the problems were caused by elected politicians, and rampant mismanagement by the eurosystem had nothing to do with it. According to orchestrated leaks (which are designed to maximise the run on Greek banks), this weekend is allegedly a "drop dead" date, whereupon capital controls will have to be imposed if Syriza does not capitulate to the diktats of the institutions. The timing is somewhat plausible, as the eurocrats possibly believe that the fallout will be contained, and they will be able to take their vacations in August without interruptions.

UPDATE (2015-06-18):  The EU finance minister talks collapsed in acrimony. Apparently there will be a meeting Monday to discuss the situation. However, this weekend would be a convenient time to impose capital controls. Have a nice day. 

Two Plausible Endings

There are two ways in which the "Greek Situation" will likely be resolved, as I discuss below. However, there is a third short-term outcome: the status quo continues. Liquidity could be magically found to allow Greece to keep going again for a few months - until the next "drop dead" date. Alternatively, the Greek government could cave in to Europe's demands, and buy a liquidity reprieve. However, since the underlying economic problems would be made worse, not better, this will essentially just kick the can down the road until the crisis erupts again. Since either case is just a continuation of present trends, I will not discuss it. That said, such an outcome has a reasonable probability of occurring.

The reason why the can be kicked down the road is that the euro is still a fiat currency. Unlike the Gold Standard, there are no gold reserves to run out of, creating a tangible limit to policies. The constraints facing governments are almost entirely determined by politics, with a nod towards the governing treaties.

The first and most likely resolution is that Greece will once again have its own currency. The most likely way this will happen is that capital controls will be imposed. Capital controls will create a "Greek euro", and it will trade at a discount to "rest-of-Europe" euros. The beauty of this is that there is no re-denomination of contracts, and the new Greek currency has a nominal anchor - the old 1:1 parity with rest-of-Europe euros. There is the problem of notes and coins, but it's fair to say that will be easily dealt with. Greek-supplied notes will be treated separately, in some devious fashion to get around the treaty rules regarding legal tender laws.

The second resolution is that European policymakers get hit by an attack of common sense, and drop their more idiotic demands. In any other region, I would normally view this as the highest odds outcome. Unfortunately, European policymaking has a pretty dubious track record going back to at least 1914, and there are no signs of improvement on the horizon.

It is entirely possible that the can will be kicked a bit further down the road, but the euro experiment will end up in the ditch eventually.

Excluded Scenarios

The following scenarios are possible, but I do not see them as being plausible.
  • Greek default, but no exit. The Greeks can announce that they are not paying whenever they want, but the rest of the euro area can refuse to listen. The only way to make the default stick is to close the Greek capital account.
  • Greek reforms magically work, problem goes away. The existing reforms are fighting against accounting identities, so I see no chance of success.
  • Deus ex machina. The rest of the world (or the euro area) could enter a self-reinforcing private sector investment boom. A rising tide would lift all boats, even Greek ones. This starry-eyed optimism was still plausible in 2010, but there is no reason to believe in it now. The global private sector already has excess capacity in practically everything, and governments are tightening the screws on fiscal policy. And in case a bright light does appear at the end of the tunnel, Fed rate hikes would probably squash the over-extended animal spirits in the financial markets.

The Beauty Of Capital Controls

The advantage of imposing capital controls is that people are so focussed on form, they do not notice function. Imposing capital controls allows Greece to create its own currency, and largely without running afoul of EU laws. They are not imposing a re-denomination upon citizens, it is just that their euros are suddenly worth less than other euros. The fiction could be entertained that the Greek euro would re-enter at a 1:1 parity, creating a nominal anchor for the new "currency". It will also let the rest of the euro nations pretend that the Greek TARGET2 balances are still money-good.

Additionally, it would allow the government to clamp down on capital flight. Some sense of normality has to return to the Greek private sector, in order to allow it to actually have a chance to grow again.

Once the realisation that Greece has a new currency has sunk in, the markets will start sniffing around for the next countries in line. Given the haplessness of euro area policymakers, that is a long list. Meanwhile, enterprising Greeks will be able to set up consulting firms that could export their capital control expertise to those other peripheral countries.

Will Damage Be Contained?

European policymakers are acting in a fashion which indicates that they believe that a Greek "exit" can be contained. This is probably correct from an economic standpoint (but hyperactive equity markets might jump around). The only immediate risk is that some of Europe's dodgier banks still have some exposure that blows up on them. 

In the longer term, the reality that the euro is not irrevocable will have sunk in. The Greek experience will repeat elsewhere, probably when the global economy next falls into recession.

Geo-Politics

Historians will be able to take the map of 2015 and mark it as the high water mark of European industrial civilisation. The loss of peripheral Greece, in the Balkan "powder keg of Europe" is somewhat ominous, particularly when developments to the east and across the Mediterranean are not confidence inspiring. Greece is a member of NATO, and there is no reason to expect dramatic developments in the near run. Political strains will make it much harder for Europe to manage the waves of refugees that are inbound. Relative to the size of continental Europe, the amount of refugees entering are small. However, they are concentrated in the poorer southern countries (the point of first entry), which are less able to absorb them.


(c) Brian Romanchuk 2015

10 comments:

  1. Which capital controls are you suggesting? ISTM the best approach is simply to close or suspend the TARGET2-ECB account that the TARGET2-Greece holds and that automatically stops any movement other than by exchange for all banks using TARGET2-Greece accounts.

    There seems to be a clause in the Harmonised TARGET2 conditions that allows either party to do that on 14 days notice.

    As to legal tender, it's always important to realise that legal tender only means that you can pay in that scrip *in court* in settlement of a debt that you are being sued for. It means nothing else really because there is no effective enforcement mechanism.

    Which means that in ordinary operations using notes and coins people outside Greece will simply refuse to accept 'Y' serial notes and coins with Greek characters on them.

    ReplyDelete
    Replies
    1. I am not an expert on the plumbing, but I believe it mainly involves the TARGET2 system. I am unsure what steps were taken in the case of Cyprus. Whether or not other measures can be taken is uncertain; they would probably run afoul of EU rules on capital mobility. Those rules are why Varoufakis argued that Greece would have to leave the EU (somehow) if they wanted to create a new currency.

      They would have to clamp down on the movement of notes and coins, which may or may not already be in place.

      Yes, I think they will be able to finesse the notes and coins in the short-term. Legal tender laws are generally not too important. But something would have to be done, eventually if the situation persists.

      Delete
    2. I am not an expert on the plumbing, but I believe it mainly involves the TARGET2 system. I am unsure what steps were taken in the case of Cyprus. Whether or not other measures can be taken is uncertain; they would probably run afoul of EU rules on capital mobility. Those rules are why Varoufakis argued that Greece would have to leave the EU (somehow) if they wanted to create a new currency.

      They would have to clamp down on the movement of notes and coins, which may or may not already be in place.

      Yes, I think they will be able to finesse the notes and coins in the short-term. Legal tender laws are generally not too important. But something would have to be done, eventually if the situation persists.

      Delete
  2. Brian,

    Always a pleasure to read your posts.

    In your first scenario, do you think the capital controls would be imposed by the Greek gvt, or by the ECB and the other EUR countries, or maybe both?

    Also, how would the issue of the imminent payments to the IMF and ECB be solved in your opinion? Even more importantly: how would Greece pay for essential imports such as energy, medicines, etc? Wouldn't Greece quickly descend into chaos unless the capital controls were accompanied by some form of EUR financing for Greece? The quid pro quo demanded by other EUR countries in return for financing is the austerity measures Greece is refusing to implement. Presumably Greece would still not want to implement these measures after capital controls have been imposed and hence other EUR countries would still not want to provide it with EUR financing, no?

    I also do not understand why Greece would want to clamp down on capital flight (which I interpret to mean EUR fleeing Greece). After the capital controls have been imposed and the new currency has been introduced, these Greek EUR would no longer be 'real' EUR but the new currency, if I understand you correctly. As such they can be created by the Greek government at will and do not represent any hard EUR purchasing power that Greece can use to pay for the abovementioned essential imports. So why bother trying to keep them in Greece?

    Lots of questions, sorry. Trying hard to understand all of this.

    Thanks again for your posts.

    J.

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    Replies
    1. As I discussed in the comment by Neil Wilson, the only capital control that I know for sure that would be implemented is closing Greece's access to the TARGET2 system, and probably clamp down (further?) on cash withdrawals. Any other steps would require finding loopholes in the EU treaties, and that is not my area of expertise. In the short term, the TARGET2 closure would be enough.

      The "rest of euro" countries would probably impose the closure, but it's unclear how loudly the Greek government would object. If the Greek government did it unilaterally, they would be crucified by the majority of Greeks who want to keep the euro.

      The government would be able to negotiate transfers with the rest of Europe. Since the capital controls will be billed as "temporary", everyone can pretend that debt payments will eventually be made in euros

      Payments for imports would have to be worked out. Solvent financial institutions with operations both in and outside Greece could act as intermediaries. Suppliers will have to take into account the lowered value of "Greek euros", but they will have a much better chance of being paid. I doubt that pharmaceutical companies would want to be permanently locked out of the Greek market.

      Greece would only really open its policy space if it starts issuing some form of scrip (such as "Tax Anticipation Notes"). They would trade at a discount to euros in other countries, but they would have a better chance of staying at a stable value versus "Greek euros". They would likely become the de facto currency.

      As for why the Greek government wants to clamp down on capital flight, it is for political reasons. The people who are fleeing the Greek banking system are the people with money, and they would get a windfall gain if and when Greek euros end up being worth less than euros held in banks elsewhere. Meanwhile, those people are not likely to be Syriza supporters.

      Delete
  3. Brian,

    It's long but read my latest on the endgame for Greece and Europe:

    http://pensionpulse.blogspot.ca/2015/06/the-endgame-for-greece-and-europe.html

    Best,

    Leo

    ReplyDelete
    Replies
    1. Hi,

      I took a look, it's interesting. I did not really cover why the existing "reforms" will fail, and what I think would work. If they opt to kick the can down the road (again), I will probably write a short article explaining why the can-kicking is ultimately futile. But if something big happens in the coming days, such an article would be moot.

      Delete
  4. Replies
    1. Hi,

      I understand the difficulties in getting traffic for a new blog. But I suggest that you put a more substantive comment next time, as I normally delete comments that are just a short compliment and links. Those comments are usually spam. Since your links seem to be to an economics blog, instead of some advertising site, I let this one through.

      Delete
    2. My weekend comment on whether investors should prepare for Graccident:

      http://pensionpulse.blogspot.ca/2015/06/prepare-for-graccident.html

      Check out the interview with Michael Hudson, think you'll like it.

      Delete

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