To Save the Euro, the Eurozone Governments Must Stand By Greece

By Marshall Auerback

George Soros probably understands the nature of the immediate problem facing the Eurozone (namely, the accelerating bank run which, amongst other things, potentially exposes Germany to trillions of contingent euro liabilities).  But even Soros reflects the prevailing – and mistaken – view that Greece might need to become the sacrificial lamb required to save the euro.  He said as much in a recent interview in Der Spiegel. Questioned about his proposal to rescue the European Monetary Union via a Debt Reduction Fund, Soros was asked whether this measure could also save Greece.

Soros: Unlikely. Rescuing Greece would require an enormous kind of magnanimity and generosity. The situation there has simply become too poisoned. I think that by standing firm and not compromising on Greece, Angela Merkel would be in a better position to persuade the German public to be more generous toward other nations and distinguish between the good guys and bad guys in Europe –(our emphasis))

Policy makers, market practitioners, indeed anyone like Soros, who keeps saying, “Well, we might have to sacrifice Greece ‘pour decourager les autres'” fail to recognize that this type attitude actually exacerbates the fatal flaw in the euro’s architecture and makes its ultimate demise more likely, not less. The same issues that confront the euro zone today would intensify in the event of a Greek exit.  As Yanis Varoufakis has noted “the lack of a constitutional (or Treaty-enabled) process for exiting the Eurozone has a solid logic behind it. The whole point of creating the common currency was to impress the markets that it is a permanent union that will guarantee huge losses to anyone bold enough to bet against its solidity.”

As Varoufakis argues, a single exit suffices to punch a hole through this perceived solidity.  It goes back to the fundamental flaw cited by Peter Garber at the time of the euro’s inception. As long as there was no perceived probability of euro exit by any euro nation, the established transfer system coupling private markets with European system of Central Bank support (Target 2, ELA, ECB repos) would function like any other monetary system in a single nation state. However, Garber recognized that if there arose the prospect of a euro exit and, therefore, a devaluation risk for holders of deposits in the banks domiciled in the country slated for exit (e.g. Greece or Spain), the European monetary system would be exposed to a bank run. Under the EU treaty capital mobility was guaranteed. Under the common currency deposit transfers from domestically domiciled banks in countries at risk of euro exit (e.g. Greece, Spain) to banks domiciled in other euro nation states (e.g. Germany, Netherlands) was costless. Faced with any non-negligible perceived risk of a euro exit and thereby a devaluation loss, rational market participants should move all their deposit funds from the banks domiciled in the country at risk of euro exit to banks domiciled in nations at the Eurozone’s unassailable core.

In the United States we have 50 states and one central bank. Likewise in other Federal systems such as Canada and Australia.  In all cases, there are fund transfers across states.  And these are permanent institutional arrangements.  It is highly likely that West Virginia or Mississippi will remain long term recipients of Federal transfer payments, even if they remain “uncompetitive” vis a vis, say, Texas or California.

But there cannot be any prospect of a secession of a state that will bring with it its own devalued currency. Hence, there is no incentive for deposit flights from banks in one state or region to another. Therefore, private markets, with a little help from the Fed, will close the financial circuit to the extent there are such fund transfers. The European Monetary System was supposed to work that way. And as long as no one worried about any country leaving the euro, it did. But once the risk of euro exit on Europe’s periphery raised its ugly head, the euro system became completely different. Peter Garber argued that, given such a perceived prospect, the euro system was a perfect mechanism for a deposit run. And once doubts arose in 2009 about a possible euro exit by Greece and Ireland, a deposit run began – and in earnest.

Openly discussing the possibility of a “Grexit” then, simply exacerbates the current problem.  It is akin to cutting an artery to demonstrate that one is serious about “discipline” and self-sacrifice”, whilst failing to realise that cutting that artery could well cause the entire patient to bleed to death.  And whether it’s Greece which withdraws (or is booted out), or Italy, or Spain, very few people have, as Simon Johnson recently noted:

gotten their heads around dissolution risk. Here’s what it means: If you have a contract that requires you to be paid in euros and the euro no longer exists, what you will receive is unclear.”  Why would that dissolution risk be mitigated if Greece were to exit the Eurozone?

Today, the euro is slowly but surely bleeding a death via the bank deposit runs that are now afflicting much of the periphery and gradually extending further into the core.  Commenting on Frank Veneroso’s analysis of the bank run, my colleague Randy Wray argued:

Euroland is now in the midst of a massive run on periphery bank deposits. If you think about it, anyone who still has a Euro deposit in any bank other than a German bank is either a philanthropist or a fool. Moving deposits to German banks is a sure bet: if Germany leaves the EMU depositors will get appreciating Marks, and if Germany remains in the EMU depositors have the safest Euro deposits available.

Why take a risk that Italy or Spain or Greece will leave the EMU, default on Euro-denominated deposits, and redenominate them into a depreciating currency?

Paradoxically, the only way to alleviate this perception is for the European authorities to stand by its weakest member, in order to enhance the perception of the euro’s permanence as a monetary union.  That means the line in the sand must be drawn in Greece, not Spain or Italy, as politically unpalatable as that might be to the German public.

Yes, Germany could leave, but as Berlin’s own Finance Ministry noted recently, it would be incredibly costly:  An internal report from the finance ministry in Berlin was leaked by Der Spiegel indicating that a breakup of the euro would lead to a 10% contraction in the German economy in the first year with the number of unemployed nearly doubling.

It is also worth noting that although much of the flight deposit funds are going into German banks, under the ECB rules Germany’s loss exposure is limited to its 28% participation in the ECB. Were Germany to exit the euro, it would abrogate the Treaty. Its banking system, including the Bundesbank, might be exposed to almost all of such losses rather than the mere 28% under the current euro system.  Which led to a very interesting comment by an Italian reader of Wray’s blog:

My life savings still reside in several Italian banks, partly due to a sliver of optimism but mainly because I fear that if / when the sh*t really hits the fan, and a large share of Greeks, Italians and Spaniards have already transferred their savings to German banks, that Germany will pass a law expropriating funds received from the periphery in order to help pay for the unfathomable costs of the end of the Euro.

Now wouldn’t that be even more foolish that keeping everything in Italy?

A scary thought and perhaps unfathomable.  But so much of what has already happened in the Eurozone crisis would have seemed unthinkable just a few months before.  And the Italian commentator here poses a legitimate question.   The answer to him is, “Yes, leaving money in an Italian bank is one possible response to a threatened expropriation by Germany of funds leaving the periphery in order to pay their counterparty claims as creditor.  But the other possibility is to take your money out of the Eurozone altogether.”

Capital flight out of the Eurozone would put the crisis in a different order of magnitude than has hitherto been the case, and would clearly expose once and for all that we have a euro design problem, not a disease of public sector profligacy. Why?  Because it would almost certainly expose Germany to risks as well as the other member nations.

Were the crisis to manifest itself as a general loss of confidence in the euro (as opposed to a problem of a major bank run in the Eurozone periphery), we should ultimately expect to see widespread portfolio preference shifts out of the euro, causing a much bigger decline than has hitherto been the case.  In many respects, a weaker euro is just what the doctor would order for the EMU nations, as it would provide a growth outlet via the export channel were the currency to fall enough on a trade-weighted basis.  But it might be viewed undesirably by the ECB, given its desire to retain a modicum of anti-inflationary credibility (however misconceived that might be) and, more to the point, could well heighten the sense of panic which has hitherto been lurking just underneath the surface of Europe’s banking system.

This has been a most extraordinary silent bank run.  We haven’t seen queues of people in front of loads of banks, desperately struggling to withdraw their money, but the Target 2, ELA and ECB repo activity all point to accelerating deposit flight. The biggest beneficiaries have hitherto been the German banks, but a generalized loss of confidence in the euro could well mean that the next wave of panic leads to outflows from the Eurozone altogether, which would likely be reflected via a sharply falling euro exchange rate.  Given that the ECB is doing all in its power to keep the run from being a subject of public discussion (to do otherwise would likely exacerbate it), it is also likely doing what it can to maintain a strong or, at least, stable euro exchange rate, to prevent the bank run from erupting wide into the open.

Why isn’t the euro falling? In the aftermath of last July’s U.S. debt ceiling wars, central banks were diversifying out of dollars into euros despite Europe’s woes. However, recently a number of Asian central banks, such as the People’s Bank of China, have acknowledged being heavy sellers of euros.  And the Commitment of Traders data continues to suggest that market speculators are net short the euro as well.

If specs in futures markets are massively short, as the COMEX data now seems to be indicating, and central banks are not buying euros, what could possibly be supporting the euro several big figures above where it was in mid-2010 when conditions in Europe were not nearly as bad?  Perhaps the ECB itself? Or the ECB in combination with the Federal Reserve via the latter’s dollar swap facilities?

If this week’s summit does not provide a comprehensive solution to Europe’s bank run (as now seems unlikely), the ECB will likely move more aggressively in terms of supporting the continent’s tottering banking system (it is already lowering collateral requirements for both Spain and Italy, and has probably done likewise for Greek banks for the past several months via the ELA).  Operationally, it can do this until the cows come home, but as more market participants (and, indeed, other central bankers) come to recognize the precarious position of the Eurozone commercial banking system, and the corresponding risks associated with holding one’s money in any euro-domiciled bank (including Germany) the euro could fall substantially.  At a minimum, the ECB must stop the rot by persuading the markets that there will be no sacrificial lambs.  To show the euro’s essential permanence, it must hold the line with Greece, not treat Athens like a forced amputation designed to save what’s left of a seriously ill patient.