Will Greece unravel by Christmas?

Much of the latest issue of the newsletter, sent out two weeks ago, was on disaggregating the trading performance of the RMB to separate market sentiment from PBoC actions, but since this was pretty technical stuff I am not including it in this blog entry. This means that once again most of the current entry will be on Europe — a topic from which it is hard to escape.

In China economists are watching the spectacle in Europe, China’s largest export market, with rising dread. Might European deterioration affect Chinese growth? October and November tend to be very important months for Chinese exports, and so the prospect of a miserable Christmas in Europe is weighing heavily on Chinese exporters.

But there isn‘t much China can really do about it. President Hu left the G20 meeting in Cannes Saturday without committing China to very much, merely saying: “We believe Europe has the wisdom and ability to solve the debt problem.” At this point, however, regardless of the amount of wisdom floating around Brussels I think it is pretty unrealistic to expect a happy solution.

We’re well past that stage. By now, it seems to me, neither wisdom nor cooperation among world leaders is going to get us out of the debt and currency problems we face. Rather than try to prevent a major disruption the policy goal now should be to engineer as quickly as possible the least disorderly and disruptive unraveling of financial markets in the peripheral countries. And while it may help relieve frustration to excoriate European leaders for having made poor, we shouldn’t assume that there really is a set of “right decisions” that will lead us out of this mess. I think there isn’t.

In Athens, the refusal by New Democracy yesterday to join Pasoc in a coalition government indicates just how difficult political cooperation is likely to become, and how drastically political horizons have shortened. What’s more, by forcing Papandreou to cancel the referendum just days after he announced it – in the face of white-knuckled threats from an enraged France and Germany – Athens has pretty much made clear just how desperate things are and how little room the leadership has to maneuver.

Indeed the whole issue of sovereignty has become fuzzy. Since France and Germany have basically exercised direct power over Greek’s electoral politics without assuming responsibility for solving Greece’s domestic problems, I can’t imagine that this won’t stoke even more resentment in Greece.

But it’s worse than just an issue of fuzzy sovereignty. Last week something new happened which cannot help but affect the near-term outlook. By openly speculating for the first time on Greece’s leaving the euro, Europe’s leaders have ensured that there is almost no chance now of preventing it from happening, and sooner even than most pessimists expected.

A country CAN leave the euro?

Not that there ever really was much of a chance, in my opinion, to keep Greece in the euro, but I assumed that European leaders would do whatever they could to postpone the day of reckoning until after the major elections this and next year. They would find ways, I thought, even if that meant putting more unemployment pressure on the middle and lower classes in Greece for another year or two.

But now I don’t think Europe can postpone Greece’s exit much longer. Statements by France and Germany may have transformed the dynamics of the crisis affecting Greece. Here is an article from Friday’s Financial Times:

In the frantic political seizure triggered by Athens’ abortive referendum plan, European leaders broke what was once the eurozone’s big taboo: that Greece could default and leave the eurozone. The possibility has long been discussed in private, not least in Germany. But for the eurozone’s leadership – especially France – the avoidance of default and preservation of the euro’s integrity was a core goal of the seemingly endless series of rescue plans and negotiations to keep Greece from crumbling under the weight of its public debt.

Only last week, Nicolas Sarkozy, the French president, said in a national broadcast that a Greek exit would be a “catastrophe” for Europe and the world. The mood has now shifted dramatically, with Mr Sarkozy and Angela Merkel, the German chancellor, publicly discussing the prospect in public as they heaped pressure on George Papandreou, the Greek prime minister, to back away from his call for a plebiscite on the €130bn bail-out for Athens.

Greece’s European partners were not just furious that they had not been consulted about the now abandoned referendum. They knew that with public hostility to the austerity imposed on Greece rising, the likely outcome was rejection by the Greek electorate, potentially triggering a Greek default and contagion across the eurozone.

In effect, Mr Sarkozy and Ms Merkel were forced to acknowledge that reality in order to bring home to Mr Papandreou, his government and the Greek opposition just how high the stakes had become. “The question is whether Greece remains in the eurozone, that is what we want. But it is up to the Greek people to answer that question,” Mr Sarkozy said. The message from Ms Merkel was the same.

By openly acknowledging that Greece could abandon the euro, Europe’s leaders may have set in motion events that will automatically force Greece to leave. Here is the logic. If Greece is ever forced to leave the euro, it will first have to re-denominate domestic corporate and household liabilities into the new currency – let’s call it the drachma – or else domestic borrowers will be wiped out by the fall in the value of revenues relative to debt as the drachma immediately depreciates against the euro.

But it doesn’t end there. If a bank’s assets – its outstanding loans – are to be redenominated into drachma, then its liabilities, i.e. deposits, must be redenominated too, or else the balance sheet mismatch will bankrupt the bank.

And there is where the problem lies. As soon as any depositor realizes that bank deposits are likely to be redenominated into drachma, he will pull his deposits out of the banks so as to protect the value of his savings. But obviously only a few depositors will be able to do this before forcing the bank into closing. In order to prevent the resulting collapse in the banking system, the only thing Athens can do is to freeze bank deposits long before most depositors have had a chance to cash out.

But depositors know this. As the probability of Greece’s leaving the euro rises – and clearly it rose dramatically this past week – anxious depositors eager to prevent their deposits from being frozen and redenominated in a weaker currency know that they will have to speed up their withdrawal of deposits from banks. And of course as anxious depositors withdraw their deposits, the likelihood of a banking crisis rises, and with it the likelihood of Greece’s being forced to freeze deposits and leave the euro.

A Bagehot intervention?

We are caught, it seems, in one of those self-reinforcing loops that almost always presage a collapse. Rational behavior by individual agents leads towards a catastrophic event the threat of which reinforces the behavior.

I don’t see any way to get out of this loop except with a Bagehot-style intervention – a very unlikely but immediately credible announcement by Germany and France that they are prepared to guarantee all deposits in the Greek banking system. I call it a “Bagehot intervention”, but of course Walter Bagehot would never have recommended bailing out an insolvent borrower.

Without a credible intervention this process almost always ends the same way. There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro. Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations. Will Greece follow suit? “If history repeats itself,” footballer Andrew Demetriou once pointed out, “I should think we can expect the same thing again.”

And it probably won’t end there. In my opinion the real risk for Europe in that case becomes a contagion of deposit withdrawal, not immediately, but at the first sign of trouble in their home countries. As households from Italy, Spain, Ireland, Portuguese, and other vulnerable countries read every day about hardships faced by Greek families (and those, it will be noted, who trusted the authorities were the worst hit), what will they do?

I know what many of my wealthy Spanish friends are already doing. They are moving their deposits to safer havens. I suspect that in other countries too anyone who can afford to withdraw money from the domestic financial system is at least thinking of doing so. If this process accelerates it may be very hard to maintain domestic confidence in the local banking systems anywhere.

If Greece gets worse in the next few weeks, Europe had already better have a plan about what steps it will take to defend banks in peripheral Europe. Once Greece goes, even the least sophisticated households in other countries will know what the consequences for depositors will be. Deposit withdrawals, after all, are one of the kinds of actions that different sectors of the economy will take to protect their interests in the face of a crisis, even though this behavior increases the likelihood of the crisis.

This is simply part of the logic of sovereign financial distress – declining credibility causes stakeholders to act in ways that reduce credibility further. What’s more, deterioration in the political process is part of financial distress at the sovereign level. Remember, as Keynes pointed out back in 1922, that resolving these kinds of crises is always political – it is about which sector of the economy (or class) ends up paying for the adjustment.

Workers can pay in the form of high unemployment and declining wages, the middle class can pay by having its savings inflated away, private businesses can pay in the form of confiscatory taxes and expropriation, creditors can pay through forced debt forgiveness, and so on, but ultimately someone must pay. Politics becomes about deciding which groups will be forced to foot the bill. Historical precedents suggest that political fault lines are likely to develop as different groups organizes politically to protect themselves.

We will probably see this happen, for example, in Spain. On November 20 Spain will hold elections. For now it looks like the conservative PP will sweep out the Socialists and take nearly 200 of the 350 seats in Parliament. This will give them a clear mandate and the power to enact any legislation they want.

Unfortunately, as I suggested earlier in this newsletter, this doesn’t mean that they can resolve the crisis if only they figure out the “right decisions”. Although it is unlikely they will mismanage the crisis to the same extent as the Socialists under Zapatero, who seemed to place a little too much importance on charm and cleverness over leadership, I am not sure there is a whole lot the PP will be able to do better than the Socialists.

Both parties after all face the same problem. They must drive the economy back into competitiveness, but aside from tinkering at the margins with tax and structural changes, really the only two ways Madrid can make Spain competitive is to drive wages down or devalue the currency. The options for the PP, in other words, are the same as for the Socialists: either abandon the euro or accept extremely high levels of unemployment for the rest of the decade. It is unlikely that any government facing those two options can maintain popularity for very long.

This is an abbreviated version of the newsletter that went out two weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.