By John Mauldin
"All folly must end eventually. Greece's ELA folly will end with the cash gone abroad and the collateral turning out worthless.
"Along the way, the rest of Europe will grow increasingly nervous. ELA loans are guaranteed by the Greek central bank, which is in turn guaranteed by the Greek government. And the Greek government already can't pay its debts without help from the rest of Europe.
"As the pile of ELA loans grows, northern European governments will likely begin agitating for limits to be placed on Greek use of ELA, or to cut it off altogether. If the Greek government threatens to default on its debts to Europe, the question of cutting off Greek ELA would likely be raised at the same time.
"But in the periphery and in France, there will be voices for leniency. A vote to cut Greece off from ELA would be a vote to force its banking system to shut down. That would send a very frightening message to depositors in Spanish, Italian, Irish and Portuguese banks, and could create a European-wide bank run.
"It requires a vote of two-thirds of the Eurozone's national central bank governors to restrict a country's use of ELA, so Greece would need only five allies to block.
"My guess is that compromises will be made, and though Greece ELA might be progressively limited, it will never be cut off entirely. Likewise, Europe is likely to suspend aid-loan disbursements from time to time, but then negotiate last-minute compromises before Greece gets to the point of defaulting on its debts.
"Eventually, Europeans will realize that the losses of the Greek banking system have been foisted on them, bit by bit, ELA loan by ELA loan.
"There is no way Greece can ever be forced to pay for the banking losses that it is monetizing through ELA. The money is going to private parties' accounts at mostly German banks. The bad assets are hanging slightly over the Greek central bank's balance sheet, ready to be dropped there in a big, stinking pile as soon as Greek banks are cut off from central bank financing.
"One way or another, the rest of Europe will end up paying for the clean-up. The only question will be whether to pay pro-actively through another, bigger Greek bailout with repayment pushed further into the future, or to pay by cutting Greece off from ELA, forcing Greek banks to shut down, and then having to replenish ECB capital wiped out by Greece's inability to make good on its guarantees of ELA loans."
There is about €240 billion in
loans in Greek banks, which could fund ELA money if the Greek central bank was
lenient with its definition of qualified collateral and haircuts. In theory,
under the current authorization the Greek central bank could fund the
withdrawal of every deposit in every bank in Greece, leaving no deposits. And
they could continue to do it until the ECB voted to cut up their credit card.
This, as Thomas points out – and David agrees – will not happen, because that
starts a bank run in Spain and Portugal the same day! And the following week in Italy?
And that is one of the reasons
why anyone who understands this system is nervous about this weekend. If the
Greek give the relatively radical-left party Syriza the largest share of the
vote, the amount of money leaving Greece will escalate quickly, as the danger
of returning to the drachma will increase. Given the rhetoric on both sides,
there could be a dramatic increase in risk.
But will the ECB unilaterally
cut off Greece from ELA funds? I rather think not. There is little question
that cutting off ELA would push Greece out of the eurozone. Rather, the ECB
will wait (appropriately in my opinion) for the political authorities to act.
This is not an issue to address with monetary policy. Draghi said as much in a
recent interview. While he would prefer Greece to stay in the eurozone, that is
a decision for the political policy makers.
A final thought about Greece
and implications for the rest of Europe. Money leaving Greek banks is money
that is not invested in Greece businesses. Cash has no multiplier. It is the
opposite of high-powered money. It is deflationary.
A run on banks makes it much
more difficult to recover, especially of an economy is reduced to cash and
barter. Greece is tragically short of medicines and needed medical supplies. It
is dangerously close to losing access to energy markets. I would say Greece is ripe
for a military coup, but if your military personnel can go on strike (which
some of them have!) that does not actually inspire confidence in their power.
Greece is going to need
massive amounts of aid and bailouts and loan forgiveness. And yes, Spain looks
like Greece did three years ago, except with a worse-off economy and a banking
crisis. Spanish and other European politicians are saying the same things about
Spain that were said about Greece three years ago. And that is why Greece
matters. If Greece is cut off, then the markets will ask, "Who is
next?"
The Bang! Moment is Here
Let's review that quote from This Time Is
Different:
"Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence – especially in cases in which large short-term debts need to be rolled over continuously – is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang! – confidence collapses, lenders disappear, and a crisis hits.
"Economic theory tells us that it is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, which makes it so difficult to predict the timing of debt crises. High debt levels lead, in many mathematical economics models, to "multiple equilibria" in which the debt level might be sustained – or might not be. Economists do not have a terribly good idea of what kinds of events shift confidence and of how to concretely assess confidence vulnerability. What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. When countries become too deeply indebted, they are headed for trouble. When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite."
I think the time is rather close. Spain cannot
borrow the money it needs to bail out its banks at a rate it can afford and has
in effect been shut out of the bond market. Spain is going to need not just a
bailout for its banks but also to restructure its debt and/or default on some
of it. That is just the math. And when Spain needs that money, the market will
get very nervous about Italy. And we mustn't forget Portugal; it will need debt
forgiveness as well. Oh, and Ireland.
German Chancellor Merkel this week warned that
the policies of the new Socialist French president, Francois Hollande, could
destroy the eurozone by bringing the sovereign debt crisis to France itself.
"As tensions within the eurozone deepened on Friday, the German chancellor dismissed 'quick fixes' and refused to consider any discussion on pooling debt for eurobonds or Germany underwriting bank deposits in other eurozone countries. She hit out at Mr Hollande for blocking EU supervision of national spending and supporting eurobonds, which she warned would 'mask' divergences between Germany and 'mediocre' or declining eurozone economies, such as that of France. 'If you look at the development of unit labour costs between Germany and France, differences have now been growing a lot more strongly, a topic that must be discussed,' Mrs Merkel said." (The Telegraph)
There is a summit coming up in a few weeks.
Gordon Brown, former prime minister of Britain, said that the "standard
but often empty" plans usually agreed to at such summits will "not do
when the euro area is finally approaching its own day of reckoning." He
warned that the crisis threatens to spread and lead to Italy and even France
requiring bailouts. Rather unusual for a former PM.
If France loses its AAA rating, then the
pressure would be on Germany to do the really heavy lifting. Merkel realizes
that and will put pressure on Hollande to back off from his campaign promises,
before he risks that rating and the entire eurozone experiment.
It appears that Merkel is ready to accept a
serious fiscal union and central budget controls, but strict guidelines and a
much more specific treaty will be conditions for German acceptance. In a speech
to supporters this week, Merkel said it was a mistake not to have done a fiscal
union 15 years ago – a rather new position for her. The unspoken quid pro quo
will be to implement labor and other reforms in the weaker countries and so
narrow the gap in productivity and competitiveness between them and Germany.
She will look to directly connect every transfer payment and guarantee that
Germany will inevitably have to give, to the shifting of control of fiscal
authority to Brussels.
But the question is time. Europe does not move
without a crisis. As Jean Monnet himself said,
"People only accept change in necessity and see necessity only in crisis."
And to negotiate the terms Merkel, will want
will take a lot of time, something that the markets may not want to give her.
Europe is down to two choices. Either allow
the eurozone to break up or go for a full fiscal union with central budget
controls. The latter option ultimately means eurobonds and a central taxing
authority. It also means that national labor unions will cede control to
technocrats and politicians in Brussels. And that will mean the changing of
labor laws. Will Europe blink when faced with central control and a European
parliament that really makes a difference?
The rest of Europe is watching Greece implode.
Spain has almost 25% unemployment. Italy has rejected basic labor reforms. The
entire continent seems to be in denial.
Investors in bonds expect to get paid back.
That is a very simple concept. And if investors worry about getting paid back,
they ask for higher interest or simply walk away. There are other places to put
money to work. Like Switzerland. Apparently, entire segments of European
citizenry seem to think that government funding is a fundamental right,
something that comes with no strings attached. "Give me what I want in
terms of pensions and work. And health care. Protect me from change and market
forces in my job. And tax someone else, preferably someone else who has more
than I do, so I can enjoy all these benefits."
There is a limit to how much debt the market
will be willing to tolerate. What that limit is, no one actually knows until it
is reached, and then it is too late. The limit has evidently been reached now
in Spain. It will soon be "now" in Italy and even France, minus
serious reforms. German credit default swaps are rising every week.
But just as there is a limit to the bond
market's willingness to fund debt, there is a limit to voters' patience and
willingness to bear pain. That frustration grows when there seems to be no end
in sight to the pain on the current path. But can changing course actually make
things worse? The answer is, of course, yes. I am reminded of that famous line
uttered by Queen Victoria, when she was informed that things must be made to
change.
"Why do we need change, my dear sirs? Aren't things bad enough already?"
But change is coming to Europe. One way or
another, a new order and a new balance will be forced upon them. Either a
fiscal union or break-up. They have kicked the proverbial can down the road
until it will roll no more. You can feel the Bang! moment arriving. This is the
Endgame.
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