29 June 2015

VoxEu: Grexit - The staggering cost of central bank dependence

This weekend’s dramatic events saw the ECB capping emergency assistance to Greece. This column argues that the ECB’s decision is the last of a long string of ECB mistakes in this crisis.

The ECB has decided to maintain its current level of emergency liquidity to Greece (ECB 2015). By refusing to extend additional emergency liquidity, the ECB has decided that Greece must leave the Eurozone. This may be a legal necessity or a political judgement call, or both. Anyway, it raises a host of unpleasant questions about the treatment of a member country and about the independence of the central bank.

As anticipated (Wyplosz, 2015), the negotiations between Greece have led nowhere. As a result, Greece is bound to default on all maturing debts in the days and weeks to come. With a primary budget close to balance, the Greek government could have soldiered on until new negotiations about the unavoidable write-down of its debt.

The risk for the Greeks of this ‘default strategy’ has always been that it depended entirely on the ECB’s willingness to continue providing the Greek banking system with liquidity, especially at a time of a bank run by rational depositors who put a non-zero risk of Grexit. Over the last weeks, the ECB has provided the needed liquidity in the face of a “slow-motion run” on Greek banks.

Suddenly, on the morning of 28 June, the ECB has stopped providing emergency funding to Greek banks. In a classical self-fulfilling crisis fashion, this decision is bound to turn the “slow-motion run” into a panic.

• The bank holiday and capital controls announced will create some breathing space, but very briefly.

These measures will not prevent the banking system from collapsing.

• The natural consequence will be the collapse of the Greek banking system.
• At that stage, possibly earlier, the Greek authorities will have no choice but to leave the Eurozone and provide banks with the re-created drachma.

Chaos is bound to follow in Greece.

Full article on VoxEU

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