07 July 2015

Financial Times / Wolf: Grexit will leave the euro fragile

Apparently many, perhaps most, of those who voted believe their rejection would force a change of heart in the rest of the eurozone. Their partners would come to recognise the error of their brutal ways and provide them with the resources they need to use the euro freely, while liberating them from austerity. But most of their partners would view this outcome as a humiliating surrender. Far more likely then is a stand-off between an emboldened Greek government and its enraged creditors.

Such a stand-off would lead to a “stealth exit”. The banks would fail to reopen. Then the government would create some sort of (supposedly temporary) monetary instrument. Later still, people would see that the provisional arrangement had become permanent. Finally, albeit after much wrangling, Greece would have a new currency, but still be within the European Union.

Only one (or more) of three developments could block the path to an exit.

First, the Greeks could live with closed banks for the indefinite future. This is not impossible. But it is unlikely.

Second, the European Central Bank could expand its emergency lending to the Greek banking system. If the ECB were a normal central bank that is exactly what it would do. Greece has a run on its banks. As the lender of last resort, the central bank ought to lend into such a run. If the ECB believes the banks are solvent, it must lend. If the ECB believes the banks are insolvent, it should arrange recapitalisation — by converting non-insured liabilities into equity, by selling banks to new owners or by securing funding from the European Stability Mechanism (ESM).

Unfortunately, the ECB is not a normal central bank. It is the central bank of a half-baked currency union. By protecting itself against losses, the ECB risks recreating the redenomination risk that Mario Draghi’s “whatever it takes” speech of July 2012 was intended to eliminate. Fear creates what is feared.

Third, the eurozone governments could still reach a deal with Greece. This is what Athens is trying to achieve. But would it make sense for the eurozone? To answer this question one needs to consider how people now view the currency union itself.

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