Shahin Vallée: The Greek deal - Lagarde and Draghi’s moment

13 February 2012

Offering his comments in Bruegel's 'The Weekender', Vallée says that the relief provided by the agreement between Greek political leaders is likely to be very short-lived because despite the extraordinary goodwill of the Greek political leadership, very few people believe that this deal and its likely weak implementation can return Greece to solvency.

The reality is that we will not get much more solid safety nets and firewalls than the ones we have now. The ESM will probably be made a touch larger at the March European Council but it will not be changed altogether and regardless of its size it may not be the appropriate tool to deal with Italy or Spain. So the value of waiting, which I defended for months, has now dwindled completely, and someone brave needs to take the responsibility for allowing Greece to reduce its debt sharply and someone smart needs to manage the rippling consequences for euro area. This is clearly a responsibility for the IMF’s Managing Director and the ECB president.

When this is done a few things will need to happen fairly quickly, probably in the following order:

• The Governing Council of the ECB will need to come out immediately with the boldest possible statement about its commitment to ensure the integrity of the euro area, its ongoing support for the ELA in Greece and a clear framework to replace defaulted Greek debt for other eligible collateral in order to guarantee some functioning of financial intermediation in Greece. (A failure to do so would then force the Bank of Greece to print euros or an alternative currency and leave the euro area.)
• The Greek government, by tapping the EFSF, will be authorised to recapitalise and take complete control of one or two large Greek banks that it will operate as utilities. The EFSF could stand behing the Greek government in a new programme that will allow the government guaranteeing Greek’s term and sight deposits so as to limit capital flight and safeguard the payment system. (The ECB and the EFSF should appoint executive board members to these banks given the absence of a European FDIC.)
• The Troika will have to immediately announce a new, and larger programme for Portugal so as to prove with force that the Greek case was indeed a unique case. This is the best way to stave off contagion.
• The IMF will accelerate its fundraising with the help of the Mexican presidency of the G20 so as to sign a large increase in its resources by June.
• The Paris Club would also need to draft a new framework for debt reduction of claims to the official sector in order to reduce further Greece’s debt burden against some policy conditionality.

I believe we have come to the point where there is no more value in waiting and where it is actually the lingering of the Greek uncertainty that is now the principal source of systemic risk. If a Greek debt reduction is implemented swiftly with appropriate safeguards so that the integrity of the euro area is not at risk, financial stability can actually improve. This is Lagarde and Draghi’s moment. She would need to call the current programme off, he would have to accompany this decision by taking the bold actions that need to go along a default inside a monetary union. This will probably not happen because both Lagarde doesn’t want to be responsible of this failure and because the ECB is not ready to deal with the consequences of a Greek default for it has no plan to avoid its consequences on the rest of the euro area.

The ECB needs to have either an unwavering commitment to the integrity of the euro area or a plan for an orderly exit of one or more countries:

• In the former, it needs to agree to expand the collateral pool infinitely, show no discomfort with the ELA and the growing balances in its Target 2 payment system.
• In the latter, the ECB and the eurogroup will need to work on a plan to introduce capital controls around all peripheral countries overnight should it prove needed. If panic were to set in, either in anticipation or after the exit of a euro area member, such controls would be the only way to restore some degree of financial stability and prevent an unraveling of the euro area. Those controls would need to be introduced simultaneously in all the countries and not one country after the other to prevent a domino effect. If one country was to leave the euro area or if such a risk was to rise substantially, runs in other peripheral countries could only be mitigated by firm capital controls. These would be temporary and could only be justified for prudential reasons and would therefore require the approval of the ESRB given capital controls are specifically outlawed by the Lisbon Treaty (no escape clause inside the euro area).

Both options carry important risks and run against its ethos and its prerogatives. But a failure to do one or the other puts the future of the euro area at risk.

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