The Grexit Mechanism: What It Means For The Future Of the Euro

Greek crisis exposes cracks in the euro’s design that won’t be fixed by Greece leaving.

Despite the euro’s legal status as an irrevocable currency union, the impasse in talks between the Greek government and its official creditors means the odds of Greece leaving the euro and returning to issuing its own currency are now higher than ever before.

Not that long ago, the notion of a country leaving the euro was greeted with ridicule by European politicians. However, the idea there is a direct link between Grexit and a failure in the current negotiations with creditors is now repeated publicly by senior European figures every day. Indeed, the threat of effective explusion of Greece from the euro is the primary bargaining chip used by the European creditor countries in the current negotiations.

The link between a failure in the current negotiations and a Greek exit is now so widely established now that many have forgotten there are still significant unanswered questions as to how this scenario would actually play out. Perhaps even more important, but also not being widely discussed, are the implications of the mechanism that would trigger a Greek exit for the rest of the Eurozone after Greece has gone. This post discusses these two issues.

The Grexit Mechanism

Lots of different theories have been offered over the years for how Greece might leave the euro. Some have focused on the idea that the Greek people would elect a government that chose to voluntarily leave the euro and introduce a new currency. That is not the current scenario. Opinion polls show the vast majority of the Greek people want to remain within the euro and the Syriza government has repeatedly stressed that this is its desired outcome.

Instead, the Greek exit scenario looks like this. It’s a five step process in which the first three steps have already happened.

1. The possibility that a Greek default on official loans could lead to an exit has been widely discussed over the past six months.
2. This has led to a run on Greek banks as people move money abroad or keep their euros at home.
3. This, in turn, has increased the reliance of Greek banks on borrowing from the Eurosystem, particularly in the form of Emergency Liquidity Assistance (ELA), which requires discretionary approval by the ECB Governing Council.
4. If Greece defaults on its official creditors, the ECB may then decide that it will no longer allow the Greek banks to be provided with ELA because they are not reliable counterparties. (There are various technical reasons that can be offered for this assessment ranging from the banks’ ownership of Greek government bonds and Treasury bills, their use of Greek-government-guaranteed bonds as collateral and the fact that the banks are largely state owned. More details on this stuff here.)
5. With the Bank of Greece banned from providing euros to the Greek banks, the banks cannot honour withdrawal requests and have to temporarily close their doors. The government then imposes capital controls to prevent people moving their money out of the country. At some point, the government passes a law that redenominates all euro bank accounts into drachmas and the Bank of Greece replaces the previous euro-denominated loans to banks with new loans in the form of drachmas. The banks re-open but the ATMs now provide people with the new currency rather than euros.

An Alternative To The Grexit Mechanism: Banking Union And A Real Lender of Last Resort

This Grexit scenario relies crucially on the Eurozone not having a proper lender of last resort or a functioning banking union. It is easy to imagine an alternative scenario to the current one. Consider the following alternative version of how the Greek crisis could have played out.

1. As tension builds up in Greece prior to the Greek election in early 2015, Mario Draghi assures depositors in Greece that the ECB has fully tested the Greek banks and they do not have capital shortfalls. For this reason, their money is safe.
2. Draghi announces that the ECB will thus provide full support to the Greek banks even if the government defaults on its debts, subject to those banks remaining solvent.
3. Eurozone governments agree that, should Greek banks require recapitalisation to maintain solvency, the European Stabilisation Mechanism (ESM) will provide the capital in return for an ownership stake in the banks.
4. Provided with assurances of liquidity and solvency support, there is no bank run as Greek citizens believe there banking system is safe even if the government’s negotiations with creditors go badly. The ECB stays out of the negotiations for a new creditor deal for Greece (because they are not a political organisation and are not involved in directly loaning money to the government) and its officials assure everyone that the integrity of the common currency is in no way at stake.

There are no legal impediments to this scenario. Despite the constant blather from ECB officials about how it is constantly constrained by its own persnikety rules, it is well known that the ECB can stretch these rules pretty much as far as it likes. Supporting banks that you have deemed solvent is pretty standard central banking practice. So Draghi’s ECB could have provided full and unequivocal support to the Greek banks if they wished. They just chose not to. Similarly, procedures are in place for the ESM to invest directly in banks so a credible assurance of solvency could have been offered.

Why did this not happen? Politics. European governments did not feel like providing assurances to Greek citizens about their banking system at the same time as their government was openly discussing the possibility of not paying back existing loans from European governments. Indeed, the ability to unleash the bank-driven Grexit mechanism has been the ace in the creditors pack all along.

Faced with massive political opposition in Germany and other Northern European countries to their existing monetary policy programmes, Mario Draghi and the ECB Governing Council have decided it is better for them to play along with the creditor country squeeze on Greece than to stabilise the Greek banking system. Imagine the hue and cry in Germany now if the ECB were refusing to threaten cutting off credit to Greek banks, thus undermining Angela Merkel’s leverage in negotiations.

Sulf-Fulfilling Cracks In The Eurozone’s Design

Time will tell how the situation in Greece plays out but the episode has revealed a set of cracks in the design of the Eurozone that could over time trigger the exit of various countries and possibly end the single currency altogether.

We have learned that debts to official creditors — European governments, the IMF and particularly the ECB — are sacred and that the ECB will side with these creditors in debt negotiations rather than preserve financial stability and the integrity of the euro.

Perhaps Greece will be the only country to ever get squeezed in the current manner but problems due to large amounts of official debt could pop up elsewhere and these problems won’t be solved simply by expelling Greece from the euro.

For example, Portugal has a public debt to GDP ratio of 130 percent and the EU and IMF are already owed a sizeable chunk of this debt. In addition, the ECB owns Portuguese government bonds from its Securities Market Programme and is now about to buy more through its QE programme. At some point, private creditors (who know the EU policy is to “involve” them when debts are unsustainable) may decide they are the thin end of a dangerous wedge and give up on Portugal. In this situation, the EU is likely to dither, provide plenty more official funding via ESM or OMT and end up with another Greek situation.

The Greek negotiations have uncovered large cracks in the design of the Eurozone which could lead to the end of the common currency. The absence of political support for banking union or a proper lender of last resort are enough to trigger self-fulfilling bank runs in which people lose confidence in the country’s ability to stay in the euro and this ultimately ends with the country being shut off by the ECB and introducing a new currency.

Whatever It Takes Or Not?

In recent years, the single most important factor that has papered over the cracks in the euro has been Mario Draghi’s “whatever it takes” commitment to preserve the euro. But if whatever-it-takes doesn’t prevent a Greek exit, there would be serious questions about what kind of euro the ECB was actually willing to bother preserving. Worth remembering is that what Draghi actually said was

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

The “within our mandate” bit has provided Draghi with plenty of wiggle room to decide what kind of euro he wants to preserve. It clearly doesn’t have to be one that includes Greece. And there may be others that get jettisoned. Whether this kind of a la carte euro will survive the test of time is highly questionable.