Greece in the penalty box

So, now we’re into round two of the big “Syriza versus Troika” superfight and, as Karl says, the pushing and shoving and flexing of muscles has begun. Yanis Varoufakis might be beginning the process of learning that it’s not a good idea to make policy on the hoof in newspaper interviews, and that an interesting Twitter feed isn’t always the same thing as a good negotiating platform. And the ECB has taken the first step in putting the squeeeeeze on Greek bank funding.

In my view, the ECB really didn’t have much option but to do what it did. Syriza’s strategy was all over the place, very chaotic and (with the proviso that there might be some kind of super clever game theory going on) really quite amateurish in the way it was communicating. At the end of the first ten days, they had said that they were defaulting, but not defaulting, that they didn’t want to borrow any more money, except maybe EUR10bn of treasury bills, that there would be no debt reduction, except that this was a euphemism for “yes there will”, and primary surplus would be maintained, although this didn’t necessarily mean any change in tax or spending plans. They’d also emphasised that they wanted to get a deal with the troika, but were not prepared to talk to the representatives of the troika.

When a borrower starts behaving like this, the natural instinct of any creditor who knows what they’re doing is to “shorten the leash”. You reduce their flexibility by increasing your own optionality; you extend credit on shorter durations rather than longer, and as far as possible on a discretionary basis rather than contractual. This way, you give yourself the maximum number of opportunities to cut out, and increase the pressure on them to co-operate. That’s the reasoning behind the collateral changes and the moves toward restricting ELA.

But everyone is worried about this, because ELA and its controls have always been seen as something of a nuclear threat — a policy lever that can never be pulled because the consequences are so drastic. It has always been assumed by a lot of commentators that this is the trigger for Euro exit and the means by which the expulsion of a country from the single currency would be achieved. The idea is that the sequence of events would go:

1) Removal of Emergency Liquidity Assistance from the banking system
2) Immediate bank run and collapse
3) The only way to get the banking system up and running again is to print a local currency
4) And they’re gone.

The concept of a threat that’s too drastic to be carried out is the sort of thing that is always likely to attract the attention of a professor of game theory, so it’s not impossible that Yanis Varoufakis’ apparently very high degree of confidence is based on the assumption that, for this reason, the ECB is bluffing. This might be a bad mistake, because I’m no longer convinced that the chain of reasoning above is necessarily valid.

Consider this: If you were to come to the belief that last year’s Cyprus crisis was a test run for something, what would it be a test run for?

Or to put it a little less enigmatically, how does the following sequence of events grab you:

1) ELA is not completely removed, but restricted to an amount somewhat less than the liquidity needs of the banking system
2) Acceleration of deposit flight, beginnings of a bank run
3) Controls placed limiting permitted deposit withdrawals
4) Compulsory writedown of bonds and/or large deposits of the banking system to rebuild capital
5) As a necessary consequence of above, capital controls.
6) Country is still in the Euro, but with an extremely inconveniently arranged banking system and a lot of angry depositors.

In my view, it’s an entirely plausible thing that might happen — rather as in ice hockey and rugby league, a player can be put in the “sin bin” for a period of time rather than being entirely ejected from the game. The consequences for Greece would be nearly as bad as those of actual Euro exit, but sufficiently less awful to prevent them deciding to unilaterally leave. The consequences for the rest of the Euro area would be greatly mitigated. The consequences for the ECB and Commission would be … they’d be really really great, because this way, they get to square the circle of not having any member states leave the Euro, but also not getting into a situation where they find themselves having to fund the entire Greek budget indefinitely while always losing the battle on conditionality.

This “third way” or penalty-box option seems to me like it might very well be used, particularly if the Greek side in the negotiations haven’t thought of it as a possibility and still think they’re playing a game of brinkmanship with an opponent who hasn’t got the stones to trigger the meltdown option. My guess is that relative to Cyprus, the losses to bondholders and depositors would be smaller (because there isn’t a real problem of solvency at the Greek banks at present, and a government default, although it would cause losses, would not render the system totally insolvent), but the capital controls could be deeper and longer lasting (because the liquidity squeeze is extreme; the ECB is providing a lot of the funding already, and there really isn’t the kind of goodwill which existed to help Cyprus out).

At the end of the day, it has to be recognised that the ECB is now the supervisor for all the big Greek banks, and under the terms of the Bank Resolution and Recovery Directive, it pretty much has a duty to take action against any bank that is “failing”. The concept of “failing” isn’t rigorously defined in the primary European legislation, but it’s perfectly reasonable to take the view that any bank which can’t roll over its funding without official support falls into that category. And that’s pretty much all the Greek banks at present. Things could get a lot more interesting before they settle down.