For 2½ years, the world has been watching and waiting to see if debt-laden Greece can remain in the euro zone. Many have been doubtful since the beginning of the debt crisis. Greece’s government debt is simply too burdensome, the fiscal adjustment imposed on Athens is too severe, the Greeks are too resistant to the tough reforms that are necessary and the rest of Europe is too bullheaded to change its approach to suit reality. But for 2½ years, Greece has nevertheless managed to scrape by and remain in the monetary union, thanks to two European Union–IMF bailouts (totaling $300 billion), which have kept Greece on life support, and repeated promises to reform by Greece’s major political parties.
Now, however, the Greek debt crisis may finally be reaching the endgame. The likelihood of a Greek exit from the euro zone has been growing, and that has scary consequences for the rest of Europe as well as the global economy.
(PHOTOS: Protests in Athens)
The spiral toward disaster has been tipped off by Greek politics. A general election earlier this month eliminated what little hope remained that Athens could press through with the painful austerity measures and structural reforms demanded by the euro zone in return for bailout cash. The fractured result made it impossible for a government to form, and a new election has been called for June 17. But even if that poll brings some political stability, the odds that the bailout can go ahead as planned are practically zero. A vast majority of the votes in the last election went to parties that either want to renegotiate the terms of the bailout or ditch the agreement entirely. Whether the bailout scheme can continue will depend on the willingness of the rest of Europe to make concessions to Greece in a better, softer rescue agreement and the willingness of Athens’ politicians to agree to new terms. These are very open questions.
The problem is that without that rescue money, Greece will very likely have to exit the euro zone. The Greek government would quickly run out of money to function, leaving Athens no choice but to return to its national currency, the drachma. This scenario could unfold with surprising speed. Here are Bank of America/Merrill Lynch analysts on that score:
If no government is in place before June, when the next instalment from the EU/IMF is due, we estimate that Greece would run out of money sometime between the end of June and early July, at which point a return to the drachma seems to us inevitable.
Even if the Greek government gets its act together and the bailouts continue, there is another force steadily pushing Greece out of the euro zone. Greeks are removing their deposits from Greek banks. They have been doing this for a while, but the pace seems to have accelerated recently. In just one day last week, Greeks yanked some $900 million of deposits from the banks. This process is quaintly called a “bank jog,” but it is much more dangerous than a quiet run through a park. It is effectively a slow-motion run on banks, and a natural consequence of the uncertainty surrounding Greece’s tenuous position in the euro zone. If Greece is forced to ditch the euro and return to the drachma, Greeks know full well that their drachmas will be sharply devalued relative to the euro. So keeping their money in Greek banks now could result in a big hit to their welfare. Instead of facing that risk, Greeks are withdrawing money from banks to preserve their wealth.
That makes sense from the standpoint of the Greek saver, but not for the banking sector. As Greek banks empty of euros, the financial system comes closer to failure. So far, the European Central Bank has been plugging the hole by acting as a lender of last resort to the Greek banking system. But there is a limit to how much financing the ECB might be willing to inject. Gavyn Davies of the Financial Times did a great job of explaining how this bank run is happening, and why the ECB could eventually fail to contain it:
The problem is that [ECB support for Greek banks] potentially exposes the ECB to much bigger losses than anything which has been contemplated so far by the core economies. Up to now, the ECB has been willing to inject liquidity to cover the financing needs of the periphery banks as the inter-bank market has dried up. If instead, they have to contemplate providing semi-permanent funds to cover large further withdrawals of bank deposits, the size and timescale of the injection becomes extraordinarily large.
If the ECB doesn’t continue to finance Greek banks, Athens could be forced to withdraw from the euro zone and restore its currency. That on its own would be destabilizing. But even more worrisome, the bank jog in Greece has the potential to become a euro zone–wide bank run. Seeing what’s going on in Greece, depositors in other weak euro-zone economies (Portugal, Spain, Italy) have the same incentive to yank money out of their banks. That could end with the total unraveling of the monetary union. The fears that this theoretical scenario will become reality are increasing in Europe. Here’s how economist Paul Krugman explained it in the New York Times:
Right now, Greece is experiencing what’s being called a “bank jog” — a somewhat slow-motion bank run, as more and more depositors pull out their cash in anticipation of a possible Greek exit from the euro. Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again. This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks. Once again the European Central Bank would have to choose whether to provide open-ended financing; if it were to say no, the euro as a whole would blow up.
How can the euro zone stop this from happening? It will require a degree of political commitment and policy flexibility so far absent from the zone’s approach to the debt crisis. When a national government confronts a run on banks, the way to solve it is to guarantee deposits and ensure that banks have enough cash to meet withdrawals. The problem with the euro is that individual national governments don’t have control over their own money. So the euro zone as a whole has to step in and back up the banks like a national government would. The euro zone likely requires some sort of guarantee scheme akin to the U.S.’s Federal Deposit Insurance Corp. But supporting the euro banking system is this way might demand yet more resources from stronger euro-zone economies like Germany. It would also probably entail more E.U.-level control over national banking sectors. Both steps would prove difficult.
More broadly, Europe can squelch the bank jog if it shows more commitment to the euro and keeping Greece in the union. The longer this period of uncertainty over Greece’s status drags on, the more deposits will flee Greece, and the more likely a euro exit becomes.
Clearly, a Greek exit from the euro zone would be traumatic for Greece and the rest of Europe, and send shock waves through global financial markets. But can a Greek exit from the monetary union really take down the euro itself? That’s a topic for another post …