Musing about the mechanics of Grexit

As the Greek debt crisis enters what may (or may not) be the a final stage prior to some sort of default it is useful to think through the mechanics of some of the things that might happen. The truth is that nobody knows what going to happen if there is a default on loan repayments or if Greece is forced out of the eurozone, because the situation with Greece and the eurozone is unique. Theoretically the EU and/or the ECB could press a number of big red buttons that would precipitate a Grexit but it would be a hugely risky thing to do and with unknowable outcomes. Unfortunately Europe has a history of its leaders doing insane things especially when they are gripped by an utter conviction that some idea or other is absolutely right. Part of the problem for the EU leadership is that by whipping up domestic support for a hard line with Greece, considered necessary in order to prevent political contagion (imagine Spain with a Syriza type government), they have boxed themselves into corner in relation to their domestic electorates. Syria’s calculation is that, as is often the case, it is the debtor who has the upper hand. Syriza wants to come to a deal with its debtors but it also thinks, correctly in my opinion, that Grexit with all the damage it would cause, is almost certainly a less worse option than yet more more years of pointless and crushing Troika imposed austerity. So Syriza is willing to risk calling the Troika’s bluff.

So what might happen?

Before looking at how a Grexit might technically take place here is a short and punchy presentation from 2012 by Professor Costas Lapavitsas, an economist and Syriza MP, in which he makes the case for Greece leaving the euro.

Some background

Before looking at some possible scenarios it is worth reiterating the fundamental reality of the situation. Greece is bust and at the bottom of a very, very deep economic depression. The only way Greece will ever be able to repay a substantial proportion of its debts is if the Greek economy starts to grow again. The ‘reform’ program of the Troika has resulted in economic collapse and a humanitarian disaster and the plight of the impoverished Greeks can only be improved if the Greek economy starts to grow again. The ‘reforms’ that the Troika keep talking about are not really reforms in the usual sense of the word, they are really just cost cutting measures designed to reduce even further Greek public expenditure so that Greece can generate a budget surplus to pay its debts. The current reform proposals that Syriza are refusing to implement are all about reducing pension payments and increasing VAT on basic essentials such as food and medicines. In a country like Greece where most of the unemployed do not receive any unemployment benefits and many are now dependent for survival on the pensions of their older relatives, and where most of the population are no longer receiving free health care such measures are anti-humanitarian and, even worse, pointless. The strategy of squeezing out a budget surplus through costs cutting has bankrupted the nation and it is a bankrupt strategy.

The Syriza response is fairly simple. If they can find the money to pay debts as they fall due they will make the payments but they will always prioritise the payments of state employee salaries, welfare payments and pensions payments before paying debts and if that means missing scheduled repayments then so be it. Syriza also want to carry out real reforms that over time will break the power of the old corrupt oligarchy but those reforms are not going to produce a budget surplus in the short term so the Troika has dismissed them. Syriza wants to refocus the entire Greek program around ways to make the Greek economy to grow, in particular ways to restart inward investment. The Troika, which is dominated by institutions such as the ECB, the IMF and the EU Commission which are gripped by various forms of neoliberal and ordoliberal ideology, think the only way to grow the economy is to carry out ruthless state cost cutting, removing protection for workers and privatisation. So far that approach has just produced economic collapse.

There are two parallel financial crisis operating in Greece at the moment. One involves the schedule of debt repayments that Greece is formally committed to meeting which over the next couple of years are mostly to the IMF and the European Central Bank, as well as some maturing short term Greek Treasury Bonds.

The other crisis involves the severe liquidity problems in the Greek banking system which is the result of a massive bank run in the months since the Syriza election victory as tens of thousands of Greeks have withdrawn their savings from banks and either stuffed the cash under their mattress or sent it abroad. If I was Greek and had savings I would do the same because if Greece crashes out of the Euro any savings denominated in the new currency (presumably called the Drachma) will be significantly devalued so its far safer to hold savings in euro bank notes or in an account outside Greece.

The banking crisis

The arrangements in the eurozone are a little odd for a currency union in that every euro member state has its own National Central Bank (NCB) but as a result of the currency union they are all subservient to the European Central Bank (ECB). The NCBs cannot set their own interest rates and they cannot print new money at will. The ability to print new money at will is what makes central banks so important as lenders of last resort in banking systems and the loss of this function combined with the failure of the ECB to act as a lender of last resort during the early stages of the euro crisis was an important factor in allowing the eurozone crisis to become so destabilising.

Since the election of Syriza tens of billions of euros have left the Greek banking system and in the last week alone 3 billion euro has been withdrawn. This is a giant national bank run and no bank can survive a bank run without outside help in the form of loans from other banks to ensure its always has money on hand to pay out to its depositors. Nationally the Greek banking system would have collapsed sometime ago without the support it is receiving from the Bank of Greece (BoG) which is pumping money into the various banks in Greece every day to prevent the supply of cash drying up. Without this support the ATM machines would cease to work, the banks would close and the entire money economy would grind to a halt. Scary stuff.

Because of the currency union the Bank of Greece cannot just create new money by typing a number into a spreadsheet on its computer system (as ordinary central bank can do) instead it has to receive approval and funding from the ECB (who can create any number of euros it wants to) in order to pass funding onto to the struggling Greek banks. Think of it as a sort of cascade, the ECB gives funds to the Bank of Greece who in turn give funds to various Greek banks who can then pay their customers cash. This sort of interbank funding is fairly normal in all banking systems and normally when funds are cascaded down at every stage the recipients of funding offer up some sort of collateral to cover the loans. The collateral usually used in this sort of operation is almost always government bonds. Outside of a massive crisis like the Greek one, or the global financial crisis in 2008, liquidity problems are usually short lived so there is usually a big enough supply of collateral (government bonds held by the banks) and once the short term liquidity problem passes the crisis ends, the bank runs stop, the funds are repaid and the government bonds held as collateral are handed back.

Prior to the Syriza election victory the Bank of Greece was receiving funding from the ECB and was using Greek government bonds as collateral for the funding. Almost as soon as Syriza won the election the ECB stopped accepting Greek government bonds as collateral for the funds being sent to the Bank of Greece, funds which were needed in order to keep the Greek banks solvent. This was, for a central bank, a scandalous action but it mostly passed unnoticed in the post election excitement. The announcement was no doubt intended to put pressure on the Greeks before the first key meeting between between Varoufakis and German Finance Minister Wolfgang Schaeuble.

This was an overtly political act by a central bank that seems to have lost sight of what are, and are not, the responsibilities of a central bank. The ECB was acting far beyond its mandate in seeking to influence negotiations between Eurozone member states regarding the terms and conditions under which member states lend to their distressed partners. The ECB has no business interfering in fiscal policy: if the Greek government decides to run 1.5% fiscal surpluses instead of 4.5%, hike minimum wages and create lots of government jobs, it is none of the ECB’s business. It should not use changes in fiscal policy by a democratically-elected sovereign government – even one that has inherited an economy in tatters with a massive debt burden – as justification for limiting liquidity to that country’s banking system.

The ECB however did not let the Greek banking system actually collapse, instead the funding being supplied by the ECB to the Bank of Greece was changed to a new system called Emergency Liquidity Assistance (ELA). The ELA scheme itself is under the control of the ECB and reviewed bi-weekly. The ECB could pull the plug on this support at any moment so switching to ELA was a sort of threat to the Greeks.

All that financial gobbledygook and alphabet soup just means that at the moment the only thing keeping the Greek banking system from going under is the ECB and the ECB could decide to stop giving that support if Greece defaults on its repayments to the IMF. The ECB is not obliged to stop that support if there is a debt repayment default and it would be an overtly political act by ECB to do so but the decision that it would no longer accept Greek government debt as collateral after the Syriza victory was also a political act intended to pressure a newly elected democratic government. Such is the way things are done in the new Europe.

Its important to remember that the ECB can create as much money as it wants, it only has to type the amount into its computer system to create new funds in its accounts and the funds are then conjured into existence ready to be sent to the Bank of Greece in order to keep the Greek banks solvent. Usually central banks creating lots of new money is frowned upon except as an exceptional measure because it will eventually devalue the currency and lead to inflation, but inflation is not a problem in the eurozone at the moment (in fact its deflation that is real danger) and the amount of newly created money needed to to keep the Greek banks solvent, in the context of the size of the eurozone economy and banking system, is pretty trivial. So if the ECB were to decide to stop giving the Bank of Greece ELA and thus deliberately cause the Greek banking system to collapse it would be a political act of punishment for Greece’s refusal to agree to ‘reform’ demands from the Troika or for Greece defaulting on a scheduled payment to the IMF or ECB. But neither a failure to negotiate a settlement on the reform question nor the default on scheduled loan repayments in any way requires that the ECB withdraw ELA support. If the ECB, which is not under any democratic control, crashes the Greek banking system in order to punish or remove a democratically elected government it will be an entirely, and outrageous, political act.

What does Greece ‘leaving the euro’ actually mean?

Currently the way the euro system works is via something called TARGET2 which stands for Trans-European Automated Real-time Gross Settlement Express Transfer System (see this video explaining how it works). This is the computerised accounting system that allows euros to circulate around the euro zone. To simplify it a bit, in a place like the UK (which is a currency union) when you make a payment from your bank account to an account in another bank the money mostly travels between the bank accounts of the two banks in the Bank of England, its in the Bank of England that everything gets sorted out and reconciled.

In the eurozone things are a bit different, and slightly odd. Under the TARGET2 system if someone in say Ireland tells their bank to make a payment to someone in Germany what happens is that the Irish bank sends a payment to the Irish Central Bank who then sends a payment to the European Central Bank who then sends a payment to the German central Bank (the Bundesbank) who then sends the payment to the relevant commercial bank who then make a payment into the intended recipients bank account. This is usually all invisible, highly automated and the TARGET2 system just whirls away processing billions upon billions of payments everyday. The entities making payments (the local bank in Ireland, the Irish bank, the ECB, etc) all have to pledge some collateral to back up the transaction. Initially that collateral was intended to be solely highly secure government bonds but as the huge trade imbalances in the eurozone developed prior to the crisis so very big imbalances in the payments developed and the countries running big trade deficits began to run short of top quality collateral to back up all the payments and so the quality threshold for collateral in the TARGET2 system was steadily relaxed. This has greatly agitated Ordoliberal economists like Hans-Werner Sinn and you can watch him explain how all this works and what he is worried about in this video. There has been much debate amongst economists about whether the imbalances in the TARGET2 system are something to be worried about or are just accounting artefacts. No definitive conclusion has been reached yet.

The point of all that dry explanation about the TARGET2 system is that it relates directly to what actually happens in the case of Grexit.

At the moment the Bank of Greece, using Emergency Liquidity Assistance credits from the ECB, is currently issuing Liquidity Assistance to the Greek banks so that deposits can leave the Greek banks and go elsewhere in the Eurozone – via the TARGET2 system. The ability of Greek euros to flow freely, via the TARGET2 system, anywhere else in the eurozone is what being part of the eurozone is all about. Because of the severity of the capital flight from Greece, and hence the severity of the liquidity crisis in the Greek banking system, a decision could be taken quite soon to impose some sort of capital controls to prevent people taking out too much cash from their accounts in Greece or making payments across the national border into the rest of the eurozone. This was what happened to Cyprus in 2013 and it did not mean that Cyprus left the euro. Those Cypriot capital controls were quietly lifted recently.

More serious would be if the ECB were to take a vote at the ECB governing council to suspend Emergency Liquidity Assistance (ELA) to the Bank of Greece which would require a two third’s council majority to go through. Theoretically this would mean that the Bank of Greece would stop issuing ELA to the Greek banks and the the Greek banking system would then collapse with unknown consequences. If the ECB did decide to stop ELA it is possible, maybe even likely, that the Syriza government would seek to reassert national control over the Bank of Greece and order it to continue to make ELA available to the Greek banks, to in effect print money. This would stop the Greek banking system from collapsing but be a complete rupture in the framework of the eurozone as a key part of the eurosystem is the fact that individual national banks are part of, and under the control of, the ECB. The reassertion of national control over the Bank of Greece would probably be resisted by its Governor Yannis Stournaras who was the Greek Minister of Finance from 2012 in a previous pro-austerity government. Under such circumstances expect to see a new governor appointed.

The only actual sanction the ECB then has is to turn off TARGET2 clearance access and effectively remove the peg between German Euros (let’s be honest about who is in charge here) and Greek Euros. At which point Greek Euros start to float and that means that for a Greek to pay a Spaniard they would have to exchange Greek Euros for German Euros via a third party transaction in the foreign exchange markets. So in effect two separate currencies would come into existence, the mainstream euro and the new Greek euro, with a fluctuating exchange rate between the two, and almost certainly the value of the Greek euro (which may well be renamed the Drachma) would fall quite quickly.

Once the exchange rate between the German euro and the Greek Euro/Drachma had stabilised then it is very likely that all the capital that had left the country would come flooding back, something that might very helpful in terms of getting economic growth going again.

A Grexit and Greek default would cost the other eurozone states direct costs as they would have to write off the money they had loaned to Greece. The really big problem that Grexit would probably cause is that it would mean that eurozone membership was not permanent, that its was contingent. In which case the market could well decide that other heavily indebted eurozone countries, like Italy, with massive debts and a stagnant economy, were a big risk. And that would force up yields on Italian government bonds, many of which are short term and have to be turned over fairly regular, and that could very quickly make Italian debt unmanageable. And then the eurozone would be in a world of pain.

All in all trying to think through what could, or might, happen is so complex that its makes my head hurt. Nobody really know what will happen, the situation is both immensely fluid and complex. If they operate with a shred of rationality the eurozone leaders will do what it takes to prevent a Grexit, but accidents happen.