Wednesday, September 21, 2011

Some damn fool thing in the Balkans

Reading Martin Wolf in the FT, Kevin Drum provides the skinny on why Greece must be saved at all costs:
1. Greece cannot pay its debts. Period. It has no choice but to default.

2. Once it defaults, it will be unable to borrow and it will be forced to cut spending even more than it has already. This will damage its economy further, which in turn will reduce tax revenues, which will require further spending cuts, which will damage its economy further, et cetera without end.

3. This is obviously unacceptable. The only answer for Greece would be to exit the euro and devalue its currency. As painful as this would be, it would almost certainly be regarded as preferable to years or decades of economic collapse.

4. But Greek exit from the euro would cause staggering damage to the rest of Europe and its banking system — far, far more damage than they'd suffer from merely increasing their bailout of Greece. See Wolf's column for more on this. It must be avoided at all costs.

5. Thus, the only option left is for Europe to prop up Greece for years. For all practical purposes, this doesn't mean loaning Greece money, it means giving Greece money. Lots of it.
Step 4 is the part that's not clear to me, so I went through the hoops of registration to see the FT column.
Yet the idea of exit is also vastly difficult to implement. Legally, it would require the country to leave the European Union. Would the latter then take the trouble of inviting the malefactor back in? Unlikely. The country would, as a result, probably be excluded from the single market, too. Moreover, it would find it impossible to exit quickly and cleanly. As the story broke, there would be a run on all its liabilities. The government would have to limit withdrawals from banks, if not close them outright. It would also need to impose capital controls, in violation of treaty obligations. It can redenominate debt contracted domestically. But it cannot do so for debt contracted abroad. Many corporations would then go bankrupt. A report from UBS estimates the total economic cost in the first year at 40-50 per cent of gross domestic product.

Contagion would also be inevitable. Presumably, an effort would be made to build a firewall between the exiting country and other vulnerable countries. But it would be tested to destruction. Much Greek debt is held abroad (see chart). Moreover, once one country has exited, currency risk would be even more real for every other vulnerable country, including even Italy and Spain. Neither governments nor corporates in such countries could easily sell their debts. Banks would experience runs. The ECB would be forced to lend without limit. The global interconnections of banks would appear terrifying. According to the Bank for International Settlements, US banks alone have an exposure of €478bn to Greece, Ireland, Italy, Portugal and Spain (see chart).

And as you'd imagine, it gets even worse if, say, Germany decides to quit. It seems that the euro was a feel-good flag of solidarity not corresponding to any financial coordination. So barring such coordination, which seems unlikely, the "contagion" seems likely to break out.

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