Wednesday, May 16, 2012

The Problem with the Eurozone’s Throw-Greece-from-the-Train Plan Is that its Timing Can’t Be Controlled

There is no democratic deficit in Greece: its people have clearly indicated they want to do two things, clean the slate by defaulting on their debts and staying within the Eurozone.  This is seen as unacceptable in Brussels and Frankfurt, and Greeks are supposed to understand that if they choose the first they will lose the second.

Alas, there is no legal procedure by which Greece can be expelled from the EZ; therefore the strategy has to be one of making retention of the euro so ruinous for Greeks that they will exit on their own volition.  The mechanism is the Target system through which euros are transferred from one national central bank to another.

The idea is this: when funding from the troika is cut off after a default, the Greek government will lack the resources to backstop its banking system.  Moreover, euro transfers via Target will be cut off.  Greek depositors who try to withdraw their funds will be told, sorry, but the cupboard is quite bare.  This will ignite a banking meltdown, and the only way out for Athens will be to redenominate financial liabilities in a new currency they can supply.  Whether they call it a drachma is up to them.

Clever, huh?  The only hitch is that, now that the game plan is becoming clear, rational Greeks are not choosing to wait for an EZ attack before withdrawing their funds from Greek banks and transferring them somewhere, anywhere, else.  There is a gradually accelerating bank run taking place which is likely to reach criticality before a Greek-EZ policy showdown can take place.

There is a broader lesson here.  By threatening to choke the Greek banking system, the EZ implicitly threatens to do the same for Spain or even Italy.  They can say otherwise, but why should depositors in shaky peripheral banks believe them?  Withholding euros from peripheral banking systems is a gun that goes off before it is fired.  Simply brandishing this weapon is causing havoc and speeding the demise of the entire zone.

Better to put the gun away and do what should have been done all along: have the ECB assume the lender of last resort function for all EZ banks, with centralized financing of deposit insurance in particular.  Don’t use the threat of a financial panic as a policy tool.


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