There is a revolt against the euro going on, and it isn't surprising. The consequences are extremely dire, though.
The whole euro concept was always more political than economic. The design was 'half-baked,' in the sense that experts knew at the time that it meant giving up adjustment mechanisms (independent monetary policy and currencies), forcing a budgetary straitjacket (the 'Stability and Growth Pact'), and engaging in a one-size-fits-nobody monetary policy.
This would be fine as long as countries would not show what in economic parlance is called an 'asymmetrical shock,' that is, events that impact the economies of member countries in different ways, triggering the need for adjustment.
The euro optimists believed that the euro itself would produce 'convergence,' economies becoming more similar and less prone to these 'asymmetrical' shocks.
Those euro optimists were wrong.
And their error has a good chance in being one of the most serious economic mistakes of the century. What happened was that the elimination of the exchange rate risk in the eurozone periphery (as a result of these countries joining the euro), produced a capital inflow of rather epic proportions.
This capital inflow was seen as benign at the time, part of the convergence mechanism. It would enable the poorer countries to grow faster and therefore catch up with the richer ones, and that is indeed what happened. Nowhere more spectacularly so than in Ireland, which moved from one of the poorest to one of the richest EU countries in less than a generation.
But this 'convergence' was highly misleading. Much of the inflow of capital in the periphery was wasted in fueling a credit and housing bubble (Spain, Ireland) or public sector excesses (Greece, to a lesser extent Portugal and Italy) while much of the capital came from banks in the center of the eurozone, which over-leveraged themselves to the hilt.
At the same time, the periphery accumulated higher unit labor cost for a decade, resulting in these economies becoming uncompetitive versus the euro center (especially Germany) and their trade balance moving sharply negative.
The financial crisis of 2008 brought this to the foreground by exposing the idiotic leverage in the eurozone banks. This stopped the flow of capital to the periphery, which made the debt much more difficult to finance, producing a housing bust in Spain, and Ireland, and exposing the dire state of public finances especially in Greece.
Bank bail-outs and the deep recession worsened public finances further to the point that three peripheral member states (Greece, Ireland, and Portugal) didn't have access to the markets anymore and had to be bailed out. Despite such bailout, the sums in one of these countries (Greece) simply didn't add up and talk began to emerge of a 'hair-cut' of the debt.
Otherwise known as 'Private Sector Involvement' (PSI), that is forcing private holders (banks, institutional investors, etc.) of Greek bonds to take a hit on their bonds. This PSI talk had dramatic unexpected consequences as investors suddenly woke up to the (emerging) fact that sovereign debt wasn't risk free but had real default risk attached. The effects of this wakening up can be seen in the figure below:
So that only worsened the situation for the rest of the periphery as it accelerated the capital flight out of there, producing much worse terms for financing the public sector. Basically producing self-fulfilling prophesies.
And after muddling through the eurozone has now created a second self-fulfilling prophesy as the situation in Greece has worsened to the extent that exiting the euro has become an all too real prospect. So while in the good times (2000-2008), both the default risk and the currency risk seemed to have disappeared as a result of the euro, they both came back with a bang right now.
This, of course, is producing another capital flight out of Greek banks as depositors and investors can deposit and/or invest in paper of German banks without any currency risk.
While the euro was merely tolerated by the population in the center countries, it was wholeheartedly embraced by the periphery as a cheap way to achieve German like credibility and seen as a convergence mechanism as explained above. But now that it, just like the Gold Standard in the 1930s, has become a mechanism for mass economic destruction, the enthusiasm is quickly waning.
In fact, the support for the whole EU project might disintegrate. The EU is comparable to the Chinese Communist Party in a sense. As long as the EU stood for prosperity and stability, it was seen as necessary. But now that, through the ill conceived euro, it spreads misery, support could quickly wane.
There is already a bit of a revolt against the wholesale destruction of living standards going on in parts of the periphery although only in Greece has this led to significant effects. But incumbent politicians everywhere are under siege. Unlike popular myth, there hasn't been any tax transfer from the center to the periphery yet. But this could soon change, and if it does, it's liable to trigger mass protest and political fall-out in the center as well.
So basically it's a bit of a race between the economic and political constraints on what will finally blow up the euro, or at least eject a number of countries. While the political dynamics is gradually worsening, the more acute situation is economic, though.
Greeks are withdrawing their money from their banks and/or buying German bunds (which would survive any ejection out of the euro). This has been going on for some time (Greek banks lost 30% of their deposits since 2009, although not all of that is due to capital flight). But with all the talk of Greece leaving the euro and the political stalemate, this is accelerating.
This isn't a surprise, in fact, one could say that it is a surprise that so many people still leave their deposits in Greek banks. The problem is, how to stop this rot, that is on the edge of becoming a self-fulfilling prophesy, before it can't be stopped anymore?
Well, that depends whether the ECB is willing to backstop the Greek banks. There are two programs for that:
- The 'normal' or 'routine' operations in which the ECB deals directly with the Greek banks
- Emergency Liquidity Assistance (ELA), which is channeled through the Greek Central Bank
The ECB created a bit of a panic in the markets on Wednesday morning when it announced that it had stopped routine operations with certain Greek banks because of lack of collateral. As the FT Alphaville blog noted, this wasn't the best day to announce something that amounts to a technicality.
For the routine operations Greek banks need to have collateral, but they were waiting for the European Financial Stability Facility (EFSF) to provide them with collateral in the recapitalization of the Greek banks program (part of the latest Greek bail-out agreement).
With No access to ECB funds, the banks concerned must go to the Bank of Greece for emergency liquidity assistance , which has fewer collateral requirements. The EFSF funds will (hopefully) arrive soon, so that all Greek banks have access to the routine operations.
But even so, the question remains how long this can go on. Greek banks have already pledged much, if not most, of their collateral and how much of it remains is a matter of intense speculation. Here is JPMorgan:
They have already borrowed €60bn via ELA which, assuming 50% haircut corresponds to around €120bn of loan collateral. Outstanding loans are €250bn, so Greek banks have a maximum of €130bn of remaining loan collateral which allows for a maximum of €65bn of additional borrowing from Bank of Greece's ELA. This corresponds to around 40% of Greek bank deposits which stood at €170bn as of the end of March. The true maximum amount that Greek banks can borrow via ELA is likely though to be significantly smaller because not all loans are accepted as collateral via ELA.
But the other side of the equation is by far the bigger unknown. What if deposit withdrawals accelerate? This is by no means an unrealistic prospect. Deposit flight in other peripheral countries is still relatively moderate (although by no means negligible). But what if, as a result of this, it accelerates there as well?
Apart from the collateral constraints that peripheral banks will experience sooner rather than later, this deposit/capital flight to the center creates ever bigger imbalances in the inter-central bank Target 2 payments system. The result of the peripheral capital flight to (mainly) Germany is that the Bundesbank has claims amounting to 645 billion euro on the peripheral central banks already, and this amount is rapidly increasing.
So far, this is all basic accounting stuff but when one or more peripheral countries leave the euro, these sums are unlikely to be repaid in full, or even at all. The German tax payer would then have to recapitalize the Bundesbank to the tune of 25% of the German GDP.
The amount of these outstanding liabilities perversely gives the periphery increasing leverage over the center. The first to explore this leverage in order to soften the Teutonic austerity metered out to his country is Mr. Alexis Tsipras, the 38-year-old (or rather, young) far-left leader and possibly the next Greek Prime Minister.
Meanwhile, capital flight is not only from the periphery to the center, but outsiders are increasingly leaving the euro area (the revolt against the euro is spreading), hence the fall in the value of the euro against the dollar. What this all does for confidence and the eurozone economy, let alone for the health of Spanish banks, we'll leave to your imagination.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.