How Greece Could Force Germany Off The Euro

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Includes: FXE, GREK, NBGGY
by: Michael Sacerdote
Summary

Greek economic default has already occurred.

Germany lacks negotiating power and cannot force a Grexit.

Greece is actively monetizing its debt through ELA.

Germany's best option is to leave the euro (but it won't happen soon).

Much of the discussion of Greece's (NYSEARCA:GREK) financial crisis has centered on whether a Greek default could result in a Greek exit from the euro. In a very unlikely worst-case scenario, an unplanned Greek departure could trigger a contagious loss of confidence that would ripple through the weaker, heavily-indebted Eurozone economies, particularly Spain and Italy, resulting in a violent collapse of the euro, massive sovereign and then corporate defaults, and a pan-European banking panic. Since the last crisis in 2011-2012, supranational taxpayer-backed institutional lending to Greece has replaced lending from large commercial banks, supposedly insulating the rest of Europe from contagion in the event of a Greek default. According to this thinking, foreign taxpayers will suffer minimally in the event of a Greek default since Greece is only 2% of the Eurozone economy. Conversely, Greek individuals will be hammered as the country defaults, leaves the euro, and either converts savings accounts to a worthless new currency and/or enforces stiff capital controls that effectively devalue holdings in Greek bank accounts.

This line of thinking is the conventional wisdom and goes nicely with a too-tight necktie. It ignores a major black swan that has hatched from a series of seemingly benign decisions over the past 3 years. Greece in fact holds all the cards in the negotiations and has been liberated from all the negative consequences of extreme behavior. Greece has been equipped with a knockout punch that could drive Germany off the euro: Greece has fired up the printing presses and is gently debasing the euro. If this debasement accelerates or becomes explicit, German taxpayers could awaken and demand an end to the theater of the absurd. As soon as they realize that they are the suckers, German taxpayers will want out from the euro. It will take time, probably years of denial, but eventually Germany rather than Greece will be the country rushing to exit the common currency.

Greece has already defaulted

The first and greatest fiction now current in the traditional financial media is that the acrimonious negotiations between Greece and the Troika are intended to avert a default. Greece has already defaulted and all future negotiations countenance only further default rather than repayment. The most explicit default thus far was the "bundling" of June payments to the IMF. In reality, Greece had no money and missed a payment, with Christine Lagarde using a technicality to avoid initiating the IMF's extremely slow mechanism for declaring a formal default. Regardless, a missed payment is a missed payment; markets don't much care if there is a 30-day grace period, frantic telephone calls among the IMF's leadership, or a formal declaration of default. The June default comes on top of the $840 million payment to the IMF in which Greece used its mandatory special drawing rights holdings at the IMF to pay the IMF; that is, Greece used IMF's money to pay the IMF. When debts are paid by the creditor instead of by the debtor, a default has occurred.

Subsequent discussions between Greece and the members of the Troika have been variations on one of two options: (1) Greece explicitly defaults on its payments (be they the $1.7 billion due to the IMF on June 30th or the 3.5 billion euros due to the ECB on July 20th); or (2) the current bailout is extended, 7 billion euros are given to the Greeks and then used for repayments to the creditors.

Because no outcome under current debate involves repayment with money whose source is Greek economic activity, all possibilities being discussed at present are de facto defaults. Euphemisms may be the true common language of Europe, but markets weigh only the underlying realities. Greece's impossible payments expected through the year 2057 are just that - impossible. Given that Greece has already missed a $300 million payment and has looted municipal coffers to keep the lights on, it is clear that none of these future payments will be made. The only reason to describe these future missed payments as a potentially restructured "bailout" is to protect the backsides of Eurozone politicians who have donated, not loaned, 240 billion euros in their own taxpayers' earnings to Greece. The ongoing negotiations are just petty arguments about what color lipstick to put on the pig rather than discussions of substance.

The second great fiction floated in the mainstream financial press is that a Greek default will necessarily lead to a Greek exit from the euro. A violent Greek exit from the euro is quite unlikely, even in the event of a default. First, Greek public opinion is strongly for staying in the euro by a margin of 74:18. Alexis Tsipras has already demonstrated time and again his fealty to democratic mandates. He was elected to default, defeat external austerity measures, and simultaneously stay in the euro. He's on track to make good on all three promises.

The only reason that Greece would leave the euro would be if it could no longer meet its day-to-day obligations. First it would delay payments, then it would issue explicit IOUs that would trade at a discount to nominal value, and then it would start issuing a formal new currency. However, if Greece is able to fund its government functions while remaining within the Eurozone, there is no economic force to crush its euro membership. Greece can meet its daily obligations if it runs a so-called primary surplus - operating in the black before interest payments are included. Greece operated with a small primary surplus January-April. If Greece halted its debt payments, Greece would no longer be obliged to exit the Eurozone due to inability to operate the government. University of Chicago economist John Cochrane has written at length about this disconnect between default and exit from the Eurozone. The lack of legal mechanism for exiting from the euro is irrelevant compared to the lack of true economic pressure on the Greek government.

Syriza holds the power

It's a cliche that "if you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Greece's creditors hold unsecured debt: there is no lien on the island of Crete and the Elgin Marbles have already been claimed. As Wolfgang Muchau writes in the Financial Times, "Greece has nothing to lose by saying no to creditors." The various enforcement mechanisms for creditor countries - perhaps embargo, restriction on movement, or seizure of assets - are banned by Eurozone treaties. Also, howitzers have gone out of fashion in Europe, despite Angela Merkel's display of force during Tsipras' post-election visit to Berlin. Greece's creditors are in the uncomfortable position of losing everything if they fail to agree with Greece versus losing almost everything if they succeed in coming to an agreement. The only potential downside to Greece if it defaults is the economic uncertainty that would be triggered by a formal default. If there is any compromise, it will be strongly in Greece's favor. Either way, the economic difference between agreement and disagreement is de minimis as almost no hard money will be transferred from Greece to its creditors.

Greece has recently tipped its hand about how it plans to play the endgame before formal default. The strategy is to divide and isolate its creditors, possibly resulting in a bidding war over waterlogged life jackets between the escapees swimming from the Greek economic Lusitania. According to Varoufakis, "if the IMF makes unacceptable demands that it well knows Greece cannot agree to in order to justify it leaving the negotiations… [it] would not prevent an agreement between only Athens and the Europeans." In other words: Greece will happily make a separate peace with each of its counterparties. Which ones? The IMF has no enforcement mechanism and will just have to eat a Greek default. As Nouriel Roubini writes in Bailouts or Bail-ins (pp. 285-6),

The IMF's own prior exposure constrains its leverage - denying IMF financing to a sovereign that has defaulted on its own priority structure could result in a default on the IMF. Even setting aside the IMF's interests as a creditor, it may be better off using its limited leverage to improve a country's macroeconomic policy framework rather than forcing a country to stick to its priority structure. The details of the priority structure will likely be contested, and the IMF may even conclude, for example, that protecting the country's banking system is more important than religiously following any preexisting priority structure. The international community's interest, writ broadly, would be better served by helping the country recover rather than punish it for failing to live up to its self-defined system of priorities.

...The core question in the debate on sovereign priorities is whether it is possible to develop a system that both can be enforced and substantially improved on the status quo. We are skeptical.

The IMF, which has a mission broader than simply getting its money back, will not get anything. In fact, it is most likely than only lenders possessing political power independent of their creditor status will have any bargaining chips at Tsipras' poker table. The European Central Bank has none and will not be repaid. Indeed, the European Commission as a whole will not be repaid. Instead, Tsipras may try to bargain with individual Eurozone countries in the event of a formal Greek default. He may try to cement alliances with foreign left wing parties like Podemos in Spain by returning at least some money to friendly countries. If any deal is struck, it will be between Greece and individual countries, all of whom will be scrambling to get at least a pittance. A failure to build friendship with Tsipras is an assurance of total loss on loans to Greece. We are confident that Tsipras, who has shown himself to be politically agile, will not only survive but may even try to extend Greek political influence as the financial crisis boils over. As is usually the case in default, Greece will attempt to make domestic creditors whole first and then may extend a token payment to friendly creditor regimes. Creditors without economies or armies will be shut out entirely.

The printing presses are busy

Emergency liquidity assistance is built on a lie: Greek banks are insolvent, not illiquid. Varoufakis himself has stated as much himself:

Suppose a friend of yours were to come to you and say that he or she had difficulty paying the mortgage because of a reduction in their income - they lost their job or something like that. They have a great idea on how to solve this problem: they would get a credit card and draw money from it in order to meet the mortgage payments for the next few months. Would you advise them that they should continue to take these tranches of loans from the credit card in order to deal with what is essentially an insolvency problem?

The individual Greek banks show every sign of being zombie banks. A cursory glance at, for example, the National Bank of Greece (NBG) indicates an institution in distress: poor specification of assets and liabilities, giant portfolios of delinquent loans with unrealistic write-downs, fuzzy marking to market, and Greek sovereign debt on the balance sheet. Any bank earning a 3.8% interest rate spread on a portfolio with 24% of loans 90 days past due has a problem. Greek depositors have voted with their feet, causing total Greek deposits to plunge about 1% per week since November 2014. Purchases of cars in Greece have soared as desperate individuals have tried to lock their savings into hard assets that can't devalue to zero at a politician's whim.

In theory, emergency liquidity assistance is supposed to be structured so that all of the risk is borne by the local national bank. According to ECB Emergency Liquidity Assistance Procedures:

Euro area credit institutions can receive central bank credit not only through monetary policy operations but exceptionally also through emergency liquidity assistance. ELA means the provision by a Eurosystem national central bank of:

(a) central bank money and/or

(b) any other assistance that may lead to an increase in central bank money to a solvent financial institution, or group of solvent financial institutions, that is facing temporary liquidity problems, without such operation being part of the single monetary policy. Responsibility for the provision of ELA lies with the NCB(s) concerned. This means that any costs of, and the risks arising from, the provision of ELA are incurred by the relevant NCB."

Aside from the fact that Greek banks are almost definitely insolvent, ELA policy suffers from the difficulty of limiting any costs and risks to the relevant NCB. Here's why:

Greece's insolvent banks are out of money. As the bank run continues, nearly every week the ECB increases ELA, which authorizes the Bank of Greece to "loan" funds to Greece's insolvent banks. Because Greece's banks can't pay the money back, these loans are equivalent to monetary expansion - raw money printing. Central banks can operate just fine with negative capital. As a result, if the Bank of Greece does not collect repayment for Emergency Liquidity Assistance dispensed, the cost of money creation through ELA not offset through repayment or taxation is distributed throughout the Eurozone in the form of devaluation. If the Bank of Greece were printing a national currency, inflation would be brisk. However, given the small size of Greece's economy relative to the Eurozone as a whole, that devaluation is hard to measure, but it is nonetheless borne by savers in all Eurozone countries. A national central bank cannot incur the costs and risks arising from ELA without spreading that risk to all other members of the common currency. As long as euros, goods, and people circulate freely across borders, it is impossible to confine the risk of emergency liquidity assistance to any one nation.

Indeed, Greece (like all Eurozone participants) is authorized to print euro banknotes, which are freely exchangeable throughout the Eurozone and not easily distinguished from banknotes printed elsewhere. Allowing Greece to use the decentralized production of money to monetize its debt was actively discussed in 2012. Syriza member of parliament Rachil Makri discussed irresponsible direct monetization explicitly.

The Tsipras administration is too subtle to wildly print banknotes. Instead, he will continue to draw on ELA as long as the ECB allows. When the ECB central administration disallows further ELA, Greece will potentially continue issuing liquidity assistance to its banks without permission. After all, central banks can create money with the stroke of a computer key. The governors of the ECB would have absolutely no recourse if the Bank of Greece were to create some extra liquidity, especially since one of Syriza's first actions after election was to cease cooperating with the Troika's auditors. In the absence of any external oversight and in decidedly desperate times, it should be a shock to no-one if some unsanctioned liquidity assistance quietly takes place - just enough to allow the government to function, just enough to grease a small primary deficit if one arises, just enough to tamp down a bank run, just enough to keep the Greek financial system from imploding, but not so gross an amount as to be immediately obvious to outsiders. The temptation to cheat will be enormous; the likelihood of discovery would be high; but the consequences of discovery are nil. The worst, absolute worst, that other countries could do to Greece would be to expel it from the euro.

Germany's last option

Individual countries using monetary policy to push their debts onto other Eurozone members was the major German fear about the common currency before the Maastricht treaty went into effect. The euro's extensive membership rules ("convergence criteria") pertaining to inflation, maximum budget deficits and debt-to-GDP ratios were created explicitly to prevent countries from gaming the system. Even when Mario Draghi's "outright monetary transactions" were clearly the right move in the setting of mild deflation, European stagnation, and a globally soft quarter, significant German popular opposition existed. Ever since the hyperinflation of 1921-1924, printing money to monetize debt has been taboo in Germany.

German taxpayers have only one source of leverage against Greece: Germany could leave the euro. As long as Germany and Greece remain in the same currency union, continued transfers from Germany to Greece will continue forever, either explicitly in the form of defaulted loans and humanitarian assistance or implicitly in the form of euro devaluation. Because Greece is immune to the economics that would force it to crash out of the euro, Germany will be unable to coerce Greece to leave the currency bloc. If German taxpayers tire of delivering transfer payments to the peripheral countries of the Eurozone, their only real recourse will be to depart themselves, just like wealthy Americans renouncing their citizenship and moving to Monaco or Singapore. A German departure from the euro isn't as crazy or outlandish as it seems: Switzerland recently pursued this exact course of action when it unpegged the Swiss franc from the euro.

Decisive action is as tardy as it is rare in Europe. In the short term, Greece will default and stay in the euro. In the much longer term, the folly of pegging the drachma to the deutsche mark will be exposed, the euro will fragment, and the European economies will all benefit from the natural equilibrating forces of functioning markets.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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