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Monday, November 07, 2011 1:48 PM

History Suggests Greece Will Freeze Bank Deposits, Exit Euro by Christmas; Spain and Portugal to Follow Next Year; What's the Rational Thing to Do?

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Michael Pettis at China Financial Markets asks the question "Will Greece unravel by Christmas?"

Pettis then makes a historical case for exactly that while stating "I don’t think Europe can postpone Greece’s exit much longer." 

From Pettis, via Email, with Permission ....

Will Greece unravel by Christmas?

President Hu left the G20 meeting in Cannes Saturday without committing China to very much, merely saying:  “We believe Europe has the wisdom and ability to solve the debt problem.”  At this point, however, regardless of the amount of wisdom floating around Brussels I think it is pretty unrealistic to expect a happy solution.

We’re well past that stage.  By now, it seems to me, neither wisdom nor cooperation among world leaders is going to get us out of the debt and currency problems we face.  Rather than try to prevent a major disruption the policy goal now should be to engineer as quickly as possible the least disorderly and disruptive unraveling of financial markets in the peripheral countries.  And while it may help relieve frustration to excoriate European leaders for having made poor decisions, we shouldn’t assume that there really is a set of “right decisions” that will lead us out of this mess.  I think there isn’t.

In Athens, the refusal by New Democracy yesterday to join Pasoc in a coalition government indicates just how difficult political cooperation is likely to become, and how drastically political horizons have shortened. What’s more, by forcing Papandreou to cancel the referendum just days after he announced it – in the face of white-knuckled threats from an enraged France and Germany – Athens has pretty much made clear just how desperate things are and how little room the leadership has to maneuver.

Indeed the whole issue of sovereignty has become fuzzy.  Since France and Germany have basically exercised direct power over Greek’s electoral politics without assuming responsibility for solving Greece’s domestic problems, I can’t imagine that this won’t stoke even more resentment in Greece.

But it’s worse than just an issue of fuzzy sovereignty.  Last week something new happened which cannot help but affect the near-term outlook.  By openly speculating for the first time on Greece’s leaving the euro, Europe’s leaders have ensured that there is almost no chance now of preventing it from happening, and sooner even than most pessimists expected.

A country CAN leave the euro?

Not that there ever really was much of a chance, in my opinion, to keep Greece in the euro, but I assumed that European leaders would do whatever they could to postpone the day of reckoning until after the major elections this and next year. They would find ways, I thought, even if that meant putting more unemployment pressure on the middle and lower classes in Greece for another year or two. 

But now I don’t think Europe can postpone Greece’s exit much longer.  Statements by France and Germany may have transformed the dynamics of the crisis affecting Greece. 

By openly acknowledging that Greece could abandon the euro, Europe’s leaders may have set in motion events that will automatically force Greece to leave.  Here is the logic.  If Greece is ever forced to leave the euro, it will first have to redenominate domestic corporate and household liabilities into the new currency – let’s call it the drachma – or else domestic borrowers will be wiped out by the fall in the value of revenues relative to debt as the drachma immediately depreciates against the euro.

But it doesn’t end there.  If a bank’s assets – its outstanding loans – are to be redenominated into drachma, then its liabilities, i.e. deposits, must be redenominated too, or else the balance sheet mismatch will bankrupt the bank.

And there is where the problem lies.  As soon as any depositor realizes that bank deposits are likely to be redenominated into drachma, he will pull his deposits out of the banks so as to protect the value of his savings.  But obviously only a few depositors will be able to do this before forcing the bank into closing.  In order to prevent the resulting collapse in the banking system, the only thing Athens can do is to freeze bank deposits long before most depositors have had a chance to cash out.

But depositors know this.  As the probability of Greece’s leaving the euro rises – and clearly it rose dramatically this past week – anxious depositors eager to prevent their deposits from being frozen and redenominated in a weaker currency know that they will have to speed up their withdrawal of deposits from banks.  And of course as anxious depositors withdraw their deposits, the likelihood of a banking crisis rises, and with it the likelihood of Greece’s being forced to freeze deposits and leave the euro. 

A Bagehot intervention?

We are caught, it seems, in one of those self-reinforcing loops that almost always presage a collapse.  Rational behavior by individual agents leads towards a catastrophic event the threat of which reinforces the behavior.

I don’t see any way to get out of this loop except with a Bagehot-style intervention – a very unlikely but immediately credible announcement by Germany and France that they are prepared to guarantee all deposits in the Greek banking system.  I call it a “Bagehot intervention”, but of course Walter Bagehot would never have recommended bailing out an insolvent borrower.

Without a credible intervention this process almost always ends the same way.  There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro.  Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations.  Will Greece follow suit?  "If history repeats itself,” footballer Andrew Demetriou once pointed out, “I should think we can expect the same thing again.”

And it probably won’t end there.  In my opinion the real risk for Europe in that case becomes a contagion of deposit withdrawal, not immediately, but at the first sign of trouble in their home countries.  As households from Italy, Spain, Ireland, Portuguese, and other vulnerable countries read every day about hardships faced by Greek families (and those, it will be noted, who trusted the authorities were the worst hit), what will they do?

I know what many of my wealthy Spanish friends are already doing.  They are moving their deposits to safer havens.  I suspect that in other countries too anyone who can afford to withdraw money from the domestic financial system is at least thinking of doing so.  If this process accelerates it may be very hard to maintain domestic confidence in the local banking systems anywhere.

If Greece gets worse in the next few weeks, Europe had already better have a plan about what steps it will take to defend banks in peripheral Europe.  Once Greece goes, even the least sophisticated households in other countries will know what the consequences for depositors will be.  Deposit withdrawals, after all, are one of the kinds of actions that different sectors of the economy will take to protect their interests in the face of a crisis, even though this behavior increases the likelihood of the crisis.

This is simply part of the logic of sovereign financial distress – declining credibility causes stakeholders to act in ways that reduce credibility further.  What’s more, deterioration in the political process is part of financial distress at the sovereign level. Remember, as Keynes pointed out back in 1922, that resolving these kinds of crises is always political – it is about which sector of the economy (or class) ends up paying for the adjustment. 

Workers can pay in the form of high unemployment and declining wages, the middle class can pay by having its savings inflated away, private businesses can pay in the form of confiscatory taxes and expropriation, creditors can pay through forced debt forgiveness, and so on, but ultimately someone must pay.  Politics becomes about deciding which groups will be forced to foot the bill.  Historical precedents suggest that political fault lines are likely to develop as different groups organizes politically to protect themselves.

We will probably see this happen, for example, in Spain.  On November 20 Spain will hold elections.  For now it looks like the conservative PP will sweep out the Socialists and take nearly 200 of the 350 seats in Parliament.  This will give them a clear mandate and the power to enact any legislation they want. 

Unfortunately, as I suggested earlier in this newsletter, this doesn’t mean that they can resolve the crisis if only they figure out the “right decisions”.  Although it is unlikely they will mismanage the crisis to the same extent as the Socialists under Zapatero, who seemed to place a little too much importance on charm and cleverness over leadership, I am not sure there is a whole lot the PP will be able to do better than the Socialists. 

Both parties after all face the same problem.  They must drive the economy back into competitiveness, but aside from tinkering at the margins with tax and structural changes, really the only two ways Madrid can make Spain competitive is to drive wages down or devalue the currency.  The options for the PP, in other words, are the same as for the Socialists: either abandon the euro or accept extremely high levels of unemployment for the rest of the decade.  It is unlikely that any government facing those two options can maintain popularity for very long.
Risk of Bank Run Rising

Allianz Global Investors chief investment officer says Risk of Greek Bank Run, End of Euro Rising
The risk of a run on Greek banks and an end to the euro has increased as the sovereign debt crisis continues to shake markets, according to Allianz Global Investors, a fund-management unit of Europe’s biggest insurer.

A bank run in Greece is a “real danger” and the country’s plan for a referendum on the European bailout package is a “very serious threat” to the currency, Andreas Utermann, the firm’s chief investment officer, said at a press event in Frankfurt today. “An uncontrolled insolvency of Greece and an end of the euro would unleash a tsunami that would make the collapse of Lehman Brothers seem like a small problem.”

While Utermann said he doesn’t expect Greece to exit the euro, leaving the fate of the decision in unpredictable voters’ hand boosts the risk. Allianz Global Investors isn’t preparing for a breakup of the euro area because even if Greece leaves, the common currency could be sustained by the remaining countries, he said.
What's the Rational Thing to Do?

The rational thing to do if you live in Spain, Portugal, or Greece is to take all of your money out of banks while it's still denominated in Euros, while you still can. If a majority, or even a significant minority of depositors act rationally, it will be all over in days.

Thus, I believe Pettis has this called precisely, while Utermann has missed the mark. Given that the German Supreme Court would not allow a "Bagehot Intervention", once a run of sufficient size starts it will be all over in days.

Please see Bagehot’s Rule, Central Bank Incentives and Macroeconomic Resilience for further discussion of the "Bagehot Rule".

Please see Germany's Top Judge Throws Major Monkey Wrench Into Leveraged EFSF Machinery, Demands New Constitution and Popular Referendum for Further Powers for reasons why a "Bagehot Intervention" is not going to happen.

Right now, Greece wants to hang on until the next Tranche of money comes in. EMU leaders want to prevent a Greek exit at any and all costs (without doing an analysis of the costs). Thus, the EMU, ECB, and IMF "Troika" have made matters much worse for themselves when the inevitable finally happens.

This is out of the hands of Greece, Germany, Merkozy, the Troika, President Obama, and everyone else who thinks they are in control.

End of the Line when Depositors Act Rationally

The end of the line comes when Greek citizens act rationally and pull their deposits. From my perspective, the sooner that happens the better as sending more money to Greece does nothing but squander more European taxpayer's money.

To that end, the Troika would be advised to not send the next tranche of money and instead coordinate an exit strategy for countries that are inevitably going to exit.

Unfortunately, EMU bureaucrats will not be bright enough to figure this out. Expect a very disorderly, disruptive, and unplanned exit accompanied by bank closures.

Mike "Mish" Shedlock
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