So what’s the problem with Grexit?

Not for Greece, that is clear, rather for everyone else.  Given bank recapitalization, the introduction of the European Stability Mechanism, European QE, a more general flood of liquidity to European banks, and a burgeoning European economic recovery — by European standards that is — it seems Grexit stands a good chance of being a non-event at the global or even the European level.  After all, Greece is only a small sliver of EU gdp; a few years ago it was only two percent, now presumably it is less.  On top of that, most of the remaining Greek debt is to public sector institutions, not private banks, which ought to limit contagion effects.  Indeed, as Greek bond yields rise, these days the bond yields of the periphery nations do not rise in tandem; some in fact have been falling.

So what’s the problem?

I think 80-20 that Grexit would not become a major macroeconomic problem for other countries, with the possible exception of small Cyprus.  But where does that 20% come from?

If Greek deposit flight forces a form of Grexit, whether whole or partial (capital controls plus scrip?), there is a good chance that markets will in essence “ask” the ECB again just how firmly it stands behind the other troubled eurozone member nations, such as Portugal.  The danger is that the current “creative ambiguity” cannot be disturbed in a useful way.  It might be hard for the ECB to announce that it stands fully behind the other eurozone nations, and in effect promise to monetize any pending default.  The incentive for moral hazard would be too destructive, and besides governments such as that of Spain don’t want to encourage the anti-austerity opposition.  The ECB is therefore likely to make a public commitment less extreme than that.

But neither will “we don’t really stand behind these governments at all” do the trick.  That probably would induce contagion along some other parts of the periphery, maybe more.

The ECB therefore must choose some intermediate point to signal — “we are committed, but member nations still bear fiscal risk.”  In part that is why they have rearranged the ex ante guarantees to fall so firmly upon national central banks, a move which some have compared to turning the euro into a currency board system.  Ex post, of course, the ECB or EU still has the discretionary option of bailing out those central banks, if and when it chooses to do so.  And, following Grexit, they could credibly say “The EU would have bailed out Greece, had an agreement on structural adjustment been reached and previous commitments honored.”  That’s basically a repeat of previous messages and maybe it is good enough.  That is where the 80% comes from.

So which ingredients will shape the new (old) message?: an intelligent but constrained ECB with a highly restrictive charter, a Europe-dedicated and wishing to atone for Grexit but electorally cautious Germany, a bunch of periphery nations which basically want any and all guarantees reserved for themselves and not for opposition parties, and lots of other voices, all mixed into a more or less unprecedented shock surprise in modern financial history.

So will the ECB get the signal right? Did I say 80-20?  Can I change that to…um…70-30?


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