Monday, February 9, 2015

What If the ECB Pulls the Trigger?

Over the past week, it's become clear that the real leverage the European authorities have over Greece is via the banking system. What does Greek need continued loans for? Not to pay for public expenditures, thanks to the primary surplus. Not to pay for imports — Greece has a (small) trade surplus. Not to service current debt, if it defaults. What does need to be financed, is the flow of deposits out of Greek banks to the rest of Europe.

So what happens if that financing is cut off, as the ECB is threatening? The usual answer is collapse of the Greek banking system, followed immediately by a forced exit of Greece.  But the other night I was talking to some friends about the situation, and we found ourselves wondering: What concretely are the mechanics of this? What is the exact chain of events from an end to ECB financing to Greek exit from the euro? I don't know the answer to this, but the more I think about it, the less confident I am in the conventional wisdom.

What concretely does it mean that the ECB is providing liquidity support to Greek banks? As far as I can tell, it is this. When a holder of a deposit in a Greek bank wants to make a payment elsewhere, either to purchase a good or asset outside Greece or to move the deposit elsewhere, the Greek bank must transfer an equal quantity of settlement assets to the bank receiving the deposits. These settlement assets are normally acquired on the fly, by issuing a new liability in the interbank market, but if other banks are unwilling to accept the liabilities of Geek banks, they can be borrowed directly from the ECB, against suitable collateral. This is the lending that the ECB is threatening to cut off.

What if the Greek banks can't acquire settlement assets? Then other banks will not accept the deposits, and it will be impossible to use deposits in Greek banks to make payments. Depositors will find their accounts frozen and, in the normal course of events, the banks would be shut down by regulators.

But Greece still does have a central bank. My understanding is that much of the day to day business of central banking in Europe is carried out by the national central banks. In principle, even if Greek banks can't acquire settlement assets by borrowing from the ECB, they can still borrow from the Greek central bank. This doesn't help with payments to the rest of Europe, since reserve balances at the Greek central bank won't be accepted elsewhere. But I don't see why the Greek central bank can't keep the payments system working within Greece itself. If the Greek central bank is willing to provide liquidity on the same terms as the ECB, what's going to force the Greek banks to shut down? It's not as though there's any Europe-wide bank regulator that can do it.

In a sense, this is a kind of soft exit, since there will now be a Greek euro that is not freely convertible into a non-Greek euro. But I don't see why it has to be catastrophic or irreversible. Transactions within Greece can continue as before. And for routine trade it might not make much difference either, since the majority of Greek imports come from outside the EU. Where it would make a difference is precisely that it would prevent Greek depositors from moving their funds out of the country. [1] In effect, by cutting Greece off from the European interbank payment system, the ECB will be imposing capital controls on Greece's behalf. You could even say that, if the threat of cutting off liquidity support can trigger a run on Greek banks, actually doing so will ensure that there isn't one.

Now maybe I'm wrong about this. Maybe there is a good reason why the Greek central bank can't maintain the payment system within Greece. But I also think there's a larger point here. I'm thinking about the end of the gold standard in the 1930s, when breaking the link with gold was considered an unthinkable catastrophe. And yet the objective basis of the money system in gold turned out to be irrelevant. I think, in the same way, the current crisis may be revealing the reflexive, self-referential nature of money. On a certain level, the threat against Greece comes down to: "You must make your money payments, or we will deprive you of the means to make your money payments."

The rule of the money system requires that real productive activity be organized around the need for money. This in turn requires that money not be too freely available, but also that it not be too scarce. Think of Aunt Agatha in Daniel Davies' parable. Suppose her real goal is to run her nephew's life — to boss him around, have him at her beck and call, to know that he won't make any choices without asking if she approves. In that case she always has to be threatening to cut him off, but she can't ever really do it. If he knows he's getting money from her he won't care what she thinks — but if he knows he isn't, he won't care either. He has to be perpetually unsure. And in keeping with Davies' story, the only thing Jim actually needs the money for, is to continue servicing his debt to Aunt Agatha. The only real power she has is a superstitious horror at the idea of unpaid debts.

In this way I've tentatively convinced myself that all Syriza needs to do is hold firm. The only way they can lose is if they lose their nerve. Conversely, the worst outcome for the ECB and its allies would be if they force Greece into default -- and everyone watches as the vengeful money-gods fail to appear.

UPDATE: It turns out that Daniel Davies is making a similar argument:
Capital controls are arguably what Greece needs right now - they have balanced the primary budget, and they need to stop capital flight. From the ECB's point of view, I'd agree that the move is political, but it also means that they are no longer financing capital flight.

There's a sensible negotiated solution here - with a lower primary surplus than the program (in which context I think Varoufakis' suggestion of 1.5% is not nearly ambitious enough), a return to the structural programs (the Port of Piraeus really does need to be taken out of the political sphere), and an agreement to kick the headline debt amount into the far future (in service of which aim I don't think all the funny financial engineering is helping).

The fall-back is a kind of soft exit, with capital controls. But the massive, massive advantage of capital controls over drachmaisation is that they  preserve foreign exchange. Greece imports fuel and food. With capital controls, it can be sure of financing vital imports.
The fact that Davies is thinking the same way makes me a lot more confident about the argument in this post.

[1] Greek banks would also presumably be limited in their ability provide physical cash to depositors, but I don't think this is important.


  1. I'm thinking also of the drama around the debt limit in the US, where the bond vigilantes were always about to appear, any minute now.

  2. Something that Greece could really lose is its ownership share of the ECB. In effect, the ECB is a secured creditor.

    1. And...? How does this affect the real resources available for any purpose in Greece?

      This concern actually seems like a good example of what I'm talking about. Should the Greek government make decisions toward improving material conditions in Greece, or toward the accumulation of money-claims?

  3. Maybe you already read it, but Krugman had a blogpost some days ago about this and he also tought that this whole ECB pulling the plug isn't really all that scary, however he had a very different take on this (and also a very different opinion on the ECB strategy):

    1. Krugman knows Draghi personally. Maybe that gives him special insight, or maybe it clouds his judgement. I tend to agree with Peter Dorman that the idea of the ECB as the defender of European democracy seems like wishful thinking.

  4. It does look like Tsipras is sticking to his guns:

    The Reuters article says: "Greek financial markets sank further on Monday, pulling European shares down, after credit ratings agency Standard & Poor's cut Athens' rating last Friday. The index of Greek banking stocks fell almost 10 percent to near record lows.

    Government bond yields rose by up to 3.7 percentage points, with three-year yields nearing 22 percent. The soaring rates mean Greece is shut out of capital markets."

    This is what the ECB move added to? How does this translate to the Aunt Agatha story?

    Isn't this the bond vigilantes attacking? And the point is even if they didn't attack, the ultimate outcome is based on whether or not the Troika will accept Syriza's demands in order to prevent a Grexit.

    If the Greeks hold fast, the added pressure is a side issue. It's as if Aunt Agatha is cutting Jim's allowance?

    I guess I don't understand the notion of the ECB financing capital flight, which Davies brought up. It's now more expensive for people to pull or move their money?

    1. It's sort of not an issue whether the ECB is the guardian of democracy. It's whether they want to keep the Eurozone together and maintain "stability" and what a Grexit would mean.

      Draghi did save the Eurozone by saying the ECB would act as the lender of last resort back in 2012. Then he pushed through QE a couple of weeks ago. These actions eased the pressure on the periphery governments.

    2. Except that Krugman used that exact phrase, so n this issue it sort of is the issue. More broadly, I am convinced that the real agenda of the ECB is to roll back social democracy, liberalize labor markets, etc.

  5. Well, I also think that the idea of "Draghi saviour of democracy" is a bit crazy, expecially since he imself is an unelected official, not really an example of "democracy".

    However, I believe that the current crisis of the EU is not a crisis of "democracy", but a crisis of "capitalism":

    The current idea of austerity pushed by the EU is based on the idea that Greece overspent in the past, and that as a consequence Greek consumption has to fall, hence austerity and falling wages. Greek wages are already (and always were) lower than German wages, hence what has to fall is the Greek wage share of total production. Suppose for example that an average Greek worker produces 100, but get 70 in wage, while an average German worker produces 200, but gets 130 in wage, a wage share of 70% vs 65%. This makes Greece uncompetitive vs. Germany. The idea of the austerity group is that the Greek wage share has also to fall from 70% to 65%, in fact it has to fall a bit more to pay back previous debt; the idea of the anti-austerity group is instead that the german wage share has to rise to 70% or more.

    Thus, while it seems that there is just a nominal difference between the two strategies, the idea that Greek wages must fall is very different from the idea that German wages must rise, not just in nominal terms, but also in distributional terms.

    However in the whole of Europe most if not all governments (democratically elected governments) crafted policies that are aimed at increasing competitivity, that in pratice means lowering the wage share. This happens because of the general turn towards the right in economic thinking that is usually known as "neoliberalism". The consequence of this is that each european nation is trying to be a net exporter, but, as this is impossible, some turn out to be net importers anyway.

    However this turn towards the right is not something undemocratic, it is just what citiziens in european nations democratically choose. Was this a stupid choice? I think so, but this doesn't make it undemocratic.

    So the problem isn't really that the EU is antidemocratic, but rather that EU citiziens democratically choose to follow self-contradictory policies.

    That said, I don't think that there is an exit from this situation, until:

    1) Debt level are abated either through forgiveness or inflation (paying back doesn't work as it is deflationary);
    2) Somehow the wage share of total production is raised everywhere to a point that nations stop to follow semi-mercantilist policies.

    This, IMHO, is true both for the EU and for the world at large.

    1. Or to put it in another way, even if Greece regained complete monetary and fiscal autonomy, for example after a "grexit", as long as all its neighbours pursue a policy of competitivity through lowering the wage share and increased exports, Greece would have only three options:
      1) Increasing debts;
      2) Super high unemployment;
      3) Greece too could compete by lowering the wage share, e.g. by thebasing the drachma - but this would only shift the problem on another nation.

      So "democracy" in the sense of control of the Greek state over macroeconomic variables isn't really the point here, as the Greek state would be pushed towards umpleasant choices even if it was outside the EU.

    2. I think your implicit assumption that trade patterns are governed mainly by relative costs, is not so solid.

    3. I was searching on the net for some data to check my idea of trade patterns determined by relative costs and I found this paper, that I think is very interesting:

      The paper in itself says that different levels of competitivity among european nations cannot be explained by a wage drift in real terms, but only by differential inflation in the various countries.
      However towards the end of the paper the data relative to the manifacturing sector alone show that, in the manifacturing sector itself, the "wage share" is actually much lower in Germany than in the periphery countries (at least this is my reading of the graphs).
      So I think that what drived trade patterns in the EU was mostly the wage share in the tradable sector, and that the effect of the capital influx in the importing countries was to generate inflation in the non-tradable sector.
      This, at least, is my opinion.

      PS: Obviously relative costs are not the only determinants of trade patterns, however:
      1) It is the determinant that can be most easily influenced by politics, for example if Greece is disadvantaged because of its geografical position it cannot choose to relocate closer to Germany, but it can choose to lower prices to overcome the burden of transportation costs;
      2) Many "structural" aspects of the economy are already taken in account in the relative costs as they influence GDP, for example if the Greeks were inefficient because of high corruption, this would first show up in a lower GDP, so it is already taken in account if we speak of the wage share (and not of real or nominal wages).

  6. First a correction. It is the NCBs that perform regular and emergency refinancing operations, not the ECB. The ECB has mainly a governing role in the monetary policy implementation framework. If you take a look at the BoG monthly financial statements you will observe that it is the one that performs MRO/LTROs and ELA ('Other Claims') for the Greek banking system.

    Regarding your thoughts I think that things are quite complicated for a possible termination of ELA. The most likely scenario for something like that to happen is that the Greek government is not able to service its maturing debt obligations (such as the Greek-law ECB SMP bonds maturing during the summer). If that were to happen the EFSF *might* trigger the cross default clauses of its refinancing agreement and consider Greek debt to the EFSF as defaulted (with obvious problems for its rating and status).

    Then the ECB would have the excuse to demand that the BoG does not accept Greek guaranteed collateral in its refinancing operations. Greek banks would then either have to replace collateral posted with new (such as performing credit claims) or reduce their financing. The latter is more or less impossible since financing has been used mainly for covering the increased Target2 liabilities.

    Now things become tricky. Would the BoG consider Greek banks in default? How it would treat its Target2 liabilities in this case (since it might end up having more liabilities than assets)? Really uncharted territory.

    A more probable scenario in my opinion is that deposit outflows lead to Greek banks reaching their ELA cap and no more good quality collateral available (their asset quality and quantity is much lower than in 2012). Then we might see an implementation of capital controls in a 'Cyprus lite' scenario. I 'm sure there are people in the Eurozone who believe that such a scenario is more than enough for the new Greek government to back down from its current demands.

    1. It sounds like a key variable here is the decisionmakers at the BoG. My understanding is that the current Governor is a holdover from the previous administration? If the ECB instructed him to declare Greek banks in default and the Syriza government instructed him not to, what do we think he would do?

      In your opinion, is Cyprus a useful guide to possible outcomes in Greece?

    2. It gets more complicated. Under the SSM the ECB itself is the supervisor of the 4 Greek systemic banks. But BoG is the one providing liquidity and facing the risk under ELA operations.

      In the Cyprus case the main leverage that the ECB has was the fact that Cypriot banks had negative capital. Greek banks have passed the ECB stress tests just a few months ago. Cyprus is mainly a useful guide as far as capital controls are concerned.

      I am telling you, it's a big mess :)

  7. First of all:

    cutting ELA off requires a two-thirds vote on the Governing Council. Until this happens automatic overdrafts for Greek banks, no collateral needed.

    Second of all:

    "...Greece imports fuel and food. With capital controls, it can be sure of financing vital imports..."

    Forgive my french but it's a pure Fear Porn :) No need to go the same argument again.

    Third of all:

    "....Or to put it in another way, even if Greece regained complete monetary and fiscal autonomy, for example after a "grexit", as long as all its neighbours pursue a policy of competitivity through lowering the wage share and increased exports, Greece would have only three options:
    1) Increasing debts;
    2) Super high unemployment;
    3) Greece too could compete by lowering the wage share, e.g. by thebasing the drachma - but this would only shift the problem on another nation...."

    Y=GDP=C+I+G+NX . How about increasing "G" instead of "NX" ? Oops , I forgot about Hyperinflation :)

    1. "How about increasing G instead of NX ?"

      That would be my (1): increasing debts.

  8. If when Greek people went to spend their Greek bank Euro bank deposits in Italy, they had to first exchange them for Italian Euros, then wouldn't we have Drachma-isation even if they still kept the "Euro" name for the Greek money?

    Wouldn't the exchange rate inevitably slip from 1:1?

    If the Greeks were no longer servicing their old debts to the troika, they were running a primary surplus and they had a trade surplus; then the "Greek Euro" might be strong against the real Euro.

    Perhaps the whole Euro zone will break up simply by each national central bank being left to be the only provider of liquidity support and each national central bank only providing that within each country. Then euros from each country would need to be exchanged for one another to move funds around and so exchange rates would develop?

    Sorry if I'm just in a dumb muddle with this.

    1. If the only paper money that Greek bank depositors could withdraw was paper issued by the Greek central bank and that paper was not excepted by the ECB, then that would go along with there being Drachma-isation in all but name. That paper would exchange 1:1 with Greek bank deposits but not 1:1 with Italian bank deposits or Italian paper euros.

    2. (Further to what I was wondering above). In the absence of support from the ECB, the Greek central bank could of course attempt a currency exchange peg between their Greek euro and the real Euro (as the Swiss or Danes did) but it would be a pegged currency (perhaps still called the euro) and not a currency union.

  9. Stone-

    You are right that if interbank payments to the rest of Europe were suspended for a long period of time, the result would be something like a separate currency -- that's why I describe it as "soft exit" in the post. With respect to paper currency, it is possible that a modest premium of physical cash over bank deposits would be enough to keep paper euros circulating in Greece; if not, you'd need a new form of currency, which would look even more like exit.

    But the big question here isn't the long term, it's the short term. If the ECB fires its big guns and Greece is more or less unscathed, the political situation is going to change radically -- it becomes much easier for Podemos to win in Spain, for instance. And that in turn means that the ECB is unlikely to act on its threat in the first place. So what really matters, it seems to me, is if the Greek banking system could continue functioning for a period of weeks or months, not what might happen if the new situation continued indefinitely.

  10. The other day we considered the possibility that even if the vast majority of Greek government debt is held by public entities outside Greece (a number that was reported somewhere), the remaining amount held by Greek banks may still be large relative to the size of the Greek banking system.
    Karl Whelan sets the value of Greek government debt held by Greek banks in relation to the Greek banks' balance sheet. That's the number we were after. It turns out it is small indeed.

  11. In a sense, this is a kind of soft exit, since there will now be a Greek euro that is not freely convertible into a non-Greek euro. But I don't see why it has to be catastrophic or irreversible. Transactions within Greece can continue as before. And for routine trade it might not make much difference either, since the majority of Greek imports come from outside the EU.

    Why would non-European exporters accept this new non-convertible Greek euro if they couldn't trade it in the rest of Europe? New contracts would be axed; scheduled shipments on existing contracts would be suspended. Commercial courts across the world would be flooded with claims and counter-claims.

    And foreign trade is about a third of the Greek economy. If it fell apart, it seems to me that would be pretty catastrophic for Greece, even if the intra-Greek payments system continued to function.

    I assume the new Greco-euro would quickly fall rapidly against the euro-euro, holders of Greek debt would take a giant bath in real terms and the financial crisis waves would wash across Europe and elsewhere?

    So this soft exit looks to me like like another form of hard exit. Within hours of the announcement that the Greek national bank is now conducting monetary policy independently of the ECB framework, the word would spread that Greece had indeed left the EZ, even if it was still calling its GNB-issued liabilities "euros".

    However, maybe its a more politically viable means of Grexit, since the Greek government could try to tell its people that it didn't leave the euro.

    1. Why would non-European exporters accept this new non-convertible Greek euro if they couldn't trade it in the rest of Europe?

      They wouldn't have to.

      Remember, Greece currently ahs a trade surplus -- that's critical to the argument. So the current flow of hard currency (dollars, non-Greek euros, etc.) entering Greece exceeds the flow needed to pay for current imports. So there is no need for anyone selling goods to Greece to accept Greek bank deposits or other Greek assets in payment. That is, provided that export earnings are available to pay for imports, rather than leaving the country as either debt-service apyments or in the form of capital flight.

      So, IF you default on the debt, and IF you have capital controls (which the ECB would effectively be imposing anyway by suspending ELA), then Greece could maintain its current level of imports even if no one outside of the country would accept Greek assets.

      Also, note that the BoG might not need to increase its liabilities substantially in this scenario; it simply preserves the moneyness of the liabilities of Greek banks by standing ready to issue new liabilities if necessary to ensure the payment system continues operating.

  12. Also, on reflection I think the physical currency issue is way overblown. I mean, cashier's checks, money orders, travelers checks, etc. already exist. The creating of currency equivalents is a long-solved problem.

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