Free exchange | The euro crisis

Going, going, gone?

With euros leaving Greece, Greece may need to leave the euro

By R.A. | WASHINGTON

SO MUCH of modern finance is a confidence game. Banks borrow short and lend long. A perfectly solvent bank can therefore go bust if depositors panic and rush to pull money out. This is why modern financial systems have backstops, despite the moral hazard cost; in their absence, the economy is at risk of irrational destruction.

European leaders have been playing their game with Greece like confidence doesn't matter. They have behaved as if an adjustment is necessary, and the only question at issue is which side will bear its costs. But confidence matters. As time has gone on, markets have become less sure of the talk that Greece would never be allowed to leave the euro area. The euro zone's chief leaders have been more concerned about moral hazard than this confidence dynamic. We know what happens in such cases; the lack of confidence destroys the system.

The slow hiss of capital leakage has been a problem for Greece since relatively early on in the crisis. That problem seems to have intensified significantly in the wake of the recent election. From May 6th to May 15th, for instance, Greeks were yanking deposits from their banks at a clip of approximately €700m per day. Why wouldn't they? If everything turns out all right, they can simply put their money back in the bank later. If Greece tumbles out of the euro area, well, they have protected their savings from huge losses. A bank run is the logical development.

The question is how long this can continue. Greece has no money. Revenue collections are falling short, and one suspects Gresham's Law may begin operating. One doesn't turn over precious euros to the Greek government if an exit is looming; one hoards them, bringing forward the day when an alternative scrip begins circulating. The mere prospect of bad money may drive out good money. Meanwhile, the flow of euros into depositors' hands ultimately originates at the European Central Bank, and the ECB is no doubt very nervous about continuing to supply them for fear of huge, open-ended exposure to a Greece that is potentially on its way out. The ECB may already be rationing euros to Greece. If that continues or scales up, we are then talking about effective capital controls—the ATMs no longer dispense euro notes—and more pressure for the introduction of alternative scrip in Greece. Exit, in other words, becomes a fait accompli.

The debate over whether or not Greece ought to leave then becomes moot. It is becoming harder and harder, of course, to argue that Greece should stay. Leaving won't spare the Greeks austerity; they still run massive budget deficits. But macroeconomic adjustment without depreciation looks increasingly difficult; it will mean more hardship and perhaps a lot more. Greece has already been in severe recession for four years. How much more can it take? How much more should it take?

That said, there are two very strong arguments against departure. One is the threat of contagion. I have no confidence that the euro area's core leadership is prepared to take appropriate steps to convince markets that no other economy will be allowed to go. In the absence of such aggressive preparation, the ECB will be the only potentially credible buffer against broad contagion and break-up. Just how much is the ECB willing to do to hold everything together? Who believes that the ECB will step into the breach and provide unlimited guarantees to peripheral economies when the worst happens (and when core governments are unwilling or unable to provide such support)? So, one very real danger is that a Greek departure will lead directly to an extremely disruptive and costly euro-zone break-up.

The other threat is that a Greek exit will lead to a failure of the Greek state. The political situation is already chaotic and will become much more so in the event of departure. If a broken political system can't manage to improve tax collection or reform public finances (and who imagines these things will improve in the near future?) then covering the government's obligations will require money printing. That will lead to a devastating hyperinflation that will only exacerbate the political dynamic. Greece will become a ward of...someone, the IMF perhaps. Should this dynamic develop, things will very clearly not be better for the Greeks outside rather than inside the euro area.

But again, potential costs may not matter; the outcome may have already been determined. I feel the need to close by saying that there is still time for the troika to get ahead of the problem, restore confidence, and put Greece on a path to continued membership in the euro area. It will take commitments and courage unlike anything we've yet seen. It will take a German leadership willing to demonstrate that they want Greece in, moral hazard be damned. I'm not sure the German leadership is capable of such things.

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