Another day… another round of eurozone soul searching. This time UBS has sent out a Tuesday triptych of eurozone angst.
The first note, from Paul Donovan, covers off the flaws in the eurozone’s conception (little new ground but always worth remembering) and touches on Target2 liabilities and parallels:
The risk is if Target II ceases to function. This, it should be noted, would have to be a deliberate action by central banks. However, there is a (distant) precedent inthe United States. The implosion of the US monetary union in 1932/33 had many facets. Banks refused to lend across state boundaries, inter-state transfer payments were limited or prevented, and so forth. One of the key markers in the fragmentation of that monetary union was the refusal of the Federal Reserve Bank of Chicago to discount the bills of the Federal Reserve Banks of NewYork (i.e. a refusal to lend dollar cash to the New York Fed), in January 1933. The consequences are pretty much the same as if central banks in the European system of central banks refused to participate in Target II, or discriminated against specific economies in some way. In all probability, such discriminationwould lead to a general fragmentation of the Euro area – as of course it did in the United States.
The second, much longer, note from… er… Paul Donovan looks at the possibilities of a Greek exit which he says can only be disorderly as an orderly breakup is rendered impossible by institutional rigidity – too little and too much government:
Any attempt to reduce the number of Euro participants would require lengthy negotiations to effect the change. However, markets, banking systems and corporates would anticipate the conclusion of the negotiations and bring about the collapse of the monetary union (in whole or inpart) in a disorderly fashion. Discussion of an orderly or negotiated break-up is pure fantasy.
And in the case of a messy divorce,
fire will reign down trade will die as Greece gets cut off from markets:
The point here is not that the new Greek currency weakens in value – the point is that no one can know by how much the new currency will weaken in value, whether it will be freely convertible, or whether contracts will be honoured. Most companies in Greece would be assumed to be in default post the exit… It is possible that some kind of barter-based trade could continue, but this is unlikely to be economically significant.
In this way the Greek economy would operate in a way not too dissimilar from the black markets that flourished in many economies during andimmediately after the Second World War, or perhaps the dollar-based black market that existed in the dying days of the Soviet Union.
We have estimated that in the event of an exit, the cost to the Greek economy post departure could be up to 50% of GDP. However, the growth devastation set out here could come in anticipation of an exit, from the moment such a thing began to be discussed in a serious manner.
Cheery. And, of course, the banking system, which is already on wobbly stilts, would collapse…
The run on the banks is what makes any attempt to break up or exit from the Euro both sudden and disorderly. It is not an exaggeration to say that the time from queues forming outside a Greek bank to a generalised run on the banking system could take perhaps forty-eight hours or so – there is precedent for this in the experiences of the US in the 1930s, or even the UK in 2008. This is a sudden panic. The panic is also likely to be an organic development. This is not something that can be managed by the political elite.
… while contagion would spread/ run/ jump (as it does) and the rest of the periphery would wither:
If Greece exits from the Euro, the consequences in other Euro area countries could potentially be visible within a matter of weeks, pushing countries to the brink of departure from the Euro within a couple of months if not successfully checked.
Contagion is not a certainty, of course, but who wants to take on that risk? And how do you prevent it?
Donovan suggests a beefed up Maastricht Treaty (we thought the first one went very well):
In short what is needed is a Maastricht Treaty for modern times – and preferably one written by economists (who understand how to create a functioning monetary union) rather than by politicians (who, at least in 1992, did not). The modern Maastricht Treaty does nothing to change relative competitiveness problems, but these can and do persist in monetary unions for long periods of time without threatening the integrity of the monetary union. What such a plan does is reduce existential risks, while ultimately leading to a set of policies that helps to compensate for the damage done by a persistently inappropriate monetary policy.
And says if Greece stays in the eurozone, it needs to renegotiate its current austerity agreement or hit the hard-default nuclear-option.
UBS’ third note comes from Stephane Deo who has a look at the options left to the European Central Bank.
He argues that a rate cut would be fairly insipid, a reactiviation of the Security Markets Programme remains unconvincing (unless the ECB goes for a target of intervention similar to the Covered Bond Programme), while LTRO3 might just do the trick – especially if it was lengthened out to 5 years.
While in the “Any other Ideas?” column:
Apply the last 3-year LTRO rules to all repo operations: This would maintain eligible collateral at a high level. Also, because banks can use illiquid collateral for the ECB, they can use the most liquid one for normal market operation.
Change collateral rules: Same idea as above, but it would come from an ECB decision, hence the fragmentation by country of monetary policy would disappear.
Change ELA rules: This would allow a buffer for bad banks – they could more easily access liquidity. It also means that, in the case of a bank run, banks could have an easier way to access cash.
But he says:
ECB action will not suffice, so ignore me [not really]
All of the notes are in the usual place.
FT Alphaville’s Grexit file