Greek Failure

It seems Greece has chosen default and capital controls. Even so, Athens can still cut a deal that would relieve both. Either way, it will remain unclear for a while whether the country stays in the common currency. In some respects, this situation is entirely manageable. That fact has fostered a dangerous complacency, for in other respects this situation carries considerable risk, for the euro-zone, for European finance generally, and for global finance.

As many media discussions have implied, the debt part of the financial equation is not especially threatening. Greece for one, is a small economy. Its gross domestic product (GDP) is barely 6.5 percent of Germany’s. For another, its outstanding debt amounts to barely 1.0 percent of Europe’s banking assets. Even if that debt were widely held, default would hardly threaten the continent’s financial stability. And since the debt is now largely held by governments and other official bodies, the financial system has an additional buffer against uncertainty. Meanwhile, the ECB’s bond buying program should stem any fears that Greek default will force unsustainable borrowing costs on Italy, Spain, and others in Europe’s troubled periphery.

But the financial equation extends beyond debt management. For all the protections on that front, European economics and finance remain highly vulnerable should bank depositors in the periphery follow the Greek example and withdraw their deposits from their banks.

Events in Greece have already made this danger apparent. There, depositors have consistently withdrawn their funds from Greek banks. Many of those moving their money explicitly fear a Greek departure from the euro-zone and a re-denomination of Greek deposits into some kind of new drachma that, given Greece’s troubles, would surely depreciate in value. They have sought to neutralize this risk by moving their assets to safer repositories overseas or simply to the local Greek branches of seemingly more secure German or Dutch banks. Some of those putting their money in motion in this way might have less specific concerns but nonetheless share a prudent sense that their liquid wealth might better reside in places distant from their own troubled country. Whatever the motivations, the outflows, which European Union (EU) officials recently estimated at some €2.0 billion a day, have already limited liquidity at Greek banks, constrained flows of lendable funds to Greek consumers and businesses, and in so doing made a weak economy that much weaker. Meanwhile, capital controls to keep the money in place will hardly encourage bank lending or instill confidence in the economy’s future.

The ECB can only do so much to alleviate these strains. After all, the bond buying of its much-vaunted quantitative easing program aims to channel funds to governments not local banks and other deposit-taking institutions. It has opened an emergency credit line for Greek banks, but it is in no position to re-liquefy the banks if the current uneasiness turns into a panic. More frightening, this weakness in the system of official support leaves a potential for considerable harm should Italian, Spanish, or other depositors in Europe’s periphery follow the Greek example. Even with great faith in their government’s commitment to the euro, Italians, Spaniards, and others still might take their money out of local banks just to play it safe. There is, after all, little cost to such a move. Athens’ resort to capital controls only tends to raise the fear level elsewhere and encourage such behavior in the near term. Should such outflows gain momentum, little could be done to save these countries from a shortage of liquidity, with all the associated economic and financial harms that would go with it. These nations would then have still more trouble making good on their debt obligations, and the ECB would have to struggle still harder to support their finances.

Such trends could, in the extreme, precipitate a full-blown financial crisis. Widespread concern over bank illiquidity would cause doubt about the ability of banks to fulfill their obligations. People and other institutions would then shy away from transacting any business with them. And since no one could know which firms had liquidity problems, that wariness could extend to just about all. Financial flows could then freeze up, shutting down the great amount of economic activity that depends on them. This is exactly what happened in the United States in 2007-08, when a similar wariness developed around each firm’s exposure to sub-prime loans. If the cause this time in Europe has different roots, the result could well be the same. And because all financial institutions in the world deal with each other, the situation would quickly spread around the globe, as America’s financial problems did seven years ago.

So far, there is little sign that depositors’ fears extend beyond Greece. On that basis, it would seem that this frightening prospect is less than likely. But it is hard to dismiss the possibility out of hand, demanding serious attention to Greek matters and not the insouciant attitude some have displayed.

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