Ed Harrison: Some Thoughts on the Coming Defaults of Greece

Lambert here: This post is a 30,000-foot view of the unfolding Greek crisis, written after the Eurozone finance minister’s meeting at Riga in April, but still good, and republished, today.

tl;dr: The opera ain’t over ’til the ECB sings.

Ruthlessly oversimplifying one aspect of Harrison’s post, Grexit is “arduous,” because the EU is a Rube Goldberg device glued together with treaties, which are hard to undo. Of course, there’s one obvious way for nation states at odds over treaties to settle the matter, hitherto discussed: a Mouse that Roared scenario. Of course, life is often not like a comic novel blessed with wisdom, a happy ending, and, ultimately, a movie version starring Peter Sellers.

By Ed Harrison, founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. Originally published atCredit Writedowns

This post, originally written at Credit Writedown Pro on 27 Apr 2015, is now available here as well.

After the meeting in Riga, it is more clear than ever that the gap between Greece and the Eurogroup finance ministers is wide. Default looks likely and so we have to start thinking about what this means for Greece and for Europe. My base case has always been default within the eurozone but eventual Grexit over the longer-term horizon. However, there are other scenarios in which Grexit happens sooner, and those will be instructive for other peripheral countries when the next eurozone recession hits, particularly Italy.

The assessment by Charles Wyplosz that Greece will probably default is very much in line with my thinking. As I wrote last month, “I anticipate either default in the hashing out of the reform list during the extension or default when the new bailout agreement is under discussion. In short, my base case is Greek default.” But default scenarios vary and my interpretation of what the options are differs from Wyplosz.

There are two principal options here. And because the ECB is the only entity in the eurozone that simulates a federal government, the scenarios depend crucially upon what it decides. In essence, the ECB will decide whether monetary union is invioable.

In the first option, which I consider a base case, Greece defaults and remains within the eurozone. In this scenario, the ECB continues to act as lender of last resort because the large majority of Greek bank assets are not Greek government bonds. And the degree to which Greek government bonds impair Greek bank capital, the Greek government is able to help recapitalize their banks in some fashion. But there will be some key points here.

The ECB would ostensibly refuse to accept defaulted bonds as collateral and this is why ECB officials have repeatedly said that the Greek banks are solvent for now, suggesting that their solvency will come into question were the Greek government to default. The first question is which bonds the Greek government will default on and whether this default makes other bonds held by the Greek banks lose enough value to cause insolvency. Since 85% of Greek debt is owed to the official sector, I believe that the Greek government could default on bonds to the institutions formerly known as the Troika and continue to service other bonds. The test would come via ECB rules on Greek issuance of short-term funding, ECB rules regarding acceptance of any Greek government collateral for ELA and the ECB’s decision regarding Greek bank solvency.

The Greek government might be able to function without issuing 3-month bonds into the market if it uses a parallel currency or currency scrip IOU’s in lieu of currency to make payments. These IOUs would be payable for taxes like the Tax Anticipation Notes suggested by Rob Parenteau in February. However, if the ECB wants Greece to continue in the eurozone, it would have to accept Greek banks as solvent and allow them to continue to receive ELA from the Greek central bank. Deeming the banks insolvent, and, thus, cutting them off from ELA would collapse the Greek banking system and force Greece into a situation that would make Grexit much more attractive.

But even if the Greek banking system collapsed, given that there is no formal mechanism for Grexit, it is still not clear to me this necessarily means Grexit, something that involves a unanimous vote of eurozone members including Greece and the printing a new currency plus thousands of other preparatory moves. This second option, Grexit, would have to, thus, be scripted, not just the currency controls and the scrip but the preparation for the Drachma and the formal voting process to remove Greece from the eurozone, deal with the Target2 issues and with the legal issues surrounding whether contracts made in euros under Greek or European law could be forcibly converted into Drachma contracts at a 1 for 1 ratio. Thus, in my view, it is precipitous to say that Grexit can follow based on an uncontrolled crisis situation, rather than based on a more methodical plodding approach.

When I penned a piece on Greece’s eventual exit from the eurozone in 2013, I wrote the following: “I don’t think it’s a big secret that I believe Greece will eventually leave the eurozone. I have said this repeatedly. But I have also written that I do not believe that Greece would attempt to do so while Europe’s economic crisis is ongoing. Instead I believe that Greece will exit once things have stabilized but it becomes clear that it faces an interminable jobless recovery.

“My view here is very much related to the post I wrote yesterday on Germany’s response to Euroland’s problems. I do not believe that Germany is the driving force of austerity and depression within the eurozone. Instead, I believe the institutional structure of the eurozone is such a straitjacket that it’s hard to find a solution to the euro zone’s economic problems within the existing framework without years of pain. Europe would need to make huge constitutional and operating changes and create even more significant dodges to existing law to prevent another decade of malaise.

“This is a particular problem for Greece given the magnitude of the downturn in Greece and the level of joblessness there.


“The only chance Greece has of remaining within the eurozone is if it can pull of a huge economic resurgence that beats back the populist political wave which will almost surely spell exit as long as joblessness remains so high. I don’t see this happening without significant reform to eurozone institutions.”

In sum, Greece is in a depression. And right now, polls show that the Greek people still want the euro. That changes the longer the depression continues or if it worsens as a result of Greek default and ELA being pulled. AT the same time, the EU wants us to believe the eurozone is inviolable, meaning they will do “whatever it takes” to keep it intact including Greece. This in and of itself means that more support should be forthcoming in some way. Yet, continued depression in Greece will eventually lead to anti-euro sentiment and voluntary exit. In my view, the question is when, not if, as long as the institutional framework and policy directives remain unchanged. If Greece were to leave, it would not be an immediate catastrophe for the eurozone because of mechanisms in place to prevent contagion. But a challenge will come later at the next cyclical downturn.

Now, the path to exit from the eurozone is arduous because there are no mechanisms for getting there. It is a legal and operational quagmire that involves considerable preparation. As a result, Grexit can only occur through mutual consent in a formalized process that takes months if not years. This outcome is instructive for other peripheral nations because it would set a clear path through which to leave the eurozone. Italy comes to mind here.

With zero real GDP growth, weak nominal GDP growth, a lack of reforms and 140% government debt/GDP, Italy will be challenged at the next recession. Recession in Italy, post-Grexit means deficits and debt increases, but to what level? 150%, 160% of GDP? That’s very close to Greek levels today. Would Italian banks be well capitalized? How many bad loans would mount due to recession? Would bail-ins feed a loss of tax revenue? All of this matters regarding contingent liabilities and private sector debt deflation if those contingent liabilities are not met. In the next recession in Italy, someone will have to increase the debt burden to replace the lost income due to souring debt. And if not, the lost income will result in a decline in GDP and tax revenue. Either way, government debt will go up substantially. Redenomination risk will mount because government debt will rise. Bottom line: the next Italian recession post-Grexit would put Italian debt/GDP levels within reach of Greek levels. Redenomination risk will be palpable. And the same is likely true in Portugal as well, but Italy matters more.

If Italy sees the Grexit path having already been paved, the Italexit path will be smoothed. And without Italy, frankly, I think the eurozone comes apart because the euro would appreciate. This would asphyxiate the economies in France and Spain at a minimum, and probably Finland and Austria as well because these are two economies I see as weak links in the core. Finland is problematic due to a low-grade depression and Austria due to government debt, contingent liabilities and a weak banking system.

Thus, even though Grexit may have a limited first order impact in the near term, it would have unintended consequences that would make a disintegration of the euro easier down the line. I believe the ECB understands these risks and is set against allowing the Greek situation to act as a blueprint for eurozone breakup. However, the risk of policy error, as always in crisis situation, remains high.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. which is worse - bankers or terrorists

    I would be interested in seeing an analysis of what happens when the ECB goes into negative equity, and what its policy options are. Can it just hit the Ctrl+P button, or open up swap lines with the NY Fed? What is likely to happen if that happens?

    1. Edwardo

      At the top of the ECB’s confinstat, listed on the asset side of the ledger, is a primary reserve holding of approximately 10,000 tons of physical. The ECB can meet any existential threat, and, of course, the euro, by extension, can meet any such threat by simply creating a bid/ask at any level they deem necessary. The physical is marked to market for a reason, and this is in direct contrast to the condition of the dollar. In any case, this is the capo de capo of nuclear options and they will avail themselves of this at some point, though they will avoid doing so in the absence of perceiving no other choice.

      1. ambrit

        Greece has some physical reserves too. The latest figure I remember seeing was somewhere in the vicinity of 3 billion USD. Plus, all that monetary metal “transferred for safe keeping” to Berlin from 1941 onward. “Forced loans” is the term of art. The latest figure for just that, excluding compensation for other depredations, is 12 billion USD.
        How big a dent in that 10,000 tons would the Greek claims make? Besides, it would all return back to the Eurobanks in the end.

        1. Edwardo

          A revaluation of several orders of magnitude of Greece’s (and everyone else’s) hoard, estimated at 112.5 tons, would render Greece’s mountainous debt burden into the proverbial molehill.

  2. plutoniumkun

    I suspect its going to be a lot messier than this – too many people have backed themselves into corners they can’t easily exit. I think most exits from the eurozone will be messy, few politicians will have the guts to say ‘we were wrong about the euro, lets have a properly phased ‘__it’. As the Euro appreciates as weak members go, then the remaining members will be crucified by appreciation.

    Excellent little essay here from the Irish perspective of how the whole thing has become something of a fairytale story:


    1. bh2

      “We exist, not as a society, but as a necessary validation for a destructive fiction.”

      Well and truly said. An excellent article.

  3. Robert dudek

    The following is a serious question, not intended to be incendiary. Its been discussed in passing but what would prevent the Greek government from ordering the Greek central bank to physically print Euro notes in sufficient quantities to purchase whatever essential imports it needs to tide them over until their presumably full blown Keynesian policies start to grow the economy.

    1. Clive

      The ELA funding for the Greek banking system didn’t involve truckloads of cash being sent into Greece from Brussels. It was formalisation, through accounting entries, of actions taken by the Bank of Greece to issue euro notes and to balance electronic payments.

      What you’re suggesting is the Bank of Greece engage in, effectively, false accounting. It would be pretending that ledger entries had been made by the ELA coresponding to its own ledger entries documenting flows of funds.

      I know I am sounding like a broken record here but it is absolutely not in Greece’s interests to start acting like a failed state (such as by taking the sorts of actions you mentioned which would be state sponsored fraud). It is close enough to being a failed state as it is, without actually trying to become one in practice. Somalia is a failed state. You would NOT want to live there. And no-one should wish such a fate on Greece either or suggest they take actions which pretty much guarentee that as an outcome.

      1. Robert dudek

        More naive questions… Can you explain to me what happens during normal times when a Euro banknote in printed as far as the accounting is concerned?

      2. Disturbed Voter

        Even if every Euro is just an electronic entry … isn’t every Euro a false bookkeeping entry. Isn’t every dollar since 1933 a false bookkeeping entry? Why should Brussels, London and Babylon on the Potomac have this privilege, and not Athens? If we want honest bookkeeping, we have to go back to 1933, and reevaluate … after we let gold hit its natural market value, instead of suppressing it. But we can’t do that can we? Since all politics since Pericles is a con game. Tzipiras is just the latest Pericles, and the new Peloponnesian War is about to start … this time with Berlin instead of Sparta.

        1. John Smith

          ” after we let gold hit its natural market value, ” Disturbed Voter

          Gold has no natural market value if it is used or there is a significant expectation thereof that it will be used as a form of expensive fiat. Instead that use or expected use INFLATES the value of gold greatly.

  4. alex morfesis

    tsipras as aldo vanucci

    after the fox…

    but a crime has been committed against the state and

    “somebody has to pay”

  5. craazyboy

    Sounds to me if Greece can default on the 85% “official debt”, pay on the 15% owed to “private creditors”, and maintain the ECB support of the Greek banking system, that would be the definition of a Greek bailout sweetheart deal.

    Hard to imagine that happening, unless hedge funds really do run the world and the world’s 99.9% taxpayers are just fodder for the hedge funds’ income statement.

  6. DJG

    Quelle surprise: “Finland and Austria as well because these are two economies I see as weak links in the core. Finland is problematic due to a low-grade depression and Austria due to government debt, contingent liabilities and a weak banking system.” But they are Northern Europeans! (I always enjoy the way that the Austrians, guarding their remnant state, go into a tizzy when Turkish accession to the EU is mentioned.)

    Throw in the demographic collapse of the Baltic States, the fascist revolution in Hungary, the collapsed government of Romania, English austerity being visited on the U.K., and Greece starts looking like the hors d’oeuvre.

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