Daily Archives: June 15, 2012

Judging from the growing number of official remarks, central banks – in a standalone capacity and jointly – have been discussing what to do in the event of major disruptions to the European payments and settlement system. The immediate focus is, of course, Sunday’s highly uncertain election in Greece. But the contributing factors go well beyond this as they are entwined in Europe’s increasingly messy debt and banking circumstances.

In welcoming such signs of responsible contingency planning, it is important to distinguish between what central banks can deliver and what they are incapable of doing. In the context of today’s complex crisis in Europe, these critical institutions have essentially been reduced to the role of fire brigades. They can try to reduce the risk of a fire and, should one occur, stand ready to fight it and contain damage. But, acting on their own, they are unable to alter materially the behaviour of those who place whole neighbourhoods at risk.

Through both emergency liquidity operations and the willingness to stand as a solid counterparty in dysfunctional markets, central banks can offset (but not eradicate) disruptions to the payments and settlement system. Most critically, they can reduce the devastating impact of market “sudden stops,” which are the equivalent of economic and financial heart attacks for capitalism.

Recent statements from a host of officials – including Mario Draghi, European Central Bank president, Mervyn King, Bank of England governor, and Timothy Geithner, US Treasury secretary – suggest this is indeed on the to-do list of major central banks. And the output, should it be necessary, would come in the form of both individual measures and globally co-ordinated ones.

But central banks are not the reason why Europe faces the tail risk of catastrophic disruptions. If anything, they have been working hard to prevent Europe from getting into the mess it finds itself in today. This, in turn, speaks to the critical policy distinction between willingness, ability and effectiveness.

While certainly willing and partially able, central banks have not been effective in severing the major “feedback loops” that erode on a daily basis the integrity of the eurozone, discourage private capital inflows and undermine the wellbeing of the global economy. Specifically, acting on their own, they do not have enough instruments to stop the bad interactions between weak banks and deteriorating sovereign creditworthiness. They have even fewer tools to stop individual country problems from contaminating what is an increasingly synchronised global slowdown. And they are powerless when it comes to breaking the adverse feedback loop between bad economics and bad politics.

Simply put, if they are not joined by more effective responses on the part of politicians and other government agencies, the best central banks can do is to slow marginally the steadily eroding impact of the west’s triple threat – of too little growth, too much debt and excessive political polarisation. And in pivoting from crisis prevention to crisis management, they can (and are) on alert to clean up the mess, but cannot counter all of the damage.

This reality is yet another indication of the extent to which the west has become hostage to a never-ending series of emergency tactical responses when what is critically needed is also a set of coherent strategic decisions. This leaves central banks in the role of a consistently scrambling fire brigade. And the longer they are in this role, the greater the erosion in their effectiveness to deal with an ever increasing number of fire threats.


Exit from the euro by Greece, or by any other member state, has become a fashionable topic for academics, commentators and market participants. The analysis is most often conducted on the basis of the economic costs and benefits, and the possible social and political consequences of such an exit for Greece and for the rest of the euro area. Most recognise that, under prevailing circumstances, the costs are too high. Even Alexis Tsipras, leader of Greece’s Syriza party, who wants to renegotiate the terms of the International Monetary Fund and EU programme, has committed in the FT to keep Greece in the euro.

It is generally taken for granted, including by Mr Tsipras, that Greece can exit the euro if it decided to do so and adopted a new currency. It is, however, not that simple.

First, it would be very difficult for any Greek government to impose on its citizens the use of a new legal tender, such as the new drachma. The value of the new currency would depreciate substantially against the euro and be eroded by high inflation, given that money creation would be the only way to finance the budget deficit and to recapitalise the failed banking system. As experienced in several other Balkan countries, such as Bulgaria or Montenegro, households and companies would immediately try to protect themselves against currency debasement by indexing their contracts to the euro, and using the existing banknotes in circulation as a parallel currency. Of the three main functions of money – as a medium of exchange, store of value and unit of account ‑ the new drachma would most likely perform only the first one, and for only a fraction of the transactions, while the euro would retain the other two. Greece would have a de facto euro-based economy.

Second, by exiting the euro Greece would violate the Lisbon treaty. When adopting the euro Greece committed to a series of obligations, including the renouncement to its own currency, which is irreversible. The European Commission, as the guardian of the treaty, or any other of the 26 signatories of the treaty, could sue the Greek government at the European Court of Justice if they felt that the decision to exit the euro had materially damaged them or any of their citizens. Citizens of any EU states – in particular creditors whose contracts were redenominated in the new currency – could sue Greece in their respective courts, which most likely would defer to the ECJ. Greece could also be sued in the European Court of Human Rights for violating property rights. Any judgment issued by the ECJ or the ECHR would have to be taken into consideration by local courts in EU countries, including Greece. This could give rise to sanctions by the European authorities in case of non-compliance.

Greece could avoid these sanctions only by disavowing the authority of the supranational institutions. This would mean that Greece would exit not only the eurozone but also the European Union as a whole. There is no exit for the euro without exit from the EU, as explained in a 2009 working paper by Phoebus Athanassiou, a lawyer at the European Central Bank.

The only alternative would be for Greece to negotiate with the other 26 EU countries a new treaty, allowing Greece to adopt a new currency. Even assuming that the other countries were willing to accept entering such a negotiation, developments in Greece would practically make that impossible. As soon as the negotiations were made known, or even the intention to hold them, Greek citizens would immediately begin a run on their banks to withdraw euros and transfer their accounts abroad.

This could not be accommodated by the European authorities. Bank holidays and capital controls would have to be imposed, preventing Greek citizens from cashing in their savings and taking them abroad. All loans to Greek residents would be frozen immediately, including to the state. The country, therefore, would not have the means then to pay for basic expenditures, such as pensions, health care, civil servant wages. Conditions would rapidly become chaotic.

If Greece remained democratic, the government would most likely lose support from its own citizens for its request to leave the euro. It would then have to start negotiating with its partners on the terms for staying, rather than leaving, the euro from a much weaker position.

Exiting the euro is an economic and political nightmare and thus practically unfeasible. The reason is that the eurozone is not only an economic and monetary union; it is also a political union, albeit imperfect.


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