If Greece Was California...

For all its rhetoric, the current situation in the Eurozone should be very familiar to most Americans: after all it is merely a Federalist organization just missing one key feature: Federalism. At least for now. Whether Europe will succeed in reversing 20 centuries of nationalist pride, a multitude of languages, religions, cultures, histories, and superficial solidarity and friendliness covering generations of broad-based enmity, blood feuds and hatred, which is precisely what will be required (because the monetary union was merely half of the game) remains to be seen. It is likely that the stock market will force this resolution sooner than most expect. Then the question becomes: will Europe truly become the United States of Europe. And if so, what would the current Greek travails look like if they were transplanted to the state of California: another place which may soon be in dire need of a bailout. Luckily Jefferies' David Zervos has performed just the thought experiment: "let's assume the European monetary system structure was in place in the US. And then imagine that a US "member state" were to head towards a bankruptcy or a restructuring of its debts - for example California." The results are below.

Separation of Bank and State

The Euro monetary system is flawed. It is a system that was cobbled together for political purposes; and sadly it was set up in such a way that each member state retained significant sovereign powers - most importantly the ability to exit the system and default on debts in times of stress. There is virtually NO federal power in the Union, as witnessed by the complete breakdown of the Maastrict and Lisbon treaties. In fact, what we are seeing today is that the structure of the monetary system is so poorly designed, it actually creates perverse fiscal linkages across member states that incentivize strategic default and exit. Our new leader of the Greek revolt - Mr CHEpras - has figured this one out. And in turn he is holding Angie hostage as we head into June 17th!

To better understand these flaws in the Eurosystem let's assume the European monetary system structure was in place in the US. And then imagine that a US "member state" were to head towards a bankruptcy or a restructuring of its debts - for example California.

So let's suppose California promised its citizens huge pensions, free health care, all you can eat baklava at beachside state parks, subsidized education, retirement at age 45, all you can drink ouzo in town squares and paid 2 week vacations during retirement. And then assume the authorities never came after anyone who didn't pay property, sales or income taxes.

Now it's probably safe to further assume that the suckers who had bought California municipal debt in the past (because it had a zero risk weight), would quickly figure out that the state finances were unsustainable. In turn, these investors would dump the debt and crash the system into crisis.

So what would happen next in our US member state financial crisis? Well, the California governor would head to the US Congress to ask for money - a bailout. Although there is a "no bailout" clause in the US constitution, it would be over run by political forces as California would be deemed systemically important. The bailout would be granted and future reforms would be exhanged for current cash. The other states would not want to pay unless California reformed its profligate policies. But the prospect of no free baklava and ouzo then sends the Californians to the streets - rioting, looting and protesting ensue.

The agreed reforms by the Governor then fail to pass the state legislature. And as the bailout money slows to a trickle. The fed up Californians finally elect a militant left wing radical, Alexis (aka Alec) Baldwin, to lead them out of this mess!

When Alexis gets into office, the US officials in DC worry. They cut off all the Californian banks from funding at the Fed. But luckily, the "Central Bank of California" has an Emergency Liquidity Assistance program. This gives the member state central bank access to uncollaterized lending from the Fed - the dollars and the ouzo keep flowing. But the Central Bank of California starts to run a huge deficit with the other US regional central banks in the Fed's Target2 system. As the crisis deepens, retail depositors start to question the credit quality of the California banks; and everyone starts to worry that the Fed might turn off the ELA for the Central Bank of California. In turn they worry that California banks will not be able to access dollars. The depositors in California banks then start to pull their funds, and send them to internet banks based in "safe" shale gas towns up in North Dakota. Because in this imaginary world there is no FDIC insurance and resolution authority (just like in Europe), the California banks can only go to the Central Bank of California for dollars, who in turn continue to lend dollars to an insolvent banking system to pay out depositors. In order to reassure depositors, California might announce a deposit guarantee program - but with the state's credit rating is at CCC, the guarantee does nothing to stem the deposit outflow.

In this nightmare monetary structure, with regional central banks, ELA, Target2 and no FDIC, the prospect of a state default FORCES a bank default. The banks automatically fall when the state goes into financial turmoil because of the financial structure. A bank run is the only equilibrium in this system.

There is sadly no separation of member state financials state and bank financials in the European financial system. So what's the end game in our little US example above? Well, after the Californians take all the their dollars out of the California banks, Alexis realizes that if the central bank of California, along with the state and the banks default, the citizens will still have their dollar wealth preserved and the state could start all over again by issuing new dollars with Mr Baldwin's picture on them (or maybe Che's picture). This California competitive devaluation/default would then leave a multi-trillion dollar hole in the Fed balance sheet and the rest of the more responsible US states would have to pick up the tab. So Alexis goes back to Washington to threaten exit unless the ouzo and baklava keep coming. And here we sit in the current battle in Europe!

Can anyone in the US imagine ever designing a system so fundamentally flawed? Its insane! Without some form of FDIC insurance and national banking resolution authority, the European Monetary System will surely tear itself to shreds. In fact, as the Target2 imbalances rise, it is clear that Germany is already being placed on the hook for Greek deposits and other peripheral deposits. The system has de facto insurance and no one in the south is even paying a fee for it. Crazy!

In the last couple days I have spent a bit of time trying to find any legal construct which would allow the ELA to be turned off for a member country. I can't. It doesn't mean it won't be done (as the Irish were threatened with this 18 months ago), but we are entering the twilight zone of the ECB legal department. Who knows what happens next?


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