'Til Debt Did Europe Part

'All is not resolved' is how Morgan Stanley's Arnaud Mares begins his latest diatribe on the debacle that is occurring in Europe. While a disorderly default seems to have been avoided (for now), the Greek problem (as we have discussed extensively) remains in play as debt sustainability seems questionable at best, economic recovery a remote hope, and the growing political tensions across Europe (and its people) grow wider. Critically, Mares addresses the seeming complacency towards a Greek exit from the euro area noting that it is no small matter and has dramatic consequences (specifically a la Lehman, the unintended consequences could be catastrophic). Greece (or another nation) leaving the Euro invites concerns over the fungibility of bank deposits across weak and strong nations and with doubt over the Euro, the EU could collapse as free-trade broke down. The key is that, just as in the US downgrade case last year, a Euro-exit implies the impossible is possible and the impact of such an event is much, much higher than most seem to realize. While the likelihood of a Greek euro-exit may remain low (for now), the scale of the impact makes this highly material and suggests the EU will do whatever it takes (print?) to hold the status quo.


Morgan Stanley: Til Debt Us Do Part

Of the importance of unintended consequences.

Our colleague Joachim Fels once described the current stage of the crisis in Europe with the acronym CCC, standing for a crisis of confidence, competency and credibility. One could add a fourth ‘C’ to this list, for consequences. A recurrent feature of the global crisis is the unintended consequences of policy actions. Perhaps the two most important milestones of the past four years were policy decisions, whose unanticipated consequences caused in each case a considerable degradation of the situation and extended the crisis both in scope and length.  


The first of these events was the decision by US authorities to let Lehman Brothers fail in September 2008, now widely acknowledged to have been a major policy error.


The second was the decision by European governments to initiate restructuring of public debt in Greece without having first put in place a robust safety net for solvent governments. This is also now widely regarded as a policy error. In each case, we note that many in the market initially applauded these decisions (when not actively calling for them beforehand) without seemingly fully appreciating the consequences.


Why would a Greek exit from the euro area be so damaging?

The euro is irreversible. Is it? The starting point of the analysis is the simple yet immensely important observation that if Greece were to leave the euro, this would imply that the euro is reversible.

Breaking down the fungibility of money. If the euro is reversible, it is not reversible in only one country. It is reversible in all. If Greece can leave the euro, then other countries may also leave the euro at a subsequent date. The implication is what we describe as a breakdown in the fungibility of money.

To explain this point, one must consider that in a fiat money system, money is the liability of a bank. It is the liability of the central bank in the case of central money, i.e., banknotes and bank reserves held at the central bank. It is the liability of commercial banks for commercial money, i.e., deposits.

As long as the euro and the Eurosystem exist in an irreversible form, these different forms of money are effectively fungible. Should the euro be reversible, however, these different forms of money are no longer completely fungible.

Federal money versus national money. Which is which? The euro may be a federal currency, but a deposit in a bank is effectively national money. If a country were to leave the euro, it would most likely be redenominated in that country’s new currency.


Strong money versus weak money. Which is which? As long as the euro is irrevocable, the distinction made above between federal and national money is irrelevant. By contrast, if the euro were to become reversible, this distinction matters. A euro held in a country more likely to abandon the euro becomes a weaker form of money than a euro held in a country more likely to keep it, with banknotes the strongest form of money.


How a run on money would unfold. In a situation where different forms of money are no longer entirely fungible, what one ought to expect is a run away from the weaker forms of money towards the stronger forms.


The erosion of deposits in Greece and Ireland provides but a glimpse of what would happen elsewhere if Greece exited the euro.

Contagion ought to be a familiar pattern by now. To illustrate this point, it suffices to recall that the failure of Lehman Brothers closed access to capital market and interbank funding to all banks, regardless of whether they were solvent or not. Similarly, the initiation of PSI for euro area sovereigns caused contagion not just to Ireland and Portugal but also to Spain, Italy, Cyprus, etc., and eventually France and Austria, regardless of whether the governments of these countries were objectively solvent or not.


No line of defence? The precedent of deposit haemorrhage in Greece and Ireland is nonetheless relevant in that it highlights the tools necessary to counter a bank run.

In a situation of a bank run, what prevents catastrophic outcomes (widespread bank failure) is the ability and willingness of the central bank to replace deposits and fund banks directly itself. This is what happened in Greece and Ireland, where the Eurosystem increased its lending to domestic banks.

Limits to the ability of the Eurosystem to intervene... The Eurosystem is however constitutionally constrained to only lending to banks against ‘adequate’ collateral.

and perhaps limits to its willingness. More fundamentally, if the euro were to become reversible, the nature of the risk taken by the central bank by replacing deposits would change substantially.



And the credit crunch would likely come back. Arguably, the points we have listed here are of secondary importance. More important is the fact that if banks lost their deposits, they are very unlikely to extend credit to the economy.


Conclusion: if one country goes, it is monetary union that goes.

Our conclusion at this stage is that Greece leaving the euro would not be a local event. It would change the nature of money everywhere across the euro area by making the euro reversible. It would turn most of money supply (commercial money) back into national money. It would hinder the ability (and possibly willingness) of the Eurosystem to act as a lender of last resort for the entire euro area banking system. For all practical purposes, it would be the end of the euro as a genuine single currency. It would also likely trigger an unstoppable run on banks, which would push large parts of the continent onto a depressionary and politically painful path.

To preserve the euro if Greece left would require total federalism in the rest of the area.