Working out who exactly owes what to whom in the eurozone is an increasingly difficult job. Money is pouring out of Greece and now, it would appear, Spain at a rapid rate. €700m apparently left Greek banks on Monday. This seems to have taken people by surprise but, for several years, this has, in fact, been one of the most predictable parts of the euro crisis.
At this moment, a euro is a euro is a euro. A Greek euro is every bit as valuable as a German euro. However, though there is huge legal uncertainty about what would happen if there were a Greek exit, it is likely that a euro in a German bank owned by a Greek would remain a euro whilst a euro in a Greek bank would be converted. Certainly, if the Greek citizen migrated to Germany, he would be able to keep the currency of his deposits in euro. There is no incentive for any other process to happen other than the complete emptying of the Greek banking system of all its euro currency to other countries.
The Greek banks that are emptying of money can borrow from the ECB. In turn the money that is flooding out of Greece and into Germany is deposited by German banks in the German central bank. This can happen in various ways, but the ECB recently made the terms of its lending easier through its long-term financing operation.
In some senses, this is what we expect central banks to do – provide liquidity and ensure that broad money does not fall in relation to the monetary base. However, these operations have now led to enormous exposure of the ECB to the less-credit-worthy nations. Furthermore, instead of private banks lending to Greek banks, the central bank is effectively funding all private sector lending in Greece. There is no functioning banking system in the way we understand it.
What happens when the music stops? The ECB may well be a prior creditor in some cases. However, if it is a prior creditor, then it means that other creditors (such as other banks) are pushed further down the queue. Given that this may lead to the failure of banks in the PIIGS countries or of banks from other countries that have made loans to banks in the PIIGS countries and no EU country seems to have any policy for dealing with insolvent banks, the debts of the banking system are likely to become the debts of the member governments one way or another.
Not only that, the EFSF, the EMS and the ECB all get their capital from the same place: EU governments, in other words, the very governments to which these institutions are lending. If a group of governments defaults on its debts, the private sector may well take the first hit, but then the EU institutions, backed by EU governments, will get hit too. In addition, if the collateral that is being used by the countries whose banking systems are emptying turns out to be flawed, the ECB will lose directly.
But even a private sector loss is not what it seems. The financial system in most EU countries is such that much government debt is owned by banks (at the outset of the financial crisis only about 6% of UK government debt was owned by domestic banks). Whilst we cannot expect the state to stand behind mutual funds and pension funds, it is unfortunately standing behind the banking system. All the time since the crisis has been wasted – there are no effective mechanisms for winding up EU banks. If French banks go under because of Greek debt, the French government will bail them out. If German banks then go under because of French government debt, the German government will bail them out, and so on.
There is a straightforward loss of wealth on the part of those who hold risky government bonds. In these countries, the last generation borrowed money promising that this generation would pay it back. This generation has refused. We have a choice. We can try to enforce those debts or we can recognise that they will not be repaid and sort them out in an orderly way. What we cannot do, however, is pretend that a solvency problem is either a liquidity problem or a monetary policy problem and keep flooding the PIIGS banking systems with money. Ultimately, the governments of the sounder countries are effectively lending to the private sectors of the unsound countries by-passing the banking system in the sound countries. The only question is whether Portugal, Spain and Italy follow Greece. Ireland may survive, but it looks as if the PIGS are about to charge over the cliff edge and out of the euro. When that happens, those who have lent to them will still lose, but the losses will simply be allocated in a different and more arbitrary way.
Some time ago, I said that this crisis was a bit like two bankrupt brothers going into a bank and asking for a loan. Both the brothers admitted that they were bust and not worthy of a loan but Fred promised that he would guarantee Henry’s loan and Henry said that he would guarantee Fred’s loan. Things have moved on. There are now about 20 bankrupt people in the bank manager’s office all offering to take loans out mutually guaranteed by themselves, Germany, Holland, Denmark and one or two others.