Therefore, assuming that Greece can pay back the other half and that no other Euro zone country defaults or writes down its debt that just leaves the European banking system to repay the EUR1 trillion of borrowings. Of course, it could do if it raised its share by probably the best part of EUR3 trillion of the total European banking sector capital shortfall. There are four ways to achieve this:
1) Print 3-4 trillion Euros tomorrow and bail the banks. This would reduce the perception of the Euro to basket currency status, potentially spark stagflation but ultimately lead to a position where debts could be written off and the Euro zone could grow again. Germany is unlikely to accept this, scarred by similar memories from Weimar days.
2) Face reality, write off bad debts, discard the Euro and close sitting duck banks like SocGen, BNP-Paribas, Deutsche, Commerzbank, etc. Stock and property markets would collapse, unemployment would soar, social unrest would run wild but within a few years a healthy functioning Eurozone economy would achieve its full potential.
3) Pray for a miracle.
4) Just keep putting it off in the hope that something turns up. This approach also involves large doses of 3) above.
As Gavekal recently pointed out, the announcement by Prime Minister Papandreou that Greece’s latest fiscal plan and settlement with the European Union will be put to referendum is the logical conclusion of a process which, after two years of belt tightening, continues to promise more pain and little light at the end of the tunnel.
Consider the following: even if the EU and the Greek government’s rosy assumptions are met (and there is little in the recent track record to suggest why this would happen), and even if European banks agree voluntarily to the suggested 50c haircuts, by 2020 Greece will still have an unserviceable 120% government debt to GDP (and again, that is only if everything goes according to ‘plan’).
Against this, the temptation to ‘wipe the table clean’ and start again must be very high. After all, what does Greece really lose in breaking away? The country is already in a massive deflationary bust (with GDP to fall as much as -5.5% for 2011, after last year’s -4.5% contraction) and is shut out of capital markets.
Needless to say, the Greek referendum will only trigger bafflement and anger in the corridors of Brussels and Frankfurt. The Eurocrats thought they had a deal (or at least the promise of a deal, or perhaps a sketch of a promise of a deal, or at the very least the outlines of a sketch of a promise of a deal...) but now Greece is risking everything by getting the voters involved! We are thus now entering the moment of European truth when democracy meets Eurocracy in an open, and even, field of play.
Make no mistake about it: the question on the referendum may be about some arcane point of fiscal policy but at stake is the country’s membership in the Euro. At least, this is how most people will go out and vote. And if Greece votes no, will it be possible for Portugal, Spain, Ireland or Italy to refuse their citizenship the same referendum?
If nothing else, this means that the run on deposits in the weaker Southern European banks will likely accelerate from here. After all, who is going to keep any real money in Greek banks if the risk is that tomorrow Greece decides to leave the Euro (a Greek exit would most likely initially trigger capital controls, conversion of foreign currency deposits into new Drachma, etc...)?
In turn, this means that either the EU responds to the Greek referendum with an immediate genuine open-cheque policy of massive fiscal transfers combined with large scale ECB purchases of Southern European debt, or we will possibly be entering the final innings of the Euro as we know it (please God!).
In reality though, European policy makers have chosen the above option 4 interspersed with liberal doses of option 3. And the markets liked it because it was their preferred option too. Now watch the governments go and pull more wool over the eyes of pathetically grateful voters who would rather happily buy into it the fantasy rather than face their own worst nightmares.
The fight between democracy and Eurocracy is now on and the gloves are off. We know whose side history typically smiles on so, in a sense, we find this development highly encouraging and positive. Still, at the risk of sounding Swiss, we think it probably makes more sense to watch this fight from the sidelines!