I'm scared again. I haven't felt this scared for over a year. Things were starting to look better, in Canada in particular, but around the world more generally. Now Greek bond yields are shooting up.
I was worried about the Eurozone in January 2009. And again in December. Maybe it was just my Euroskeptic "Anglo-Saxon" genes talking, but those old posts read quite well today. I mentioned my worries again in January 2010, when I made my New Year's forecast for Canada. "My main worry is that something will go badly wrong in Eurozone financial markets. I find it very hard to predict how that would affect Canadian financial markets."
That's what I want to try to do now: predict how the fallout will affect the rest of the world, including Canada.
The main problem with the Eurozone is that there's a central bank, but no central fiscal authority. To paraphrase Kissinger, "Who do I call, if I want to talk to the Eurozone?". (Or Gertrude Stein "There's no there there"?) They can't coordinate monetary and fiscal policy. The Bank of Canada can buy Canadian Federal government bonds. It can even buy Canadian Provincial government bonds, if it feels it really needs to. The Bank of Canada and the Federal government can decide whether or not to bail out a Canadian bank or province. Ultimately, the Canadian monetary and fiscal authority are spending out of the same pot. They can decide to deal with, or not deal with, a liquidity and/or solvency crisis. There's nobody in the Eurozone that can make that decision. The ECB holds Greek government bonds as colateral when it expands the monetary base. And commercial banks both inside and outside Greece hold those same bonds. Who bails out what if Greece defaults? And what if the liquidity/solvency crisis spreads to other Eurozone countries?
It's difficult to know what will happen in the Eurozone. My own guess, for a worst-case scenario, is that we will see multiple Argentinas. No country will want to leave the Euro, but some might have no choice. The only way for a government to pay wages will be in scrip. That scrip will become a new national currency. They will rewrite the laws to make debts payable in the same national currencies.
It's harder still to see how a Eurozone crisis will affect the rest of the world, and Canada.
My own event study, using the time-honoured "eyeball method", suggests that a Eurozone financial crisis will raise the exchange rate of the US dollar against the Euro (obviously), but also (less obviously) raise the US dollar against other non-Euro currencies, like the Loonie. Presumably because the US dollar is, by social convention, the ultimate liquid asset, and the Loonie isn't.
Since Canada does much more trade with the US than with the Eurozone, a Eurozone crisis would probably depreciate the Loonie on a trade-weighted basis. By itself, that would tend to raise Canadian aggregate demand. But the Eurozone is big enough to affect world aggregate demand, and directly or indirectly the demand for Canadian exports, including commodity prices. The net effect could go either way.
Then there's the effect on Canadian financial markets. As far as I know, Canadian financial institutions are not especially exposed to Eurozone assets (anyone know better?). But financial contagion, in a liquidity crisis, seems to follow symbolism as much as fundamentals, as can happen in any case of multiple equilibria. "Canada" doesn't sound much like "Europe"; but who knows.
That's all I can figure out. Anyone got any better ideas?
Worthwhile Canadian Initiative 
The fallout is already occurring….. there is a capital flight fro Europe and some irrational fear of inflation in the US that is for sure transferring money into commodities. The effect is higher direct investment into Canada…. this results in from lowering of exports (balance of payments)
We have a lot of free money that isn’t really going to put towards anything useful… except maybe to lobby for a lower capital tax rate and less regulation in Canada….
This is how the mess in the US started… except it was China that was funding the direct investment… this time it the rest of the world funding us…..
anyone for a bubble watch?
To those worried about runs on Greek banks please be assured nothing is happening. Even a new drachma is introduced, keeping euro accounts will be mantained as there are dollar accounts.
Why you are not considering debt restructuring with maturity extension and discount/par bond issue, especially since mark to market has validated debt value discounts in portfolios and the effect is neutral. It is even easier since 82% of Greek public debt is foreign owned. From then own public debt will be issued domestically since the private sector is a net saver with low debt to income ratio!
Yiasou Panayiotis, ti kanete?
I’m not so sure that a “bank run” hasn’t started happening. To quote from an earlier comment:
“Local savers transferred about €10bn of deposits – equal to about 4.5 per cent of the total in the banking system – out of Greece in the first two months of the year, according to the central bank.”http://www.ft.com/cms/s/0/edbfc18c-4268-11df-8c60-00144feabdc0.html
I’m not so sure that introducting a new Drachma could be done easily or effectively. The whole purpose of introducing the New Drachma would be to devalue it. Upon its introduction, the New Drachma would immediately drop in value versus the Euro. If Euro accounts were still open, the incentive would be for people to sell the New Drachma and buy Euros, putting further downward pressure on the new currency. Basically, you would see a massive flight of capital out of the new currency into Euros until that currency stabilized, and it would be ugly.
The alternatives are also ugly. The Greek gov’t could introduce the New Drachma at a peg with respect to the Euro and install capital controls. They might also seize all local Euro-denominated deposits and pay them out in New Drachmas (Argentina did something like this). I’m sure that fear of this possibility has driven the capital flow quoted above.
With regards to debt restructuring, if it’s done voluntarily, it would avoid a default, but what is the likelihood of the foreign owners of 82% of the debt voluntarily giving up some of their claims?
As for relying on the private sector, if Greece could rely on domestic sources for all of its funding needs, it would not be having the problem it presently has.
Kosta,
The 4.5% of the total deposits you mentioned includes withdrawals from normal course of business and this outflow has not continued. As far as introducing a new drachma for transaction purposes, of course it can devalue! However, economic units can mantain euro accounts for savings purposes with no problem for the banking system. As far as restructuring is concerned, lenders have no choice because a sovereign state cannot be forced to repay if it has not pledged collateral.It better to get 70% than none at all! Turning to domestic savings answers the threat of future financing of a development program that Greece needs based on deficit spending because the private sector will not invest unless the economic conditions improve!
Panayiotis,
That’s good news if the withdrawals did not continue into March and April. Of course, we won’t know for sure for another month or so, but let’s hope that you’re right.
I’m not sure that an introduction of a New Drachma will run as smoothly as you suggest. We both agree that the New Drachma will devalue. If economic units can maintain a euro account for savings, why would they transact in the New Drachma, knowing that it will devalue? People and businesses would be happy to have liabilities in the new currency, but who would be willing to take the other end of those transactions (i.e., own the assets) given the likely devaluation? There will be continuous flight from the New Drachma to the Euro, leading to constant devaluation and very high inflation. Interest rates for New Drachma denominated loans would be astronomical to contend with both the inflation risk and the currency risk. The results will be catastrophic for everyone in Greece without access to Euro-denominated income (which is most everyone). If Greece left the Euro and introduced a New Drachma, it would impoverish all of Greece’s middle- and working-class through the combination of devaluation and inflation. I don’t this is at all a good outcome.
With regards to restructuring, I really see two potential paths: either it is a cooperative deal between Greece and its lenders which avoid a default, or it’s done after Greece defaults. I think the distinction is important in part because if Greece defaults, its creditors (and the EU) will take a much harder stance (and also because a default will lead to CDS payouts which will force certain players to take certain actions).
I am all for Greece restructuring its debt if it can do so without actually defaulting. However, there are some doubts about a restructuring being sufficient to rescue Greece. Two Barclay’s Capital research notes suggest that even with a large haircut to their debt (post-restructuring), Greece will still have to cut its fiscal spending by 7.5% to 10% of it’s GDP http://ftalphaville.ft.com/blog/2010/04/26/211846/restructuring-the-parthenon/ . So while restructuring will help, it won’t save Greece.
But really, I’m skeptical about Greece’s ability to restructure its debt without defaulting. Given that there’s a wide range of Greek debtholders, undoubtedly some of them will take hardline stances forcing Greece to either settle to their terms or formally default. Subsequently, I think negotiating with all the bondholders to restructure the debt is unlikely to successful, at least in the timeframe we’re looking at.
The other option is for Greece to formally default. That would give Greece extra leverage against its present bondholders. But it would also mean that Greece would lose access to additional funding. Given that Greece presently has an 8% or so primary deficit, the loss of the external funding would be very painful. Also, defaulting would likely result in Greece’s exit from the Euro. Most of the Greek debtholders are Europeans, and while they might not hold collaterol, they do hold the ears of their gov’t’s, and somehow I would think that those gov’t’s would not be happy if Greece defaults and stiffs the bondholders.
Finally, lest we forget, I assume Greece wants to stay in the EU. If Greece does, then it will have to try to meet all of its obligations. Greece really can’t pull an Argentina and force restructuring on its own terms, not unless it’s willing to be isolated like Argentina was isolated.
Greece downgraded to junk. Portugal downgraded too.
I wasn’t really all that worried but I am now. I figured the Germans where just, well, being Germans and they would see sense after playing hardball for a while. But it seems that they aren’t and won’t – which strikes me as odd because it’s German (and French) banks that are going to collapse and need bailouts if there is a cascade of defaults.
Maybe they’re thinking they’d rather bailout German bankers than Greek citizens?
Patrick: “Maybe they’re thinking they’d rather bailout German bankers than Greek citizens?”
That’s what Felix Salmon said yesterday: http://blogs.reuters.com/felix-salmon/2010/04/26/the-depressing-outlook-for-greece/
I started to write a post yesterday, saying that with bond yields over 13%, it’s game over. Never finished it. Couldn’t get my head around what the ECB could and would do.