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Multi-dimensional chicken

4 June 2012 By Hugo Dixon

The euro zone crisis is a multi-dimensional game of chicken. There isn’t just a standoff between the zone’s core and its periphery; there is also one between the European Central Bank and the euro zone governments over who should rescue the single currency. In such games somebody usually blinks. But if nobody does, the consequences will be terrible.

The brinkmanship between the governments is over how much help the northerners, led by Germany, should give the southerners. The core is effectively threatening the peripheral countries with bankruptcy if they don’t cut their deficits and reform their economies. The periphery is saying that, if they collapse, so will the entire single currency which has been so beneficial to Germany’s economy. The game is being played out transparently in Greece and covertly in Spain.

But even if the core eventually decides to help the periphery, there is a struggle of whether the aid should come from governments or from the ECB. Politicians would like the central bank to do the heavy lifting to avoid having to confront taxpayers with an explicit bill. But the ECB doesn’t think it is its job to help governments, arguing that such support violates the Maastricht Treaty.

This standoff is making it hard to devise a Plan B to cope with what is now a clear and present danger: an explosion in the euro zone.

Look at the most immediate problem: what to do if the “jog” out of Greek bank accounts accelerates into a run. The ECB’s exposure to Greek banks is about 125 billion euros – through a combination of its normal liquidity operations and emergency liquidity assistance (ELA) provided by Greece’s central bank.

The Bundesbank, Germany’s hard-line central bank, says the eurosystem, the collection of national central banks, shouldn’t increase its risk level in Greece. Instead, it wants governments to guarantee any further liquidity injections. But the politicians don’t want to face that issue, at least until Greek voters have given a clear answer over whether they want to stay in the euro.

The snag is that the June 17 election may not provide a clear answer and that might provoke a bank run. At the moment, there isn’t a plan of how to respond. Would the ECB blink and authorise extra ELA – in which case it would look remarkably silly if Greece then quit the euro and the central bank faced massive extra losses on its exposure? Or would it shut off the tap – in which case cash withdrawals from Greek ATMs would have to be rationed, quite possibly provoking panics elsewhere?

The difficulty coming up with contingency plans goes beyond Greece. What, for example, should be done if bank runs do spread to other countries such as Spain and Italy? Mario Draghi, the ECB’s president, last week gave what might seem like a reassuring comment to the European Parliament, saying: “We have all the means to cope with this as far as solvent banks are concerned”. What he didn’t spell out, though, is how the ECB would react if there were runs on insolvent lenders.

There would probably be brinkmanship. The ECB would argue that it was the governments’ job to recapitalise their banks. The politicians would try to avoid injecting taxpayers’ money into their lenders, not least because the governments don’t have the cash. The ECB would then probably say the governments should borrow money from the European Stability Mechanism (ESM), the euro zone bailout fund.

The politicians might come up with inventive schemes, such as giving their banks IOUs which could then be swapped with their own national central banks for ELA. That fudge was used two years ago to recapitalise Ireland’s banks – and Spain was originally toying with a variation on the theme to shore up Bankia. But the ECB doesn’t like it, not least because ELA is supposed to be only temporary.

On the other hand, if neither side blinked, some banks could collapse – triggering runs even among solid ones.

Yet another weakness in the euro’s defences is what to do if investors refuse to buy Spanish and Italian government debt. Madrid, for one, wants the ECB to step in with massive purchases of its bonds through what is known as the securities markets programme. The central bank, though, thinks it should do this only to a limited extent and that if a government needs cash, the relief should come from the ESM, that is from the other governments.

The snag is that the bailout fund doesn’t have enough money to rescue both Madrid and Rome. That’s why France and other countries have argued that it should be allowed to borrow money from the ECB – back to the central bank again. But Draghi has rejected that idea, saying that it would constitute “monetary financing” – or bailing out governments by printing cash – which is forbidden by the Maastricht Treaty. Others argue that the legal position isn’t so clear.

Either way, another potential standoff is being set up. If Italy lost access to the markets and the ECB didn’t blink, then Rome would have to turn to extreme measures: force its citizens to buy bonds, suspend debt repayments or something else. That would be a pretty hairy moment, which might spell the end of the single currency.

Of course, all hell might not break loose. And, if it does, some clever compromises might be found. But multi-dimensional chicken certainly heightens the risks. 


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