The End of the Euro

The former Chief Economist of the IMF, Simon Johnson, is anything but bullish, expecting a complete collapse of the Euro system.  Be sure to read the whole thing as I couldn't excerpt it all below:

Europe's crisis to date is a series of supposedly "decisive" turning points that each turned out to be just another step down a steep hill.  Greece's upcoming election on June 17 is another such moment.  While the so-called "pro-bailout" forces may prevail in terms of parliamentary seats, some form of new currency will soon flood the streets of Athens.  It is already nearly impossible to save Greek membership in the euro area: depositors flee banks, taxpayers delay tax payments, and companies postpone paying their suppliers – either because they can't pay or because they expect soon to be able to pay in cheap drachma.

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During the next stage of the crisis, Europe's electorate will be rudely awakened to the large financial risks which have been foisted upon them in failed attempts to keep the single currency alive.  If Greece quits the euro later this year, its government will default on approximately 300 billion euros of external public debt, including roughly 187 billion euros owed to the IMF and European Financial Stability Facility (EFSF).

More importantly and currently less obvious to German taxpayers, Greece will likely default on 155 billion euros directly owed to the euro system (comprised of the ECB and the 17 national central banks in the euro zone).  This includes 110 billion euros provided automatically to Greece through the Target2 payments system – which handles settlements between central banks for countries using the euro.   As depositors and lenders flee Greek banks, someone needs to finance that capital flight, otherwise Greek banks would fail.  This role is taken on by other euro area central banks, which have quietly leant large funds, with the balances reported in the Target2 account.  The vast bulk of this lending is, in practice, done by the Bundesbank since capital flight mostly goes to Germany, although all members of the euro system share the losses if there are defaults.

The ECB has always vehemently denied that it has taken an excessive amount of risk despite its increasingly relaxed lending policies.  But between Target2 and direct bond purchases alone, the euro system claims on troubled periphery countries are now approximately 1.1 trillion euros (this is our estimate based on available official data).  This amounts to over 200 percent of the (broadly defined) capital of the euro system.  No responsible bank would claim these sums are minor risks to its capital or to taxpayers.  These claims also amount to 43 percent of German Gross Domestic Product, which is now around 2.57 trillion euros.  With Greece proving that all this financing is deeply risky, the euro system will appear far more fragile and dangerous to taxpayers and investors.

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Jacek Rostowski, the Polish Finance Minister, recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery, and that – to avoid a greater calamity – all remaining member nations need to be provided with unlimited funding for at least 18 months.  Mr. Rostowski expresses concern, however, that the ECB is not prepared to provide such a firewall, and no other entity has the capacity, legitimacy, or will to do so.

We agree:  Once it dawns on people that the ECB already has a large amount of credit risk on its books, it seems very unlikely that the ECB would start providing limitless funds to all other governments that face pressure from the bond market.  The Greek trajectory of austerity-backlash-default is likely to be repeated elsewhere – so why would the Germans want the ECB to double- or quadruple-down by suddenly ratcheting up loans to everyone else?

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Forget about a rescue in the form of the G20, the G8, the G7, a new European Union Treasury, the issue of Eurobonds, a large scale debt mutualisation scheme, or any other bedtime story.  We are each on our own.