If you’re worried about this read the ECB mess as set out in 25th May FT

It’s ever more obvious, Greece must leave the euro

I’ve hardly been alone, but that’s no excuse. For more than a year now, I’ve been regularly predicting the euro crisis’s final denouement, yet still it hasn’t arrived.

A protester holds a banner in front of the Greek Parliament during a peaceful rally attended by thousands on Wednesday against painful austerity measures.

By Jeremy Warner, Assistant Editor

 7:42PM BST 25 May 2011

So I’ve been forced to reach a different conclusion; perhaps it never will. Instead, the eurozone has entered a seeming state of permanent crisis. In desperation, European policymakers have adopted a very British characteristic – the hope that they can somehow just muddle through.

But though no one can know the exact timing of the endgame – that’s ultimately for the politicians to decide, so no time soon might be a reasonable bet – it’s now fairly clear what that endgame must be.
What’s presently being played out among the GIPS (Greece, Ireland, Portugal and Spain) is final proof that you cannot have a monetary union of such size among sovereign nations without compensating fiscal union. That simple underlying truth leaves the euro facing a choice between two equally unappetising outcomes.

Either the richer countries carry on bailing out the poorer ones more or less indefinitely, rather in the manner that Germany subsidises its formerly communist East, or membership of the euro has to be reconstituted on a smaller and more sustainable basis. There’s really nothing in between. The longer European policymakers remain in denial about this choice, the worse the situation will become.

So it’s with a sense of weary familiarity we approach the latest impasse. The European Central Bank is implacably opposed to debt restructuring, but the eurozone’s solvent Northern states have reached the limit of their appetite for further bail-outs. This leaves Greece in an impossible position; it can neither reduce its debt burden through restructuring, nor will anyone lend it more money.

Who knows, maybe this time, the Greek sub-plot really will bring the euro’s wider crisis to a head. Greece is apparently unable to agree additional austerity measures so the International Monetary Fund is refusing to release its share of the next €12bn tranche of bail-out funding, or at least not until – and please don’t laugh – its eurozone partners commit to more aid for Athens to plug next year’s funding gap.

From the sublime to the ridiculous, Greek newspaper reports have it that Prime Minister George Papandreou has threatened to call a referendum on the austerity measures if he cannot secure political agreement. The story has been denied, but it demonstrates how desperate the situation has become. Mr Papandreou is in such a fix that he was thinking of relying on the idea that turkeys really would vote for Christmas.

The nub of the problem is this. The eurozone periphery has in essence been borrowing money from the core to buy the core’s goods and services. In order to reduce this external indebtedness, the periphery must now rapidly close both its current account and fiscal deficits. Only then will things come back into balance.

The challenge is not dissimilar to the one faced by the UK, which has also borrowed to spend. Only in the UK, devaluation provides a relatively painless way back to current account surplus and again paying our way in the world. There’s no such get out of jail card for the GIPS.

What’s more, the problem is significantly bigger for the GIPS than it is for the UK. Years of grinding wage and price deflation are required to make them competitive again. By providing temporary liquidity support, the bail-outs at least buy time, but the time so bought only works if it is used effectively to address the underlying solvency issue. There’s no sign of this.

In circumstances where both debt restructuring and further bail-outs are thought unacceptable, policymakers have been left clasping at straws. Forcing the Greeks to sell all that’s left of the family silver is seen as one possible solution, even if that means taking matters out of sovereign hands and privatising Greece’s remaining assets through an independent agency. But who will buy when there is every possibility of Greece eventually leaving the euro? Capital is already fleeing Greece as fast as it can; what chance of attracting it in?

It’s ever more obvious that Greece needs both to restructure its debts and leave the euro to become economically competitive again. But equally obvious is why policymakers refuse to contemplate such a solution.
For the ECB, both strategies are a complete no-no. In part, this view is instructed by self-interest. It’s hard to know precisely what the central bank’s exposure to the GIPS is, but more than €400bn in government bonds is the ballpark. If this was significantly impaired, it would destroy the ECB’s balance sheet. The central bank’s independence would be a likely casualty.
But ECB intransigence is also for genuine fear of the fallout. If Greece went, it might start a chain reaction in the periphery and a second credit crunch in the core as sovereign debt losses became crystallised in a still fragile European banking system.

Ever more austerity, the present policy prescription of choice, is most unlikely to do the trick either, for consolidation on the scale necessary threatens to create a self-reinforcing cycle of decline, never mind the risk of social insurrection.

It’s easy to say there are only two conceivable solutions – reducing the euro’s membership or indefinitely subsidising the periphery to carry on spending more than it earns. The problem is that the first is a debt default in all but name, and would cause the rest of the eurozone the same problems as a restructuring, while the second is politically unacceptable to those that must do the subsidising. What a mess.