What Happens If Greece Leaves?

The Conscience of a Liberal (NYT Blog) – Paul Krugman: Eurod?mmerung
Some of us have been talking it over, and here’s what we think the end game looks like:

1. Greek euro exit, very possibly next month.
2. Huge withdrawals from Spanish and Italian banks, as depositors try to move their money to Germany.
3a. Maybe, just possibly, de facto controls, with banks forbidden to transfer deposits out of country and limits on cash withdrawals.
3b. Alternatively, or maybe in tandem, huge draws on ECB credit to keep the banks from collapsing.
4a. Germany has a choice. Accept huge indirect public claims on Italy and Spain, plus a drastic revision of strategy — basically, to give Spain in particular any hope you need both guarantees on its debt to hold borrowing costs down and a higher eurozone inflation target to make relative price adjustment possible; or:
4b. End of the euro.

And we’re talking about months, not years, for this to play out.

Comment

We largely agree with the above scenario. This is why, as we noted in the block above, a Greek departure would be very bad for the euro.  As the next chart shows, almost one-third of Greek bank deposits have left the country.  This will surely accelerate as the risk of these euro deposits becoming Drachmas increases.

As the next two charts show, Spanish bank deposits have only recently begun to decrease.  Italian bank deposits are holding steady.

Should the precedent be set that countries can get kicked out of the euro, depositors in these countries will fear their euros could be turned into pesetas or lira and start moving their money to German banks.

 

What happens if money leaves the banks for Germany?  Let’s use Spain as an example.

As the next two charts show, Spanish banks borrow heavily from the ECB.  The central bank of Spain (Banco de Espana) also borrows heavily from the ECB to further support the Spanish banks.  What do the banks do with the money?  As the third chart below shows, they pile it into Spanish government debt.

If Greece is kicked out and the perception is membership in the euro is contingent on pleasing Germany, the money will leave Spain.  Despite massive borrowings, the Spanish banks will have to sell Spanish government debt which would push their yields up even further.  It these yields go high enough, Spain will need a bailout similar to Greece’s bailout.

 

Source: Bianco Research