From the lowy interpreter......
Clearly Greece has entered a new and perilous phase. Until now, the Greek crisis has been under control: grossly mishandled by policy-makers, but still able to be 'kicked down the road' a bit further, putting off the denouement until another day. Each time the situation arrived at the point of no return, the authorities were provoked into doing something previously politically unattainable.
Now, however, with a slow-motion run on the Greek banking system as depositors take the obviously sensible precaution of withdrawing euros from their accounts, the situation is no longer under the control of the authorities. Even before this run gathers pace (as it will surely do when the Greek elections next month bring more scary populist pronouncements from the candidates), funding the run has required the European Central Bank to provide a further €100 billion in Emergency Liquidity Assistance (ELA) to Greek banks to allow these currency withdrawals.
The ECB can't continue to do this. To save Greek banks from a classic depositors' run would require the sort of comprehensive bail-out which governments and national central banks provide in extreme circumstances but which is beyond the mandate of the ECB and beyond the capacity of the Greek central bank.
This doesn't mean the end will come soon. The ECB will be very reluctant to be the one to declare that the emperor has no clothes. For one thing, it would trigger big losses on the ECB's own balance sheet. Moreover, ECB President Mario Draghi is unlikely to act without the full endorsement of the 17-member Board, and boards have great capacity for procrastination and self-deception.
But the moment has passed when this crisis can be resolved by a resolute display of austerity on the part of the troubled country combined with solemn pledges by the European authorities that they stand ready to back the country when it comes under market attack. That approach either works quickly to restore confidence, or it fails definitively. For Greece it has failed definitively.
For the past six months its prime minister has been a former central bank governor, well-known and trusted by his European colleagues and able to do enough (and promise enough) to keep the crisis at bay. He also had the unambiguous objective of keeping Greece in the EU even if this meant years of austerity. Last month's inconclusive election saw 70% of Greeks vote for parties which promise to abandon austerity, a deal-breaker for the European assistance package. If this remains the case in the mid-June elections, it's hard to see how the policy chasm between the new Greek authorities and the Germans can be bridged.
The prolonged agony of this crisis must tarnish the IMF's reputation. When the crisis first broke in May 2010, European politics constrained sensible responses and diverted the debate into unattainable solutions such as fiscal union.
The Fund alone was in a position to take a clear-sighted stance and require debt rescheduling (de facto default). Taken in a timely way before financial markets had time to work themselves into a frenzy of self-interested concern about contagion, the outcome might well have resembled Iceland in 2009 or Korea in 1998: a painful cut in living standards for the troubled country, but quick resumption of growth and access to foreign capital markets. Once this opportunity was lost, it was hard for the Fund to avoid pouring good money after bad. There is a real chance that some of the Fund's newly-gathered US$400 billion (including Australia's contribution) will be tipped into this bottomless well.
Did the time bought make a departure from the euro any less traumatic? It allowed private sector creditors to unload more of their potentially-worthless Greek assets onto European governments, and some financial institutions may have been able to strengthen their balance sheets.
But the mechanics of departure will still be traumatic. One central problem is the decision-making process: the official sector can't make any preparations for departure without precipitating the event. They can't, for example, put in an order for printing New Drachma. And resolution would certainly involve closing all the banks and opening them again as state-owned or state-backed entities, dealing in a new, greatly depreciated, currency.
It is the chaotic nature of any departure which has encouraged the authorities in both Europe and Greece to keep the show on the road. But they are no longer in control. Greece and its collateral damage have hobbled world growth for the past two years. The cost of default is now much greater. In addition to the ELA, the ECB holds perhaps €50 billion of Greek Government paper, Greece is in deficit with the euro payments system for more than €100 billion and the official support package is well over €200 billion. Most of this will have to be written off.
As usual in political economy, nothing is certain and Greece could still battle on as part of the euro area (which an overwhelming majority of Greeks say they want to do). After all, Edgar Allan Poe's character did extricate himself from the maelstrom.
But this is no longer a matter of incremental modification to policy: it would take an extraordinarily bold shift in policy mindsets, especially in Germany. There would have to be agreement on a softening of austerity, a recognition that Greece’s huge foreign debts are essentially worthless, and easier euro monetary policy (including higher German inflation which might help restore Greek competitiveness). It now seems more likely that Greece will be sucked under.
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