Greek actors seek divorce from reality

Reuters columnist James Saft's article Greek actors seek divorce from reality is an excellent summation of the current state of the Greek mess.

Greece, shut out of the capital markets, needs money, and soon, and is willing to play along with the fiction that the next tranche of aid, perhaps 90 billion euros, from the European Union, International Monetary Fund and ECB will buy them enough time.

The ECB, which is up to its eyeballs in exposure to Greek debt, steadfastly maintains that it won’t countenance a soft restructuring, or default, presumably because it fears this will be too much for it, the banks, and the global financial markets to bear.

Germany, however, is insisting on just that; it maintains that the private sector will have to bear some of the costs, and while there is much discussion about “soft” restructurings featuring debt repayment extensions, no one has credibly explained how the private sector can take its lumps without it being considered a default.

The ECB has perhaps 40-50 billion euros’ worth of Greek bonds on its balance sheet, and has lent about another 90 billion or so to Greek banks. It has threatened, in the event of a restructuring, to stop accepting Greek debt as collateral, a move that would be tantamount to cratering the entire Greek banking system at once. This would also deal sharp losses to the many euro zone national central banks which are exposed, potentially causing some to need additional capital.

By destroying the Greek bank sector, the ECB would, quite possibly, effect the exit of Greece from the euro zone. Depositors in Greek banks understand this, and have been withdrawing funds.

Given all of this, it seems likely that the ECB will relent, though in doing so they will seriously impair their credibility. And of course, as soon as Greece defaults, the eyes of the market would immediately turn to Portugal, Ireland and even Spain.

Rather than figuring out how to keep Greece upright without knocking over the banks, they would have been far better off figuring out how to actually make the banking system solvent and sound given Greek insolvency. That would involve huge private sector losses, inevitably, but might just have laid the groundwork for sustainable growth.

Instead we will have a sinking euro and waves of deflationary force coming out of Europe.