A CRISIS FOR THE WORLD: Citi's Willem Buiter Warns What Happens If Greece Quits The Euro

Citi's Willem Buiter is out with a new note firmly opposing all those who toy with the idea of a Greek exit from the eurozone.

"The prospect of Greece exiting the euro area is seldom viewed with the proper degree of fear and trepidation," he writes.

While Buiter admits that a Greek exit could have euro-positive implications in the long term, in the short term it would be an "economic disaster" for both Greece and the remaining 16 euro states with "severe economic and political implications" for the rest of the world.

Here are a few of his main points:

- A Greek exit is still unlikely but has become a lot more possible in the last few weeks.

- While the Euro Area can't formally kick Greece out of the euro, denying it bailout funds or forcing it to adopt unfeasible austerity measures would virtually amount to booting the Greeks out. Buiter cites stalled negotiations (set to resume tomorrow) between Greek officials and ECB/EU/IMF troika inspectors as a bad sign that this not impossible. "For the sake of economic stability and growth in the euro area, the wider European Union and the global economy, we hope that this message is taken to heart by the European authorities."

- Buiter believes that the troika will continue to give Greece funding, but will probably force Greece to endure more austerity cuts and will be directly involved in designing the program.

- Private creditors to Greece will probably accept a haircut of 65-80% net present value of their investments. More than 90 percent of Greek sovereign debt held by private creditors was issued under Greek law. That means Greece could pass a single law and walk away from all these debts. Creditors would have no recourse. Not that Greece will do that -- just that it can.

- Were Greece to exit from the euro, however, Buiter would expect private creditors to lose 90-100% net present value on all Greek debt.

- Greece will not leave the euro on its own. "A collapsed banking system, widespread default throughout the economy, a continuing non-competitive economy and high inflation with a material risk of hyperinflation would make for a deep and enduring recession/depression in Greece. Social and political dislocation would be certain. There would, in our view, be a material risk of a downward spiral of dysfunctional politics and economics."

Here's what would happen in Greece if it left the euro:

- Greece immediately issues a new currency, a run on banks would ensue, and no one will be able to get cash in Greece. The banking system there would be kaput. This also wouldn't restore growth or competitiveness to Greece in the long run.

- The big deal for the rest of the euro area is that an exit from the area was allowed and precedent was broken.

- After a Greek exit, markets would immediately focus on the PIIGS countries most likely to follow suit. Investors would withdraw any deposits they would have there.

He paints a pretty picture of just what would happen:

Apart from bank runs in every country deemed, by markets and investors, to be even remotely at risk of exit from the euro area, there would be de facto funding strikes by external investors and lenders for borrowers from these countries. Again, putting under foreign law (most likely English or New York) all cross-border (or perhaps even all domestic) financial contracts and instruments could at most mitigate this but would not cure it.

The funding strike and deposit run out of the periphery euro area member states (defined very broadly), would create financial havoc and mostly like cause a financial crisis followed by a deep recession in the euro area broad periphery. The counterparty inflow of deposits and diversion of funding to the ‘hard core’ euro area and the removal (or at least substantial reduction) of the risk of ECB monetisation of EA sovereign and bank debt would drive up the euro exchange rate. So the remaining euro area members would suffer (at least temporarily) from an uncompetitive exchange rate as well from the spillovers of the financial and economic crises in the broad periphery.

DON'T MISS: Here's who gets crushed if Greece goes bust >

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Citi's Willem Buiter: There's A Big Third Option For Europe That Nobody Is Thinking About

The debate about the Europe is basically a debate between two starkly opposing ideas: Breakup or full fiscal union.

In a new report, Citi's Willem Buiter argues that there's a big 3rd outcome that hardly anyone is talking about.

Says Buiter: "We suggest a third alternative as the most likely eventual outcome: ‘You Break it, You Own it Europe’."

Basically, politics will make the fully federal Europe an impossible dream.

And the cost of breaking up the EU (or leaving the EU, in the case of a single country) is just too high.

So as for this 'You Break It, You Own It Europe,' the idea is to allow a European system that allows for sovereign defaults and restructuring in a way that doesn't necessitate contagion risk.

YBIYOIE consists of the minimum institutional, fiscal and regulatory set-up to ensure
survival of the EA, including:

– i) Large enough liquidity facilities to prevent illiquid but solvent EA sovereigns and
banks from being forced into default by a loss of market access.  
– ii) A debt restructuring mechanism for insolvent EA sovereigns.  
– iii) A special resolution regime for EU banks and a Euro-Tarp for cross-border
sibanks and other sifis.

So what does this mean specifically? Buiter identifies 4 key things:

A sovereign debt restructuring mechanism that actually has some teeth to make solutions happen: "To minimise the risk of contagion and the cost of protracted negotiations between private creditors and sovereign debtors, the SDRM will also have to have a statutory component, including the ability of the body in charge of the SDRM (which will presumably
consist of representatives from the Eurogroup of finance ministers of the EA member states, from the European Commission and from the ECB (and possibly from the IMF as well) to impose a solution on all parties involved in a sovereign debt restructuring should a stalemate threaten."A special resolution mechanism for banks, and a EUROTARP for systematically important institutions.Removing the ECB has the supplier of fiscal resources as last resort.Creating a liquidity pool of last resort for sovereigns that are illiquid but remain solvent.

Finally, Buiter proposes three additional mechanisms, which are turning the EFSF into its own official counterparty to the ECB, raiding the resources of the European Investment Bank (an existing institution with lending capacity that doesn't ever get discussed).

And finally, something called Enhanced Cooperation, to deal with recalcitrant nations like Finland.

Here's his full comment on that:

As pointed out in Buiter (2011), even if not all 17 Euro Area member states ratify the
enhanced and enlarged EFSF later this year, an enhanced and enlarged EFSF can
still be created, if necessary, by the ‘coalition of the willing’ through Enhanced
Cooperation. Enhanced Cooperation is an EU procedure where a minimum of nine
EU member states are allowed to establish advanced integration or cooperation in
an area within EU structures but without the other members being involved. The
arrangements cannot violate the Treaty, of course, and they must be open to any
EU member wishing to join. Although as of March 2011, Enhanced Cooperation had
only been used in the fields of divorce law and patents, but it seems purpose-made
for overcoming the problem of a small Euro area member state vetoing EFSF
enhancement or enlargement.
This case could soon apply to Finland for the second Greek bail-out package which
will be carried out under the umbrella of the EFSF.

The recent decision by Finland to request cash collateral for its share of the
guarantees needed to fund the second Greek bailout is clearly a non-starter,
because it would undermine the ability of the Euro area member states to provide
effective financial support to any other member state. If the Greek sovereign had
cash collateral to post against the guarantees provided by the 14 Euro area
member states that are supposed contribute to the second Greek bail-out, it
probably wouldn’t have needed the second bail out in the first place. In addition, the
Netherlands, Austria, Slovakia and Slovenia have made it clear that if Finland
succeeds in getting cash collateral for its contribution to the second Greek bailout,
they too will demand such cash collateral. So either Finland will give in and provide
its guarantee without cash collateral (but perhaps with a face-saving offer as
collateral of something illiquid, impossible to value and of dubious perfectibility as
security), or Finland insists on receiving cash collateral, in which case it should be
excluded from the club of contributors to the second Greek bailout. This bailout can
then proceed without Finland (responsible for about 1.8 percent of the total
guarantee) under Enhanced Cooperation.

Buiter concludes:

Progress towards YBIYOIE will not be fast. Agreement needs to be found domestically in EA member countries and between the member states. Laws have to be written or rewritten and institutions will have to be built. Resolution of the current crisis will take up much of the EA political and institutional capacity in the near-term. Policymakers will not take the most direct route to YBIYOIE. The periodic
crises that we expect until a full resolution of the EA sovereign and banking crisis will trigger responses according to what is most opportune at that time, rather than in the long-term interest of the EA. But even resolution of the current crisis will involve substantial further private sector burden sharing which we expect to be a major element of YBIYOIE.

Europe blunders and Europe stumbles, but it never stays down. This unique hybrid between a federation of nation states and an intergovernmental alliance will likely use the current crises the way it has used all past crises: to emerge stronger and more capable of dealing with future challenges and crises.

It's almost enough to make not make you want to jump off a bridge.

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