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You assume that the Eurozone collapse will be contractionary. Maybe, but let's suppose it isn't. It could be a bit like 1992, when sterling's exit from the ERM had Norman Lamont singing in his bathtub, with UK monetary policy free to respond to the needs of the UK economy. Why shouldn't the re-launch of the drachma, escudo, punt and peseta have similar effects?

Admittedly the immediate aftermath of the breakup will be chaotic. But if creditors lose and debtors gain, the impact on AD is surely positive.

Putting it another way, maybe what everyone will be saying a year from now is: "We should have done XYZ to accelerate the breakup!" Of course that still leaves the question, what's XYZ? Weaken the dollar by quantitative easing might be one answer. That would heighten the contradictions for the ECB.

Kevin: Hmmm. You may well be right. But Eurozone collapse would be a lot messier than sterling's exit from the ERM. The latter was a simple devaluation, with no big financial crisis, introduction of new currencies, and everybody getting into a big fight about who owes who what in what currency. I'm thinking Argentina x a number bigger than 10.

I'm not sure about having a better answer; this is food for thought.

If the shock will affect our exports, then we could make it easier to export now. EDC, for example, provides buyer financing (ie, provides better lending terms to possible buyers of our exports). In anticipation of the fallout, our exporters could search for buyers who would be near-certain to remain solvent, and the EDC could facilitate the deal.

I don't know much about trade regulations, so I'm not sure if this would constitute as export subsidizing. Perhaps someone knows. Also, EDC would be taking on some credit risk. But I assume that they are capable of managing their risk.

Hefty debts owed to foreigners denominated in foreign currency? An emerging domestic political consensus that such foreign debts are odious and should not be honoured? Sharply devalued domestic currency? Are we talking Greece 2011 or Germany 1921? And that's without the hullibaloo about switching currencies.

OK, Greece isn't Germany, but collectively the PIGS are, well, not small.


I've been missing your Greece posts :) Regarding a Eurozone collapse, what kind of collapse are you posing? Is the base case that Greece, Portugal and Ireland leave/get ejected from the Eurozone? Or does the whole edifice collapse and each nation goes back to its national currency?

Perhaps we should restrict ourselves to the less severe case of Greece, Portugal and Ireland leaving, with the Eurozone stepping in to save Spain and Italy. One of the first effects will be that money will move to safe havens, with Germany losing some of its safe haven status. The US Dollar will jump, as will the Japanese Yen. The Canadian dollar will fall, maybe back to $0.80. This will be stimulatory for Canada, although probably insufficiently so.

U.S Gov't bond yields fall with the move to safe havens, as will Canadian gov't bond yields. But I doubt this will get translated to the broader economy.

The bigger question comes from the impact of Greece, Portugal and Ireland defaulting on the national debt (and their banks defaulting as well). The ECB will be bankrupt and the European banking system will be collapsing. Whether or not Canada and Canadian banks have any ties with the periphery of Europe, there is exposure to the core or Europe (and to the UK, which will be in trouble as well). It's hard not to imagine that many Canadian banks will be facing potentially crippling losses, and the credit system in Canada could freeze. I would think that the Gov't of Canada and the BoC should be prepared to step in and get credit flowing again immediately.

I think these are two fairly obvious primary effects of a Eurozone (partial) collapse.

I really like Colin's answer (that Export Development Canada be ready to take on an expanded role in trade-financing Canadian exports.) Definitely a worthwhile Canadian initiative. Boring yes, but practical. Something that will need doing and that we can do. That helps us and helps them too.

(One I think largely untold story is how EDC expanded its role a couple of years ago to help keep finance flowing.)

Kosta: my scenario will be that some countries default, and some countries leaves the Euro, and a lot of banks go bad, and financial markets freeze up, and there's a big legal/political fight. The free flow of goods, capital, and people gets seriously disrupted.

" It's hard not to imagine that many Canadian banks will be facing potentially crippling losses"

Kosta: I think you might be over-egging the pudding on that one.

FWIW, Another Lehman style global liquidity crisis would be my worry - which could lead to solvency issues. And who will save the world this time? Trichet has lost his mind (*raised* rates today! WTF!), so Uncle Ben will be the only game in town, and with Ron Paul and a Congress gone mad breathing down his neck, his ability to save our collective asses again may be extremely limited.

Two feasible alternatives:
1. Switch to the floor system (like Norway)
2. Start targeting 3 month Libor (like Switzerland)

Patrick: we're on the same page, but let me rephrase. If the European banking system collapses and the ECB is insolvent, I think many (all) Canadian banks will fear that they *might* take significant losses, be it from exposure to Europe, or elsewhere. This fear, combined with the loss of liquidity, could freeze up the Canadian banking system.

While Canadian banks aren't particularly exposed to the periphery of Europe, I wonder what their exposure is to the core of Europe (and the UK).

Nick: thanks for the clarification. I wonder what the international impact of the European legal/political fight will be? It will impede a unified European response to the crisis, as well as Europe's recovery. I suppose it might spark the resumption of trade protectionism, which could be bad for Canada.

If the Eurozone comes apart, it will ultimately be because, whether explicitly recognized or not, retention of a common currency renders maintenance of monetary equilibrium throughout the eurozone impossible. Increasing the number of currencies, whether it be via a shift back to national currencies, ejecting one or more of the PIIGS but otherwise maintaining the euro, Germany fleeing the euro screaming, or splitting the Eurozone into PIIG/non-PIIG, can presumably only increase the potential for monetary equilibrium.

Also, if a write-down in the value of (say) Greek loans held by (say) German banks results from the new exchange rate, which I am assuming it will, it will be easier for the German monetary authority to pursue an accommodative monetary policy for domestic currency than to agree to a similar policy for the euro as a whole given the reduced possibility that they would be creating additional moral hazard for potentially profligate foreign governments and foreign banks.

I would have thought therefore that the break-up be expected by the markets to be positive for AD throughout the Eurozone once the plans are known and understood by the markets.

In terms of liquidity effects on Canada, the demand for even high quality assets in Europe and for the euro itself for investments purposes has likely been depressed by heightened uncertainty over the value of the euro. That has led to the markets viewing the Canadian and Australian dollars and assets denominated in those currencies more favourably. Once the Eurozone, and the sources of the currency risks, are unbundled, and it is possible to hold, for example, deutsche marks, one should probably expect that whatever nascent safe-haven demand for Canadian dollars and assets might be reduced to some degree.

The difficulty, as pointed out above, will be during the markets “learning” phase. There is likely to be a flight out of the euro obviously and from equities and corporate debt everywhere into safe currencies. Canadians, at a minimum, probably would be wanting to hold more Canadian dollars. The question is to what extent the US dollar is still considered the reflexive short term safe haven of choice. In any case, the key point is that since any short term demand for Canadian dollars would be coming not only from reduced consumption but perhaps also and primarily from other assets, it would presumably not be enough to target inflation if the Bank of Canada’s ultimate objective was to maintain monetary equilibrium.

As an afterthought, this has made me wonder whether, in effect, bailing out banks through various means, such as central bank purchases of troubled assets or credit easing, is not in fact really a special (asymmetric and non-competitively-neutral) case of central banks attempting to maintain monetary equilibrium by targeting asset prices even though they usually claim not to.

Wouldn't expanding EDC financing essentially be what has been tried and failed catastrophically over the last few years, i.e., governments lending (or facilitating lending) as a policy specifically where it is not commercially viable to do so? See: subprime, Greece, etc.

Can't we just stop doing that and focus on getting monetary policy right?

Given that the Canadian economy is so intertwined with the U.S. economy, perhaps the analysis should focus on what would happen in the U.S. in response to a Eurozone breakup. For instance, after Lehman collapsed, the flight to quality to U.S. dollar assets was largely driven by U.S. firms bringing back international investments. This 'repatriation' was a large driver in moves we saw in the Canadian Dollar.

In the case of a Eurozone breakup, would the U.S. investment community act in a similar fashion? Or would they simply pull back from Europe? Without a doubt there would be some flight to quality, and the U.S. Dollar would appreciate, both as U.S. investments were brought home and European investments sought safer pastures. But perhaps U.S. investments in Canada would be left in place? Perhaps David is right in suggesting that Canadian assets will be in demand in the wake of a Eurozone breakup?

Not only should we be concerned as to whether the Canadian financial system is threatened systemically by a Eurozone breakup, we need to ask if the U.S. financial system is threatened, and whether the U.S. response will affect Canada.

I can't resist.... what would effect would such a crisis have on monetary disequilibrium?

Some of the best analysis I've seen of the Greek situation was on the Daily Show, see this WSJ blog for links

It will be an immediate disaster of course. The fallout will I suspect be determined by the willingness of central bankers to print money (channelling Scott Sumner here!). The one possible optimistic possibillity is that the authorities will at the end of the day print the money necessary to avoid the collapse. They are denying this now of course. But such denials are not always credible. See Murdoch, Rupert.

No answers, but I have another question.

How, exactly, can the Eurozone "collapse". How can Greece, for example, exit the zone? Suppose it decides to go back to the drachma, how can it do that practically? Seems to me that few would want to hold the reinstated currency. I suspect that Greeks would probably continue to demand Euros as payment for everything and regard the new drachma as worthless. If that happened, Greece would effectively still be in the Eurozone, only it would presumably have lost all say in how it is run and would get no more bail-outs.

One idea: On a certain date, the Greek government simply declares all the Euros held in Greek banks to be Drachmas instead. Might work if no-one expects it is coming. But imagine the temptation for anyone who knows or even guesses to withdraw all their money from Greek banks and get it out of the country, expecting the value of Drachmas to drop like a stone after launch. Dangerous and potentially very messy and unfair, but I don't see a better way.

It's easier to imagine strong countries like Germany leaving.

One other problem with above idea: How would you print bank notes and stamp coins without word getting out and triggering the mother of all bank runs?

Food for thought for WHEN Greece defaults:

FT, July 8, Gavyn Davies, "The ECB's worst nighmare": http://blogs.ft.com/gavyndavies/2011/07/07/the-ecbs-worst-nightmare/#axzz1RWP6crBz

Absolute Return - Niels Jenson, July 8: "What happens next?" [after Greece defaults] http://www.arpllp.com/newsletters.asp?section=00010004

FT, Martin Wolf: July 5, "A moment of truth for the eurozone", http://www.ft.com/intl/cms/s/0/113bd482-a737-11e0-b6d4-00144feabdc0.html#axzz1RQflzpPI

Project Syndicate, June 30, Prof Hans-Werner Sinn, U Munich, "Farewell to the Euro?" http://www.project-syndicate.org/commentary/sinn38/English

Telegraph, May 20: Andrew Lilico, Europe Economics: "What happens when Greece defaults": http://blogs.telegraph.co.uk/finance/andrewlilico/100010332/what-happens-when-greece-defaults/

Paul: I think the idea is that Greece would leave once the the bank run and financial crisis had already happened.

The EU members are really all prisoners of a financial and banking system that is - one way or another - inevitably going to blow-up. It's a bomb with half a dozen triggers: Ireland pulls an Iceland - booom! Greek default - boom! Portuguese default - boom! And how long can Spain have +20% unemployment without sparking a revolution? I can't imagine they will go quietly into that good night. And when they decide to rage against the dying of the light ... BOOM!

Paul: Imagine that a government cannot borrow, and doesn't have enough tax revenues to cover its expenditure. It issues "scrip"/new drachmas to pay the bill. Plus, the banks can't raise the Euros to pay their depositors. The banks are closed, and all deposits are re-denominated in New Drachmas.

Not a *planned* exit from the Euro, but an exit forced by circumstances.


I can't find it now, but there was a story in the Globe last week about how people were already pulling their savings out of Greek banks and putting them oversees. I think the theory was they were worried that Greek banks would collapse. That may play a part, but since Cypriot bank (apparently a favourite destination) or other European Banks are so exposed to Greek debt (so also vulnerable to collapse), I'm not sure that's the whole story. My own theory was that people were getting their money out of the country before the Greeks started enforcing their tax laws, but you may also be onto part of the story. They know that Greece is getting out of the Euro, and they want to make sure their savings are in hard currency.

I´ve not answer of course, but I´ve fund a complete analysis in
where Alen Mattis says the only possible way for the Euro to survive is inflation: ECB as central bank of the Eurozone, must trigger inflation buying without limits bad debt (or its substitute if there is a Brady´s plan).
I agree, but I am very pessimistic. I think that the euro has proved to be based on wrong theories -basically, theories which ignore that "money matters". And not only because Mundell OCA theory: I think that the euro crash will be a source of new OCA theories more oriented to financial aspects.

Nick, I am less concerned about the fallout of the Greek crisis than you seem to be. Yes, the euro area is in a serious crisis and one can certainly not rule out that one or more countries will have to leave the euro area and yes, Friedman was right in calling the euro a “great mistake”. That, however, but that is not the same as assuming that we will have yet another Lehman event.

One reason that I am pretty optimistic on the overall global market implications (not on Greece) is that market participants are well aware of the risks. Hence, it would be natural to expect that market participants over the last one to two years have reduced their exposure to the Greek (PIIGS) story. Obviously a disorderly Greek default will not be positive for global market sentiment and things can of course go terribly wrong, but let me remind everybody reading this that the Argentine default in 2002 had remarkably little global impact despite the fact it happened at a time when the global economy and the global financial system was rather fragile. Why was that? In my view the reason was the investors had had time to hedge direct and indirect exposure to Argentina. So if I would have to take a bet in market terms – I would recommend being positioned for little or no spill-over to the global markets from a likely Greek debt restructuring/default.

In terms of central bank’s actions in response to a Greek default – and possibly Greek euro exit etc. – I think the answer should be: No response – or rather put in place policy rules that ensures monetary stability also in the case of shocks to money demand. An excessive increase in money demand in respond to a likely Greek default should of course be met by an increase in the money supply. Irving Fisher, Earl Thompson, David Glasner, Scott Sumner etc. all have nice ideas how to ensure that. The important thing is that any drop in velocity is met by a one-to-one increase in the money supply.

That said I see no reason to act in advance. Canada for example does not seem to need easier monetary policy. Neither do countries like Sweden, Poland, Austria, Turkey or Brazil etc. – so why easy monetary policy? Just announce a clear-cut rule on monetary stability so changes in V will be met by changes in M. That by the way goes for the ECB as well...

No special precautions would be necessary if the BOC switched from inflation targeting to price level targeting.

Agree Scott - made the exact same comment above. I think the important think is rules rather than discretion. And I seriously have a hard time seeing why this should be a major concern for BOC if the bank implemented price level or NGDP targeting - and even with inflation targeting there should not be much need to preemptive actions.

Lars: Greece isn't the problem. It's small, and as you point out, there's been ample time for market participants to hedge their risk. The problem is contagion. If Greece finds a solution where their debt is repudiated (be it default, debt forgiveness or what not), Ireland and Portugal will immediately want to exploit that same solution. If those countries also default in some form, will not Spain and Italy also want to avail themselves to these debt reduction mechanisms? The problem becomes very large, very quickly, and we end up with Nick's scenario, where one or more countries leave the Euro, a lot of banks go bad, the financial markets freeze, and countries are squabbling over who pays what.

Greece isn't the problem, it's the precedent that Greece sets that is the problem.

Well Kosta, why should an expected default/debt restructuring in Greece trigger contagion? Why hasn't it already happened if we all know "who is next"? The markets might not be completely efficient, but market participants are not totally ignorant. I am not saying everything will be fine - far from it - I just oppose the view that contagion is unavoidable as it to mean is based on an assumption that the markets are ignorant of the risks. Said, in another way if the market already price in Greek default - why should it not also have everything else priced in? As was the case with the Argentine default in 2002.

Lars, I do hope you're right about contagion not happening, but seeing the weekend's events with Italy, it looks like there's more than one cockroach in the Eurozone. I'm not entirely convinced by your argument that the market has correctly priced risk for all countries. Perhaps more importantly, if Greece defaults, does not the market have to reprice risk for the remainder of Europe given this event? Is not this repricing of risk the driver behind contagion?

Specifically, if Greece defaults, then the probability of either Portugal or Ireland defaulting increases substantially. Will not the market's reaction to this increase in default-risk force defaults in each of these countries? This in turn will force revaluations of risk in Italy and Spain, which could potentially force additional defaults. Lather, rinse and repeat until the Eurozone breaks up.

Well, given what's been happening today with Eurozone bond yields, it looks like something is going to be happening rather soon. And it's maybe a bit too late now to ask what we can do in advance to protect ourselves from the fallout. But Canadian and US stock prices fell. So it looks as though the market doesn't think we are insulated from Eurozone troubles.

You can't understand how a Eurozone collapse affects Canada without understanding what it is and why it happens.

This is NOT about the difference between inflation or price-level targeting, or rules versus discretion. This is about financial contagion and runs on banking systems. Modern macroeconomic models don't have such features. Using such models to analyze the effects of such a collapse (hello Scott and Lars) is a great way to show that you don't really understand modern macroeconomics.

This is also NOT about a Greek default. This is about a "Euro-zone collapse" which we can assume would include (at least) Greece, Portugal, Ireland, Belgium, Spain and Italy. (Lars: I'm not saying how likely this is -- I'm saying this is the definition of the scenario we are talking about.) Understanding the impact requires that we understand (a) the short-run impact on financial sectors around the world of their exposure to events in these countries, and (b) the medium-term impact of the economic linkages to these countries.

This is about a chain-reaction of highly-indebted Eurozone countries finding that (a) the markets are suddenly demanding higher yields on their debt, (b) at those yields, they can't service their debts, (c) knowing they can't service their debts at existing yields makes their debt increasingly hard to roll over, which feeds back into (a) and (b). This is a multiple equilibrium system; predicting which equilibrium you'll get in future is a mug's game. But as the odds of the bad equilibrium increase, we know pretty much what happens from the many previous examples (the MBA crisis of the early '80s was a nice example for those who remember it.)

Those government debt worries then stoke fears for any banking system thought to be holding government bonds. So we see deposits drain out of domestic banking systems into "safer" neighbouring states. (I'd hate to the governor of the central bank of Cyprus right now!) Banks then face a terrific liquidity crunch, but governments can't lend them money to fight it (they can't borrow, remember?)

When the bank run suddenly starts, the government is forced into action. They can try to buy time (days) by arranging emergency credit lines, banking holidays, etc. But the fundamental problem is a lack of capital in the banking sector; the government can find some way to recapitalize it or watch the system collapse.

At this point, the worry is that governments will abandon the euro "overnight". The scenario is that they (a) announce a new currency, (b) announce that bank deposits have been converted to the new currency, and (c) can now print as much as they need to recapitalize the banking system.

I'd go on, but this post is already much too long.....

So, suppose that a Eurozone collapse has happened. How does it affect Canada?

In the short term, there will be a global financial panic as everyone worries that their counterparties may have been exposed to lots of suddenly illiquid and impaired government debt. How bad will that be in Canada? Um.....bigger than the Asian crisis and smaller than the 2008 crisis is my guess. I'm guessing that the biggest Asian, US and UK banks will not have substantial exposures and I'm assuming that the German and French governments move aggressively to support their own banking system.

In the medium term, we get to worry about the macroeconomic effets. Canadian interest rates do not go up; we're a safe haven and there's lots of capital flight. Don't know about the exchange rate; the post-crisis slump in the crisis countries will surely weaken commodity prices which most would expect to weaken the CAD. My guess is that the biggest effect on the Canadian economy is through depressed natural resource prices and tourism revenues.....but that's just a guess.

Simon: your guesses are about the same as my guesses. Wish we could do better than guess though.

But you ducked the big question: what, if anything, can Canada do in advance to prepare? Or do we just wait and see, and hope the Bank of Canada acts quickly and decisively in response to circumstances to try to keep AD stable and financial markets functioning?

I suspect that the BoC will largely replay what they did last time around; offer backup credit facilities if and when interbank markets appear to be distressed. Make statements that they're ready to do more should conditions warrant. Then wait and see what else (if anything) is needed.

But you've been in Ottawa while I've been traveling in Australia and Europe over the last year, Nick. What do you think the BoC learned over the last 3 years that would cause them to do things differently next time?

That's the banking crisis response. The other question is how to handle the macroeconomic shock. With current interest rates, the BoC can't add very much stimulus. I like Brad DeLong's advice; when markets decide that they hate risk and you're perceived as a safe haven, it's a wonderful time to borrow long-term and invest. I'd hope for counter-cyclical fiscal policy (and the research I see says that increasing spending does more in the short-term than cutting taxes.) That means identifying "shovel-ready" projects now (or starting projects that can be scaled up if required.) Again, this is contingency planning; I'm guessing that the need will not be large, but the uncertainty is large.

They could also act now to try to beef up the regulatory capacity and authority over foreign-owned banks operating in Canada....but I doubt that is of macroeconomic importance.

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