Mr El Erian’s defence of Yanis Varoufakis is accurate, elegant and powerfully articulated. Yet I wish he would provide an answer to the following crucial question: Do German, French and Dutch banks have sufficient wherewithal to stand the adverse impacts of liquidity shocks that would be the inevitable outcome of a Greek debt relief?



In fact, recall that since the inception of the euro in 2001, mainly through leveraging of their equity capital, these banks bought an astronomical amount of Greek, Portuguese, Spanish and Italian sovereign debts. It is true that, the “troika” of the European Central Bank, the International Monetary Fund and the European commission has simply replaced the banks and the hedge funds as Greece’s creditors of her €300 billion debt, and it is also true that private investors are not now heavily exposed to Greek assets. But private banks are still holding astronomical debts of the other fragile European states.



Some economists assume that governments and international institutions are strong enough to cope with a Greek default. But are they strong enough to cope with any deterioration of Portuguese, Spanish, Italian and French finance? Such simplistic assumptions about the possibility of a trouble-free Greece’s debt relief ignore the fact that tax payers of Northern European countries are well aware of their implied tax burden and will not be prepared to allow these public institutions to just create paper money to save these unsustainable debt dynamics. The result would be an inevitable freezing of credit which would again adversely affect the European banks and with some lags its ripple effects will reach the North American shores.



As the ECB’s financial stability report, released this May, has stated “A continuing legacy from the sovereign debt crisis is a large and, in some countries, still increasing stock of non-performing loans. Further progress in removing impediments to the supply of bank credit – including faster NPL resolution – is necessary to improve credit conditions, which should be also supported by the ECB’s targeted monetary policy measures.”



The fragile stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. These measures have temporarily reduced stress and fragmentation in euro area sovereign bond markets resulting in very low term premia. But as the ECB report points out “Clearly, any implied deviation from long-term norms might very well prove to be transitory, so that it is important that investors have sufficient buffers and/or hedges to cope with any prospective normalisation of yields over the years ahead, either from global or from euro area-specific changes in financial risk sentiment.”



It appears to me that the window of opportunity for a global coordinated action for restructuring international finance is closing fast. When the time for a disorderly adjustment arrives, perhaps by this October, central banks will not be in a position to clean to the mess. Now is the time to pre-empt the upcoming crisis.

