ECB lending to Greek banks rose by a further €7.2 billion in March, to stand at €67.1 billion, according to Bank of Greece balance sheet statistics released yesterday. Banks, additionally, withdrew €3.6 billion from their reserve accounts at the central bank, implying an increase in their net borrowing from the ECB of €10.8 billion – see chart.

The rise was needed to cover a continuing loss of wholesale and retail funds – likely to have accelerated this month. Foreign banks withdrew a net €8.2 billion from the Greek banking system in March, while deposits from private non-bank residents fell by €2.6 billion. These deposits declined by €11.3 billion, or 4.7%, during the first quarter. Foreign banks have an aggregate net "short" position vis-à-vis the Greek banking system, with borrowing exceeding loans by €26.6 billion. This partly counterbalances their exposure to Greek government bonds.

Bank of Greece lending to Greek banks remains below Central Bank of Ireland lending to the Irish banking system – €82.6 billion in March. As a proportion of banks' assets, however, support is the same – 13.4% versus 13.5%. The Greek loan of €67.1 billion amounts to 27% of annual GDP, based on the OECD's 2010 forecast.

Greek banks' ability to access further ECB funding may be constrained by a shortage of acceptable collateral. Their holdings of securities excluding shares and derivatives stood at €98.1 billion in March but a significant portion may fail to meet ECB eligibility standards – government securities, mainly Greek, amount to €42.7 billion. ECB rules also allow advances against non-marketable assets, suggesting that banks can borrow against their €9.7 billion of direct loans to the Greek government and possibly even part of their €192.5 billion domestic private-sector lending book. At some point, however, ECB hawks are likely to baulk.

Suggestions that the rescue package currently under discussion should include a restructuring of government debt (see Roubini / Das in today's Financial Times) fail to address the consequences for the banking system. A debt write-down would wipe out banks' capital and cut off their access to ECB funding. Any package, therefore, would need to bail out the banks as well as the government, probably making it prohibitively expensive. 

Budget forecasts imply that public spending ("total managed expenditure") will fall from 48.1% of GDP in 2010-11 to 42.3% in 2014-15. The consensus view is that a cut-back on this scale will cripple economic growth and entail huge public-sector job cuts. Evidence from the 1990s suggests otherwise.

TME fell from 42.5% of GDP in 1994-95 to 37.2% in 1998-99 – a 5.3 percentage point reduction over four years versus the 5.8 pp cut envisaged by current plans. GDP growth averaged 3.3% per annum over 1995-99. This resilience, moreover, did not reflect offsetting monetary policy loosening – Bank rate was little changed between the start and end of the period.

Pessimists claim that public-sector jobs were slashed. They cite Labour Force Survey statistics showing that public-sector employment fell from a peak of 6.01 million in 1991 to a trough of 5.16 million in 1997, a reduction of 840,000. These numbers, however, are misleading because they fail to adjust for privatisations and outsourcing. An alternative measure unaffected by public-to-private-sector transfers is the Workforce jobs series covering public administration, education and health. This fell by only 130,000 – see first chart.

Rather than slashing jobs, the pay bill was contained by limiting wage rises. Public-sector earnings growth lagged inflation and was much lower than in the private sector – second chart.

Minimising the pain of fiscal adjustment requires policies to promote offsetting private-sector expansion. Rather than spending cut-backs, the key risks currently are tax rises that damage incentives to work and invest and excessive financial regulation that restricts credit supply needed for a sustained economic recovery.

Avoidance of a Greek default requires not only a large expansion of the proposed official aid package but also a commitment by the ECB that it will continue to lend to banks against Greek government debt in unlimited size even if other credit agencies follow S&P in downgrading its rating to junk. A run on the Greek banking system is already under way and will accelerate without this commitment.

In an article in Monday's Wall Street Journal, Daniel Gros of the Centre for European Policy Studies suggested that Greece could default without abandoning the euro. Greek banks would lose access to ECB support and the country's status "would resemble that of Montenegro, which adopted the euro as legal tender without officially being a member of the single currency zone". According to Mr. Gros, "the spanner in the works would ... be contagion", with default likely to "trigger speculative attacks on government debt and financial institutions in systematic countries like Spain and Italy".

In reality, any government attempting to default without simultaneously exiting EMU would be unlikely to survive. Greek banks would become insolvent, as Mr. Gros acknowledges, and could not be bailed out by a bankrupt government. Bank depositors would suffer large losses, while credit would freeze. A resulting economic collapse would undermine any post-default fiscal reconstruction plan.

The only viable escape-route would be EMU exit and recreation of a national currency, which the central bank could then print and use to recapitalise the banking system – the policy approach of the UK authorities during the financial crisis. The new currency, of course, would trade at a large discount to the euro but the aim of its creation would be to provide the means to rescue the monetary system rather than boost the economy via an improvement in Greek competitiveness – the initial devaluation benefit would probably dissipate rapidly in rising prices.

The Bank of Canada last week became the first G7 central bank to signal policy tightening by abandoning its "conditional commitment" to maintain the overnight interest rate target at 0.25% until mid-year. This surprised economists but had been foreshadowed by a recent rise in short-term bond yields – see first chart.

The consensus view is that Canada represents a special case because of its healthier banks and budget finances. Policy-makers in other G7 economies, it is argued, will be slower to tighten because growth will be constrained by restricted credit supply and fiscal tightening.

The differences, in fact, are not so great. Loan officer surveys suggest a similar improvement in credit conditions in Canada and the rest of the G7 – second chart. Canada's fiscal position is better but it is still running a structural deficit of more than 3% of GDP, according to the OECD. Other G7 countries, moreover, are hoping to delay wielding the axe until 2011 or beyond. The Bank of Canada, like other G7 central banks, believes that domestic economic slack is substantial. With core inflation below target and the exchange rate strengthening, policy tightening is arguably less urgent than in the UK, where the Bank of England is losing control of inflationary expectations.
 
This suggests that either other G7 central banks will soon follow the Canadian lead or else the Bank of Canada will be forced to backtrack, perhaps because of a surging currency. A rise last week in US and UK short-term bond yields is consistent with the former scenario – first chart – but a policy shift could be delayed if the Eurozone debt crisis continues to escalate.

The US monetary base, comprising currency in circulation and banks' reserve balances at the Fed, contracted by a further 1.4% in the week to Wednesday and is now 7.3% below its February peak – see chart.

As previously discussed, the fall reflects a build-up of cash in the Treasury's accounts at the Fed, mainly due the "supplementary financing programme" (SFP), involving the Treasury issuing additional bills and depositing the proceeds at the central bank. The resulting reduction in bank reserves has contributed to a recent firming of short-term market rates.

The liquidity withdrawal suggests that the Fed is in the early stages of a tightening process that could result in a rise in official rates this summer. If so, the statement issued after next week's policy-setting meeting should be less dovish, qualifying the commitment to "exceptionally low levels of the federal funds rate for an extended period".

The SFP is now up to the targeted $200 billion, implying no further negative impact on the monetary base. If the Fed wishes to continue to drain liquidity, it must either request an expansion of the programme or begin to conduct reverse repo operations or auctions of term deposits, as described in a February speech about exit strategy by Chairman Bernanke.

GDP is provisionally estimated to have risen by only 0.2% in the first quarter but this is likely to be revised up, as were the prior three quarters – fourth-quarter growth was raised from an original 0.1% to 0.4%.

The current estimate is overly reliant on data for January and February, when the economy was hit by bad weather. National Statistics has assumed that GDP rose by 0.3% between February and March – see chart – but this may underestimate the catch-up effect. An upward revision is also suggested by labour market data and business surveys, showing a further rise in capacity utilisation last quarter.

GDP is currently estimated to have been 0.3% lower than in the first quarter of 2009 but this decline is explained by lower North Sea production – gross value added excluding oil and gas extraction was up by 0.1%, the first annual gain since the third quarter of 2008.