The probability that Greece is out of the euro in the next 2 months has increased to high levels. The risk of contagion to Spain and others is significant. This is clear to EU policy makers, which means they ought to be thinking about the response, which in this case needs to be a big and visible enough bazooka to stop individual depositors in Spain from following the rationale of bank runs. That requires a bazooka, in crisis management lingo. This time, the bazooka would be the ECB guaranteeing deposits across the EU. A deposit guarantee is a serious step in the direction of integration, one that most countries would not want to take in almost any scenario, but one they will have to accept for the sake of the euro.

The elections in Greece put the extreme left in the driver’s seat, which can be interpreted to mean that the Greek people want the euro but reject austerity. The traditional political parties in Greece had negotiated the austerity programs with the EU, only to then lose all popularity. It can also be seen as the EU imposing those programs on them, and the Greek people now rejecting those parties that caved in those negotiations. Now Mr. Tsipras (Syriza Party) decided to play a game of chicken with the EU, telling them Greece wants the euro with less austerity, and that the EU has a lot to lose if Greece leaves. The EU exposure to Greece in terms of bailout packages, Greek debt and liquidity provision is now higher than 250 billion euros and climbing as fast as deposits fall in Greek banks. It is difficult to see how the EU caves in a game of chicken with an emerging extreme left political party. Moreover, it is difficult to think the ECB and the EU will see the exposure to Greece go through 300 billion euros as they continue to fund the run on deposits in Greece (the ECB is providing liquidity to the Greek Central Bank through the ELA facility).

Policymakers in the EU have to be thinking how to respond to a Greek exit or collapse. The problem to address now is not only how to satisfy bond investors in financial markets, but depositors in the streets of Spain and other countries. The bailouts or Fiscal Compact were the responses to previous episodes of the euro crisis, and clearly were not enough to calm markets. This time they need to also convince the people in these countries not to run on deposits. They need what is usually called in crisis management as the bazooka. There is hardly any other one decision that all people will understand and likely respond to than a full-blown guarantee on deposits by the ECB. There are not many other bazooka options; this is most likely the one.

There are at least 2 very big problems with this scenario. On the one hand, the EU has a very mediocre track record in understanding the extent of the crisis at hand and getting together on time to produce an appropriate response. Secondly, a guarantee on deposits by the ECB is a very serious step towards integration that eliminates each country’s control over its banking system, as it would then have to be centrally regulated by the ECB or some other EU body. Most countries would hate to see ECB or EU bureaucrats telling their banking system what risks they need to reduce or why they need to increase capital given their traditional practices. These two are not simple obstacles to what most likely should be the next step in this never-ending crisis.

In sum, the June 17^th Greek elections and the game of chicken being played around them between the EU and Greek’s Syriza Party would continue to feed the run on deposits in Greece, and a risk of the same in other countries. The fear of a disorderly exit of Greece from the euro, the potential contagion effects, and how soon an appropriate response would materialize should continue to produce severe market volatility. On the other hand, the EU and ECB have taken some meaningful decisions, and once a deposit guarantee is put in place, we are bound to see markets recover as they have done since the ECB changed its approach back in December (which in reality had started in early October with the policy debate that led to the first LTRO auction and the expansion of the ECB balance sheet). Thus the dilemma on portfolio allocation, as we see medium-term opportunity but short-term volatility. Our portfolios have higher cash levels, low equity and commodity exposure, but not as low as those who only see the short-term risks.