Archive for October 19th, 2011

A Greek Tragedy

All eyes are on Greece as the fate of Europe’s economy and the European common currency is on the line.    The IMF and G20 states have pledged to prevent an economic collapse in Europe which would, undoubtedly, have severe ramifications for the US.   As one German friend of mine joked “Greece, the cradle and the grave of western civilization.”

The plan looks good on paper.  Greece borrowed an unsustainable amount of money and now must cut spending and raise its taxes to balance the budget.   Meanwhile the EU and IMF will intervene to both help stabilize Greek’s finances and recapitalize banks that may be vulnerable to Greek default.    It should work, in theory.

In practice, though, things are messy.   One problem is Greek domestic politics.  Angered by the corruption and political incompetence that brought them to this point, the Greeks are engaged in a two day general strike that has essentially shut down the country.   125,000 protesters in Athens, Thessaloniki, Patras and Heraklion showed anger at the government and its austerity plan.   People’s incomes are declining in real terms, and the mix of spending cuts and tax increases make the recession even worse.     Calling the cuts “unfair, anti-social and inefficient” they demand the country reject the austerity proposals.  3000 police classed with 70,000 protesters in Athens, mostly peacefully but not always.

The Greek government is in bind.   They need to cut debt; their debt load is unsustainable.   The bond markets still show a 24% interest rate on Greek bonds, meaning that any more debt would be extremely costly, and would drive up bond yields further.   Greece cannot simply go along as it has been.   Moreover, austerity is the price the EU is demanding to help them avoid default and stay in the Eurozone.

The Greek government is thus implementing the austerity measures out of necessity.    However, they could decide not to, and simply accept default.      If Greece defaulted, the pain would shift to the banks of Europe which could fail unless recapitalized with government funds.   The danger would be that the Greek default could lead to a dumping of Spanish, Italian, Portugese and Irish bonds, creating a crisis far greater than the Greek default.  As I noted awhile back, contagion is the real danger.

To be sure, a Greek default would make it a bit easier for the country to dig itself out of its hole.  There would still need to be spending cuts and tax increases to get a balanced budget, but they wouldn’t have the burden of so much debt to repay on top of that.  That is the path favored by many protesters in Greece; bankruptcy is welcome if debt is weighing you down.    Any default, however, almost ensures contagion.     It might help the Greeks, but ignite a global crisis.

To try to minimize the risk of contagion, a Greek default would probably be coupled with a removal of Greece from the Eurozone.   Letting a country default while maintaining the Euro as its currency is something that the Europeans cannot allow.   If Greece leaves the Eurozone, the result would be inflation and devaluation of the Drachma.   Since new Greek bonds would have very high interest rates (especially given the certainty of inflation), Greece would find borrowing money nearly impossible, and still would have to institute austerity programs.   That would push Greece back into crisis, and serve as an example to others the potential cost of leaving the Eurozone.

The EU could then try to prevent contagion by making it clear that defaults by other states are not likely given the cost it would entail to have them leave the zone.     Seeing what happens when set adrift from the Euro, governments in countries at risk would be more motivated than ever to engage in austerity politics.   After all, those in power listen to the moneyed elite more than the people on the street.

For Greece the devalued drachma would lead to increased trade competitiveness and lure in tourism.   Over years they’d stabilize the economy and potentially be able to rejoin the Eurozone in a decade or two.   No doubt the EU would by that time enforce the criteria strictly — Greece never should have been allowed to join in 2001.  Greece could not leave the Eurozone without defaulting.   Otherwise the depreciating drachma would mean that Euro denominated debt would grow dramatically simply do to changing exchange rates.   So leaving the Eurozone must be coupled with default.

For the EU the dilemma now is whether they should continue trying to save Greece, or focus instead on recapitalizing the banks and defending against contagion.   They have already spent so much money to stabilize Greece that switching tactics would be seen as an admission they got it wrong on the tax payers dime.   That money would have simply been thrown into a pit, bringing nothing of value.

That leads them to want to see this through to the end.   Yet it’s like getting your car repaired over and over — at some point you have to eat the loses and just buy a new one, realizing you should have done so at the time of the first repair.   If Greek protests grow and the government becomes unstable, default may be inevitable.   In that case it would again need to be coupled with leaving the Eurozone to avoid contagion.

Watching this play itself out is fascinating, even though I think most people are oblivious to the implications this drama has for the rest of the world.     Where once the fate of Europe was decided in war rooms by generals with maps spread out tracking troop movements and supply lines, now it’s in board rooms with business and political leaders looking  at spread sheets and bond yields.

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