Greece’s Pieces, and Europe on the Ropes

It’s always fun writing about fast moving events, as what you’ve written can be obsolete before it makes it to print. With that in mind, I think it makes sense on occasion to consider the future, rather than commentate on what is occurring.

Photo by FrangiscoDer / CC BY-SA

With the landslide rejection of further austerity measures by the Greek people in last weekend’s referendum, the issue has come to a head. Greek Prime Minister Alexis Tsipras is now firmly skewered on the horns of a dilemma:

Either move to push through a new German-approved austerity package similar to the one his people just decisively rejected, or oversee a potentially catastrophic national default and ejection of his country from the Eurozone and the EU.

As I have previously written, I see ‘Grexit’ as an inevitability at some point. Market movements to date have been remarkably benign, suggesting the event has been at least partially priced in. The posturing of skeptical EU negotiators, led by German Chancellor Angela Merkel, further suggest that its occurrence in the near term is something the EU is economically and politically prepared for. In short, Greece is looking like it has overplayed its hand.

Statistics are nobody’s idea of fun, but bear with me, because context is required here to grasp what all the fuss is about.

Greece’s current government debt (this is just public debt, it excludes corporate debt, consumer debt, mortgages and off-balance sheet liabilities such as pension entitlements) currently stands at 175% of its total GDP.

This is up from roughly 150% at the beginning of the crisis five years ago, and compares to 130% for Italy, 105% for the United States, 68% for Germany and 25% for Australia (yes, hard as it is to accept, government debt in Australia is not a big problem).

Yet it also compares to over 220% for Japan, which continues to fund its deficits without trouble.

Japan can fund its deficits for two reasons. First, its private sector has an enormous reserve of savings willing to be invested in government bonds at incredibly low yields. This works partly due to certain cultural tendencies of the Japanese with regard to money and savings. The other side of that equation is that for decades Japan has existed in a low-inflation, and at times outright deflationary environment where the pittance the bonds do yield is at least preserved and in some cases enhanced by the direction of living costs.

The second, and more potent reason is that when push comes to shove, Japan can print its own currency. It is unpalatable for creditors to see their returns debased in this manner, but it does trump an outright loss of capital.

Greece enjoys none of these privileges. It does not have enormous reserves of savings in the private sector. It does not have a cohesive cultural tendency toward saving and financial conservatism. And it cannot even control its own monetary policy, let alone print its own Euros. This obviously also applies to every other country in the Union.

What is totally unknown right now is what the precedent will mean for the future of Europe. There are several schools of thought, two of which make sense to me.

One is that Greece will become something of a sacrificial lamb. An example to other members with shaky finances of what happens when you fail to toe the line and meet your obligations.

Under this scenario, countries such as Spain, Portugal and Italy will do as Ireland ultimately did: See the light, tighten their belts, and get their houses in order. For the record, Ireland shaved almost 10% from its debt ratio between 2013-2014, so there is some credibility to the idea.

It follows that confidence will then be restored, the staggering mountain of debt under which these countries are buckling will be gradually paid off, and all will be well.

The second school of thought is a little more apocalyptic, and goes something like this:

With the implicit German guarantee gone, peripheral European nations will experience financial contagion from Grexit. Their banks (along with everyone else’s) will suffer heavy losses on their Greek debt holdings, possibly requiring a recapitalization by their respective governments. Government debt will continue to rise, as will financing costs as debt markets begin pricing nations on their own economic merits rather than lending on the assumption that Germany and the EU will indeed ‘do whatever it takes’.

At this point, with the Greek precedent established, nothing less than an explicit debt union and blanket guarantee of the debts of all EU members states will satisfy markets in the event of another crisis.

That, if it occurs, would pose two very obvious problems. First, moral hazard would tempt reckless borrowing by the economically weaker states, effectively repeating what caused the crisis in the first place.

Second, the German public is unlikely to stand for it, which brings us full circle to the problem the Greek crisis (and the public referendum) has exposed: That yielding monetary sovereignty while maintaining political sovereignty is a tough sell in good times, but it becomes a nightmare in bad times.

I fall somewhere between these camps. In my view Grexit will not cause immediate financial contagion. Brussels has spent a great deal of effort building firewalls against the event since its spectre was first raised in 2010. The question is, what does the precedent say about the supposed irreversibility of EU membership? What will it mean domestically for nations where political parties explicitly in favor of leaving the EU are already gaining traction in the electorate?

Contagion from Grexit may not in fact be financial. It may be political.

My expectation therefore is that regardless of the short term outcome, the long term future of the European project is not good. As the greater EU collectively comprises a greater component of the world economy than the US, this matters to everyone.

While mulling it over, consider this: How happy you would feel if the rate on your mortgage increased during a domestic recession because Australia was in a multi nation currency union dominated by, say, China? Two closely related economies, Australia and New Zealand, haven’t seriously considered sharing a currency for this very reason.

That, unfortunately, is the problem the 19 very different members of the Eurozone are now staring down the barrel of.

By Aran Dunlop

Aran Dunlop is an ex-international money marker trader who was responsible for billions of dollars of bond trades. He now resides in Florida, and works closely with Steve McKnight, sourcing properties for the Passive Income Fund.