On my disbelief over the Greek exit chatter

I just re-opened the thread on "How and why Greece will leave the euro zone" because there has been so much chatter about a Greek exit. I am still a bit in disbelief that Europe would allow the Greek economy to crumble so much thy would be forced to exit. You have to think contagion risk from a Greek exit is still pretty high. That tells me Europe is bluffing about cutting Greece off. But politicians sometimes get backed into a rhetorical position that takes on a life of its own. So bad things can definitely happen.

Here’s the thinking behind an exit:

A Greek exit from the euro zone would be traumatic, yes. Nevertheless, Greece’s fiscal path is still not sustainable even after the default and haircut. They have over 100% debt to GDP and a very large primary deficit. Contrast that to Spain which has under 70% debt to GDP but a high primary deficit or Italy with its high debt to GDP and primary surplus. And they still can’t collect the taxes they need. Look at this sad story on taxes from FT Alphaville.

Moreover, I noted in my Greek exit piece as well that even with Greece fulfilling the Maastricht criteria after a haircut down to 60% government debt to GDP that includes the ECB, Greece has a long way to go on structural reform to stay competitive. Right now, Greece is simply not competitive as part of a currency union with Germany. I don’t think it ever will be.

Greece’s banks have been completely shut out of credit markets and are wholly dependent on the ECB. And since the ECB simply cannot to improve the banks’ liquidity position with the government hopelessly bankrupt even after a massive default, some ECB policymakers are starting to think Grexit.

A Greek exit from the euro zone would damage confidence in the single currency bloc but not necessarily be fatal, Irish central bank chief and European Central Bank policymaker Patrick Honohan said on Saturday.

Honohan is not an uninterested party of course. He wants to prevent the Greek situation from spilling over into Ireland and the easiest way to do that is to allow Greece to exit while doing everything humanly possible to support those countries that remain: we’re talking ECB backstops, eurobonds, EuroTARP, etc, etc.

From a Greek perspective, a Greek exit from the euro zone is the only way Greece can gain control over its taxes, banking and whole monetary system.

Simon Jenkins puts it well:

An estimated £28bn in euro notes is said to be hidden in Greek mattresses, awaiting release into the economy via a devalued currency. There will be no recovery until this happens. The bullet must be bitten. Banks must go on holiday and come under state control, while debts are redenominated in drachmas. Lenders, savers and importers will take a mighty haircut. Many of the wrong people will suffer. But that is what happens when a country lives on tick.

Only then can this nightmare begin to end. Only with the decks cleared of debt can Greece, likeIceland and Argentina before it, start rebuilding its economy at a realistic rate of exchange. One thing only is certain. A year on, Greece will be on the mend and everyone will wonder why exit took so long, and why anyone believed the fools who said it would be an inconceivable calamity.

The delay in acknowledging this reality is the true calamity. Already the bears are gathering round Spain and Italy, not because their economies are like the Greek one but because markets can read election results as well as they can read riots. The austerities required to bring all the eurozone economies into cost equilibrium with Germany are breaking the back of democracy, and it is Greece that is distracting attention from remedies.

But again, you would need to see a massive infusion of liquidity into Europe if Greece exits. Sober Look outlined some of Greece’s external liabilities that would necessitate this approach.

  • The May 2010 Eurozone/IMF loan: €110 billion
  • The October 2011 Eurozone second loan: €130 billion
  • The Bank of Greece TARGET2 liabilities to the Eurosystem: €104 billion
  • Greek banks’ liabilities to other nations in the Eurozone: €130 billion
  • Greek new government bonds held by non-Greek Eurozone/EU banks: €25bn (roughly; possibly more)
  • Plus Greek corporate and household debt held by non-Greek Eurozone banks

If Greece left the euro zone and the country and its banks and companies defaulted on loans, these liabilities would boomerang onto euro zone creditors.

So, this is a really damned if you do, damned if you don’t kind of situation. The Greeks want to be a part of the euro. There is definitely prestige to their being in on it. And being kicked out would be a loss of face.  But the euro is killing their economy. Being part of the euro means another decade or more of economic depression. And that’s simply not politically sustainable. The sooner the Greeks give up on the euro, the quicker they can return to health. The Germans don’t want to be the bad guys here. After World War 2 they have wanted their role to be the good guys, the ones holding Europe together economically and politically. But their insistence on austerity during an economic downturn is simply not realistic given the high debt levels and macro outlook in the periphery economies. They risk precipitating a Great Depression.

I am still in disbelief over the possibility that Greece could exit the euro but it is clear it will happen eventually, the question is the timing. And judging from events on the ground in Europe, the sooner Greece leaves, the better for Greece and the rest of the euro zone. The problem is the political will to do the things necessary to contain the fallout from a Greek exit. EuroTARP is about all the Europeans are prepared for – and that’s just for Spain, not for the rest of Europe.

Bottom line: regardless of whether Greece leaves or stays, the risk of serious policy errors is increasing significantly in Europe. The political about-face necessary to prevent contagion is just too great to believe we can get through the next several months without large policy errors. This is certainly negative for risk assets. So my preliminary call is to cut weight on Equities and move more into cash and non-euro area government bonds until the Europeans make their next big move.

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