About four weeks ago, I wrote a post on Greek eurozone exit scenarios. While I believe that Greece will eventually exit the euro zone, I think it is premature to expect this to occur now as there are many avenues for compromise. The posturing has begun though and elements of the German government are leaking Grexit as a viable option to the press. At this point, I see this talk as speculation more than substance. However, I do want to put down some thoughts on where this is came from and where it is heading. Contagion is going to be the biggest concern.
I am writing this on a plane to the West Coast right now. So I may not be able to be as complete as I would like. But the whole Grexit talk has exploded into the mainstream media due to a speculative story published by the German magazine Spiegel over the weekend that quoted sources in the German government saying that Merkel and Schäuble would allow Greece to exit the eurozone if no amicable compromise was in the offing. The Euro has plummeted against the US dollar as a result and crisis is now palpable.
When I write these things I like to go back and see what I was saying a few months (or even years) ago to get a sense on what has changed and to keep myself honest about how I am thinking about the situation. Let me do that with you here briefly because I think it could be enlightening as to why we are in a crisis and what we could expect politically. I am going to write this as I read the posts to keep myself as honest as possible here. So let’s start with the last deal that Greek made with the Troika in late 2012.
- 30 Nov 2012 post title: “Why the Greek deal will see the country through to 2014”. Here’s what I wrote:
“What’s clear from my own post chronology is that the Greek situation was inevitable given the fragility of the European banking sector and the negative economic consequences of the financial crisis. My January 2009 post on The Eurozone and the spectre of banking collapse makes that clear. However, what was not clear is how much the situation in Greece would deteriorate. I give Hugh Hendry credit for understanding that Greece was deeply insolvent as early as February 2010 and I see everything that has happened subsequently as makeshift responses to this insolvency, constrained almost entirely by political reasons and not economic ones. I think this is an important point because it highlights how deeply economics and politics are interwoven in crisis. While financial and economic crisis make plain unsustainable economic trajectories, political inertia and the commitment to previous economic policies will always mean that the full extent of crisis is not dealt with until the situation is almost near collapse.”
I wrote this just after Greece had entered into its 2012 deal with the Troika. In reading through the post, it strikes me as well-judged, especially the end paragraph:
“For now then, the Greek deal seems to fit the bill. It does not create an unnecessary domino effect that catapults Spain, Italy or France into crisis. And it does not force a public sector default with destabilizing political consequences. However, I expect Greek politics to radicalize as the economic situation worsens. And I expect a Greek re-default down the line, but this will probably not occur until after 2013. In the meantime, attention will shift away from Greece to the rest of the periphery and to France, where the situation is also becoming more precarious.”
- 22 Jan 2013 post title: “Grexit”. Here’s how this starts:
“I never subscribed to the idea that Greece was going to be expelled from the euro zone in 2012. However, my view on Greece is more pessimistic than most. Most policy makers in Europe would have you believe the euro crisis is over. It’s not.”
Here’s what I said will eventually occur:
“Bottom line: in Greece, austerity is going to be the policy of choice for the EU for some time to come. Eventually, after the contraction in GDP this engenders, we are going to understand that Greece’s public debt burden is still unsustainable as part of the euro zone. At the same time, Greece’s economy won’t exactly be firing on all cylinders. Faced with a choice of an interminable adjustment process or Grexit, I believe the Greeks will eventually choose Grexit, the key word being eventually.”
That’s where this is heading. Clearly we are seeing the interminable misery in Greece but Germany is still acting like the debt burden is sustainable and they are trying to force more bloodshed. It is not politically sustainable. This is why we are in a second crisis.
- 8 May 2013 post title: “Why I am bullish on Greece”. Here’s the explanation:
“Greece’s sovereign bonds outperforming was one of my ten surprises for 2013 three months ago. And with bond yields now falling below 10%, Morgan Stanley is getting onboard so I am not the only one recommending this trade. I would also posit here that Greek equities have been well beaten down and trade at low multiples based on low earnings, meaning that if recovery does take hold in Greece as I expect it to, then you will get a double benefit from earnings growth and multiple expansion.”
Nowhere in this post do I mention Grexit. But clearly, if I thought Greece would eventually exit the eurozone, I saw the uptick in Greece as temporary (like Abenomics was for Japan). And this was a very good trade for 2013.
- 21 May 2013 post title: “On Greece’s eventual exit from the eurozone”. Reiterating that after the uptick coms more pain in Greece. It’s simple:
The only chance Greece has of remaining within the eurozone is if it can pull of a huge economic resurgence that beats back the populist political wave which will almost surely spell exit as long as joblessness remains so high. I don’t see this happening without significant reform to eurozone institutions.
I have a number of subsequent posts that fill in some of the gaps but the tone is set from the four above. For example, I wrote on 6 Nov 2013 Why an eventual Grexit is still unavoidable. But it wasn’t until October that crisis became real again. See The rise in periphery bond yields is sovereign debt crisis, round 2.
Here’s the summary: Greece’s debt load has always been unsustainable given the lack of currency sovereignty in the euro area and the Maastricht 3/60 hurdle. I think most realistic observers recognize this. The question is how and when to cut the debt burden in real terms. And that is a political question. Europe’s institutional structure is inadequate and can only move paradigm because of crisis. In large organizations, paradigm shifts are usually progressive slow-moving shifts instead of wholesale abandonment of existing and staked-out political positions. That made a long depression in Greece inevitable because of the Maastricht hurdles on debt and deficits and the limitations of ECB policy. Therefore, my sense from the very beginning here was that there were no viable political solutions that aligned the interests of Greece with those of Germany before an economic depression and the resulting political radicalization in Greece forced the issue.
The post I wrote last month gave four options. The first option in which Samaras wins the vote is now gone. Now that Samaras is gone, Syriza likely will gain power, though that could change if we have a calamitous market period. The second option is the best case scenario: “where we see minimal commitments to reform to labour markets and pensions. We see tax collection and corruption promises too and this satisfies the Troika. But then we have to get a debt restructuring as well. And that is the sticky wicket here because the ECB is loath to take a loss. A deal that lengthens maturities and lowers rates is the only way we get there. But is that even legal under the ECB government financing rule? I don’t know. The institutional challenges here are big.” I still see this as possible. Olli Rehn has raised this as an option. The last two scenarios are default and Grexit. And they are catastrophic.
The concern here is that, again, everyone is talking about Grexit, the worst option. While I don’t believe the German government sees a Greek default and eurozone exit as a first choice, they have clearly tired of this whole affair. The only reason German Chancellor Merkel compromised on Greece in 2012 was contagion. And this is well-documented in the German press. Without contagion risk, you are going to see different tactics from the Germans. And the Germans really think contagion from a Greek eurozone exit could be managed. So they are playing hardball.
Right across the political spectrum Germany thinks the Greeks need to do more. Finance Minister Wolfgang Schäuble says, “if Greece chooses another way, it’s going to be tough.” Former Green Party and leftist Foreign Minister Joschka Fischer says “any renegotiation [of Greek debt] would unleash a political avalanche in the southern EU that would sweep away austerity and reignite the eurozone crisis,“ strongly indicating he believes austerity is a must. And of course, Fischer is saying there can be no debt renegotiation as well. This is a left-leaning politician. Almost all the leading German politicians are saying there will be no compromise on Greek debt obligations. Only the Left Party says differently. Moreover, the Germans think Greece is now a separate case and are not willing to show room for any concessions as a result.
That is the genesis of the Spiegel article. I am certain the article represents the thinking in German policy circles, at least directionally. The article mentions the ESM as a backstop which German officials believe will stop contagion. But there is also the ECB and quantitative easing as a buffer to contagion, especially for Spain and Italy.And so we are in a dangerous place where the Germans believe their best alternative to a negotiated agreement is Grexit. That makes them a very difficult negotiating partner and raises the potential for policy error and crisis.
This sets up very bad scenarios for two reasons. First, it isn’t at all clear contagion can be stopped. Italy in particular is in a bad way and given the Maastricht framework, there is no reasonable chance of growth there anytime soon. Italy has not grown at all since the euro was introduced. It is in a permanent malaise that has government debt going higher and higher. If Greece looks like it will default and Germany wants it out of the eurozone, all we need is one GDP contraction in Italy to start the contagion. Second, contagion isn’t the real problem anyway. Internal devaluation was always a fool’s errand that ensured depression in the periphery. External devaluation as in the 1930s would move the periphery back to competitiveness much more quickly. So the real problem here is that Greece could exit the eurozone and do reasonably well after the initial trauma. And so redenomination risk for Spain, Portugal, Italy and others would mount. I believe this would put upward pressure on the euro because a rump euro would appreciate vis-a-vis the countries exiting. That would be toxic for eurozone growth and make the situation that much more difficult.
Europe is in crisis. There’s no doubt about that now. A lot of people have convinced themselves that contagion is not a risk and, therefore, Greece can be taken to the woodshed. I think negotiating from the belief that contagion will be minimal limits policy choices and increases the potential for policy error and a full-blown crisis. Right now we are just in the posturing stage but the Grexit talk is real. And Grexit will lead to full-blown crisis one way or another.