May 27, 2012

Greece and The Future Of The Euro: Humpty Dumpty Sat On a…

by Hal Gershowitz

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The Euro Humpty Dumpty (17 of 27 EU countries tied to the Euro) is not comfortably perched on, shall we say, the EuroWall.  Euro Humpty Dumpty is falling, and the only question is whether it can be gently caught before it hits the ground, in which case all the king’s horses and all the king’s men will never put it together again.

In years gone by, a common answer to a very difficult question was often, “It’s Greek to me”.  With respect to understanding the best way to navigate through the financial imbroglio on the Aegean, we suspect it’s Greek to just about everyone. Perhaps in the long run Greece leaving the Euro may, in fact, be the least worst option facing Greece…if not the rest of the EuroZone as well.  We don’t underestimate the turmoil that would accompany a total Greek default and the country’s exit from the Euro, but nor do we underestimate the turmoil that will be caused by prolonged and repetitive “haircuts” administered by the barbers in Athens, Brussels and Frankfurt. It is not likely that the politicians and bankers in Europe are going to be able to finesse a soft landing in this gathering storm, which, given the growing political unrest, is now propelled by an ever-growing tail wind.

Too many EU countries have been spending too fast and borrowing too much, while earning or collecting too little.  No one lends money, or continues to lend money, to spendthrifts once it seems certain that they have no ability nor, in some cases, any intention of ever paying off their debts.  Furthermore, there is a limit to how much pain hard-working, responsible citizens of one country are going to tolerate in the service of those in another country who they see as indolent and irresponsible.

Powerful voices in Athens are campaigning hard for default and daring the EU to expel Greece.  The central bankers of the ECB, on the other hand, are flying by the seats of their pinstriped pants.  The price of admission to the Euro Club was that each member country had to follow certain rules of fiscal responsibility with the understanding that there would be no bailouts.  The European Central Bank was to be there to guard against inflation, but definitely not to be a banker of last resort.  Well, those rules are now in tatters.  In fact, with respect to Greece, those rules were in tatters from day one. Greece has never been in compliance, notwithstanding their books that were cooked to suggest otherwise.

The real issue is whether the very rational fear of contagion to other EuroZone countries is most likely to be realized with Greece remaining appended to the Euro or with Greece on her own.  We do not pretend to know, with any certainty, the answer to that question, but we suspect no one else does either.

Here’s what we do know. In exiting the EuroZone, Greek citizens would be traumatized as bank accounts were frozen pending the distribution of new drachmas worth but a fraction of the Euros that depositors had previously entrusted to their banks.  Some banks, already weakened by successive haircuts in their sovereign debt portfolios could fold as their depositors began pulling funds out of banks in anticipation of a Greco-Euro divorce.

Almost no one would be deemed credit worthy, even if there were banks in a position to lend.  Denied of credit, business growth would remain a thing of the past for a long, long time, and many businesses would most certainly fail. Because the value of the new drachma would plunge relative to the Euro, prices and wages would have to be adjusted upward, which could further cripple Greek exports.  Unemployment, already very high, would soar even further. The government would have no choice but to impose strict fiscal discipline in order to regain access to credit markets, thereby increasing the likelihood of serious civil disorder.  A very bleak picture, indeed.

Meanwhile the remaining members of the EuroZone would be scrambling to keep the Greek calamity from spreading. Whatever Greek loans were still on the books of other European creditors would be wiped out overnight or paid in drachmas that creditors would be reluctant to accept.  According to Bloomberg, somewhere upwards of a half trillion Euros are owed by Greece to banks and businesses throughout the Eurozone. Rather than allow these banks and businesses to collapse Governments would have no choice but to (one way or another) bail them out, thereby referring the pain to European taxpayers.  French banks and businesses are believed to have particularly high exposure to massive Greek default.

At this point, depositors in other European countries, especially the weaker ones or those with very high debt to GDP ratios such as Spain, Portugal, Italy, Ireland, and, perhaps, France might begin pulling their Euros out of banks, doubting the integrity and stability of their financial institutions.  To forestall such an eventually, there would be an immediate need for the fittest of the European countries to guarantee these deposits.  This burden would fall on a handful of solvent countries, particularly Germany.  The resulting turmoil would inevitably spur political challenges to those in power from both traditional opposition parties and new fringe parties that would be certain to spring up.  The cost of borrowing could go through the roof throughout Europe.

This bleak scenario, once unthinkable, today informs the thinking of every central banker and government official in Europe.  One strong Greek leftist party that made a strong showing in the recent elections (Syriza) dares the EU and the ECB to cut Greece off.  It’s a bluff we doubt the ECB would call.

Instead, one alternative might well be for the ECB (think mainly Germany) to become the guarantor of virtually all EuroZone debts and deposits. That’s an alternative that would likely cost German Chancellor Merkel her job.

Another proposal is for the EuroZone nations to issue Eurobonds, whereby (theoretically) risk is shared and the aggregate strength of the entire EuroZone stands behind the debt, thereby lowering interest rates for the weaker countries (while increasing rates for the wealthier countries).  One problem with this proposal is that such mutual risk sharing is prohibited by the founding Maastricht Treaty, and for good reason.  However OECD Chief Economist Pier Carlo Padoan told Reuters as we were completing this essay that the time was ripe to begin thinking about introducing Eurobonds jointly underwritten by Euro nations.  Reuters also noted that New French President Francois Hollande is also eager for the Euro area to begin talking seriously about such bonds.  Germany, according to Reuters, remains deeply opposed to the idea out of concern it would be tantamount to wealthy countries footing the bill for countries that overspend in the absence of more oversight of fiscal policy from the EU.

“The reason Eurobonds are seen by some as a problem rather than a solution is because this is the old problem of Europe, and mutual trust is not strong enough,” Padoan said. “We have to be very serious and ask ourselves which are the institutions that could guarantee enough mutual trust to think of ourselves as one, not as a group of countries.” While the stronger nations (again think Germany) have, in the past, opposed the issuance of Eurobonds, times change and it is viewed by a growing number of European countries as the most appealing alternative.

At first blush, doing whatever is necessary to keep Greece afloat might seem the way to go, but only if a case can be made that Greece can begin growing again.  Without significant economic growth, Greece would become a permanent ward of the EU or the ECB, a politically implausible circumstance.  Economic growth, however, is not likely as long as Greece’s debt to GDP remains well over 100%, its labor force maintains an abysmal rate of productivity and few people pay the taxes they really owe.  If there is a serious plan to remedy these bleak realities, we haven’t seen it.

There is a flaw, perhaps a fatal flaw, inherent in a EuroZone tied to a single currency. The EU is not one people indivisible, nor does it consist of one people united by a common raison d’être, or a common work ethic, or a common tax structure, or by a common budgeting process.

It was, for several years, very seductive to judge the EuroZone (and the Euro) based on its brief six-year history during a very prosperous time before the run up to the world financial crisis, when economies were growing, exports were strong, tourism was robust and debt was cheap.  That has all changed now and the unity of this union is being severely tested.  The smart money is wagering that the EuroZone members will do whatever they have to do to keep Greece afloat.  It’s a very high stakes wager indeed.

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3 responses to “Greece and The Future Of The Euro: Humpty Dumpty Sat On a…”

  1. Mark J Levick says:

    You note that “too many European countries are spending too fast and borrowing too much”. We are fortunate that our President has formulated policies that have kept our debt increase under two percent per annum. Unfortunately he has used the same accountants who reported on Greek debt compliance to the European Union. There is always the Argentine model to fall back on. Thus Obama is ahead in the polls, the stock market is about even for the year and we can concentrate our efforts on punishing those who forced millions to buy Facebook at the offering price or refused to give a break to those who purchased homes with no equity contribution, defaulted on their mortgages and fought foreclosure. Blissfully ignorance is a manifestation of hope but the change to which it serves as a precursor will come as a shock to the hordes who believe that life is fair.

  2. Dan Newell says:

    “The lack of understanding of how money is made and the rewards given to those who make it are as relevant today as they were (sic) in the days of Savonarola” – Lorenzo Smaghi, European Central Bank, 2011

  3. John Fairfield says:

    Why does any Greek or anyone else still have Euros on deposit in any Greek bank?

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