24 May 2012 Why Greece Matters

Ancient Greece is known as the cradle of western civilization. But today, the bough on which it rests threatens baby, cradle and all. How does a country barely 3% of the Euro economy, ($318B compared to $425B for NC) with a population roughly the size of North Carolina’s (10 million) threaten an entire global economy?

Let’s begin with a brief description of the European Union (EU) and its function. The EU is comprised of 27 member states largely in Europe. The Union’s roots go back to 1958, but it developed into its current form as the EU in 1993. The goal was a unified European economy. It was facilitated by a standard set of laws and a body of governance to ensure the free movement of goods and services across sovereign national borders. In 1999 a monetary union known as the eurozone was created and the euro became the official currency for eleven of the now 17 countries. EU gross domestic product in 2011 was $17.6 trillion according to the IMF. The EU represents 25% of global GDP and is 117% of US GDP at $15.1 trillion.

While a grand idea to improve Europe’s economy, prevent repeating the horrors of two world wars, and facilitate a more level playing field with the United States, the EU suffers an inherent and significant organizational flaw. As it is primarily a political organization, it lacks the teeth to enforce fiscal responsibility among its member states, which have sovereignty over their own budgets. There are standards and rules governing national debt and deficit levels, but enforcement breaks down when a member loses fiscal control. The single currency euro insulates the poorly run economy from devaluation that would naturally occur if the country had its own currency. Without the equalizing effect of a sovereign currency, the imbalances of deficits and debts grow unchecked, making it virtually impossible to get their houses back in order on their own.

When a country’s currency declines in value imported goods become more expensive and domestically produced goods become cheaper, thus more attractive. The rising demand for goods produced at home stimulates the domestic economy. The country’s exports simultaneously become less expensive on world markets which boosts the country’s exports, further improving its economy, balance of trade, and debt repayments. Many in Greece see these dynamics as sufficient reason to leave the EU. Add strong anti-German and EU sentiment stemming from overly strict austerity measures as conditions for aid, and it’s easy to see how Greece’s next vote on June 17th could well position them to leave the EU.

US economist Kenneth Rogoff has argued that Athens should be granted a sabbatical from the eurozone while remaining in the European Union, allowing it reintroduce the drachma at a deep discount to the euro and making its tourism industry wildly popular as reported by CNN. Hans-Werner Sim, head of German think tank Ifo, agrees. “The drachma will immediately depreciate, and the situation will stabilize very quickly. After a short thunderstorm, the sun will shine again,” he told German magazine der Spiegel.

Now let’s move to the subject of Greece’s debt. In the simplest of terms, a debt is an obligation or liability to pay or render something to someone else – in essence a promise. And the promise is only as good or as strong as the trust or confidence the lender has for repayment. Uncertainty is the buzzword for Greece today as it has been for two years. And markets (specifically lenders) hate uncertainty. Two thirds of Greece’s $455 billion in loans are held by Greek and European banks and other financial institutions. As uncertainty grows in Greece’s ability to pay and to remain in the EU, markets continue to punish Greek bonds and banks.

But, we still have not addressed how a country representing only 3% of the EU’s GDP can so dramatically swing global markets. Perhaps the proverbial chain and its weakest link provides the best analogy. If Greece is the weak link, then the weakest part of the link is its banks. Making matters worse is the corrosive effect of uncertainty which drives markets to gnaw away at weaknesses until repairs are made or a link breaks.

Greek citizens are now pulling cash out of banks at a rate of more than €600 million a day. Market traders are beginning to worry about a run on the banks. People are pulling their Euros for a highly rational reason: if Greece leaves the Eurozone, their euros will suddenly be converted to Drachmas which will likely go into free-fall. It is much better to convert as you need to spend money, because the fall may continue for months or years.

Markets are beginning to fear a chain reaction. A Greek exit may embolden countries such as Ireland, Portugal, Spain and Italy to follow suit. Spain, for instance is suffering a terrible recession. An exit by Spain would spell the certain end of the EU. It is too big to fail and to let go, but also too big to save if conditions get worse. Bloomberg reports that European banks sit on $1.19 trillion of debt to Spain, Portugal, Italy and Ireland which may very well falter if Greece abandons the euro and defaults on its bailout pledges.

So we come back to uncertainty. What happens if bank runs develop in more significant countries such as Spain, or Italy? Bloomberg suggests that Europe would have to devise a kind of pan-euro deposit guarantee program that would be authoritative enough to persuade people to keep their money in the banks of these countries. “Putting the program in place, though, would require a quantum leap in the integration of euro-area banking supervision and regulation. Control over banks in the area would have to be transferred to the supranational level. In other words, a euro-area banking union could emerge as the direct result of a Greek exit” according to Jacob Kirkegaard of Bloomberg.

This week EU leaders gave President Herman Van Rompuy the job of sketching out “building blocks” for a more integrated euro region by the next summit on June 28-29, which follows a Greek election that may trigger the country’s withdrawal from the currency. A joint unemployment insurance fund might be a first step toward such a fiscal union.

What are those ‘building blocks’ likely to contain? One most likely outcome would be for the ECB to stand behind the debt of sovereigns and to issue bonds, a move Germany currently rejects. Bloomberg and economists suggests the need for a mechanism that would transfer money to economically troubled countries to make the euro area a workable currency union. Clearly though, EU leadership is going to have to find a way to integrate more stringent fiscal controls in the monetary union for it to survive this storm and future ones.

Richard Quest of CNN has said that a Greek exit from the EU could make the Lehman collapse in 2008 look like a tea party. While no one can know the potential damage, all agree it could be huge. And it is that uncertainty that continues to roil markets and investors’ worries.

We cannot tell you what will happen to Greece or the European Union. But clearly these are not times to take more risk than is necessary. We can help you see beyond today’s uncertainty to reveal not only risks, but opportunities which may be completely new to you.

Have a great Memorial Day weekend and thank a vet. Our offices will be closed this Monday.