What’s Going on in Greece and Why You Might Care
The concept of the European Community and a common currency worked okay (though with massive misallocation of capital) as long as long as there was lots of growth and lots of money and lots of subsidies for poorer countries and low interest rates. For a long time, what you could earn on a German bond wasn’t that much lower than what you could earn on a Greek bond of similar duration (as little 20 basis points- one fifth of one percent- in 2007), implying a similar risk. The idea was that they were both parts of the Community, had a common currency, and that the rich would continue to take care of the not so rich.
Then, a few weeks ago, the bond market, which tends to have a mind of its own and doesn’t much care what speeches government officials make, decided that support wasn’t going to be there and that Greece, to use the technical financial term, was going in the crapper. Rates on five year Greek bonds soared to 15%.
Normally, when a country screws up financially like Greece has, a big part of the solution is to devalue the currency. That makes exports grow as they become more competitive, imports fall as they become more expensive, and it’s cheaper to pay off debt denominated in local currency. And of course, the tourists flock to the suddenly inexpensive country (assuming the people aren’t rioting in the street over austerity measures).
This has been doing on ever since there’s been money. Well, maybe not the tourist part. Go read This Time is Different; Eight Centuries of Financial Folly by Reinhart and Rogoff. One of the things they note is that Greece has been in some form of default for half of the last 200 years.
The Greeks should just crank up the printing press and turn out a whole bunch of Drachmas. It wouldn’t be easy, but over time would work. Oh wait- there aren’t any Drachmas any more. There’s only these Euros and Greece can’t devalue them. Well, that’s an inconvenience.
As Greece’s cost of financing its debt goes through the roof (even ignoring that they are going to have to issue more debt that somebody is suppose to buy- no idea who) the austerity measures will have to become even tougher. This of course slows the economy further and reduces tax collections, making the problem worse.
I should note the Greeks are already notorious for managing to not pay taxes. In the last year for which figures are available, there were only 6 (yes SIX) Greeks out of a population of 10 million who reported income of a million Euros or more. Damn clever those Greeks. Maybe a bit too clever.
So I suspect that Greece is heading for an even deeper recession (I won’t use the “D” word though that’s what I really think will happen). I won’t even be surprised to see them default on some of their debt. That may take the form of a rescheduling which stretches out the term, reduces the interest rates or some other manipulation. As far as I’m concerned, that’s as much a default as just not paying.
The Europeans are making a whole lot of noise about injecting liquidity and bailout packages and backup lines of credit. But at the end of the day this is not longer about liquidity. It’s about a national balance stuffed with liabilities they can’t pay. Somebody is going to take a loss. The argument is just over whom. We are, by the way, having the same argument in the United States.
But what the hell. Our industry doesn’t sell much to Greece and we don’t buy much from them so why should we care? In the first place, the somebody who may take the loss is all the European banks who hold most of this Greek government debt. When banks lose money, their capital declines. Banks make loans based on some multiple of their capital. If they lose money, they either have to raise more capital or cut lending. If they lose 100 Euros and are leveraged ten to one, that’s 1,000 Euros of lending they can’t do. You may have noticed that has had a bit of an impact over here.
In the second place, there’s the little matter of Portugal, Spain and Ireland which are in none too good a shape themselves (though nowhere near as bad as Greece). Where’s the money going to come from to bail them out and which banks hold their debt? They use the Euro as well, so devaluation isn’t an option for them either.
Again, if each country still had their own currency, the Greek Drachma, Irish Punt, Italian Lira, and Spanish Peseta would all be devaluing, the German Mark would be rising, and the usual adjustment mechanisms would be working. They aren’t and they can’t while the currency union exists.
The financial markets see this and are concerned that either the currency union comes apart (very messy in the short term, though perhaps a good results in terms of resource allocation in the longer term) or there’s a potential for default on sovereign debt. The result is a lot of pressure on the Euro.
I expect that Europe will have a double dip recession and won’t be surprised if the Euro goes to parity with the dollar. I’m actually putting my money where my mouth is in this case and have started the process of pulling some Euros we have back into dollars. Wish I’d started two months ago.
I’m hopeful it’s clear by now why you care about Greece and the mess in Europe in general. Tougher economic times there mean less consumer spending. A weaker Euro means our exports become more expensive. The good news, I suppose, is that imports from Europe become less expensive. Maybe all those snowboards being made in China will be made in Austria again.
Remember when the subprime crisis started? “It will be contained,” said Fed Chairman Bernanke. And in Europe they couldn’t figure out why they should possibly care about a bunch of bad residential housing loans in the US. Then Lehman Brothers blew up and we went from “It will be okay” to global economic recession in about 20 minutes.
That’s how these things have always happened (go read that book I mention!). It’s okay until it isn’t and everybody gets caught by surprise. Maybe, if you think my analysis is reasonable, there are some things you should be looking at now just in case so you don’t get “caught by surprise?”
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