Greece Poised to Default & Exit the Euro
Halbert Wealth Management
By Gary Halbert
May 23, 2012
IN THIS ISSUE:
1. Overview – Greece Default Risk Accelerating
2. Is An Orderly Default by Greece Possible?
3. Greece’s Upcoming Elections Look Grim
4. G-8 Summit Members Ambush Germany’s Merkel
5. Webinar With Yacktman Capital Group on Thursday
I have maintained all along that the European Central Bank’s loans of apprx. one trillion euros to banks in financially troubled nations in January was only a measure of kicking the can down the road. Like many other analysts, I predicted that another potentially larger crisis would be coming in the not-so-distant future.
The not-so-distant future, many of us worried, would be May 6 when Greece was to hold its parliamentary elections. As many feared, the citizens of Greece ousted those leaders who had agreed to unpopular austerity measures in return for bailout loans from the European Central Bank and the IMF, and voted in candidates that promised to roll back the austerity plans.
The problem is, none of the candidates received a majority of the vote, so a second election will be held on June 17. It is widely expected that the anti-austerity candidates will prevail and Greece will have a left-leaning Prime Minister and top leaders in the Parliament after the elections.
If you keep up with the news even occasionally, you know that there are now widespread predictions that Greece will: 1) default on its debt sometime after the upcoming elections on June 17; 2) withdraw as a member of the European Union; and 3) drop the euro as its currency and replace it with its former currency, drachmas.
We’ve all heard horror stories about the global financial crisis that could unfold if tiny Greece defaults on its debts later this year. There are genuine fears that if Greece defaults, that leaves the door open to similar defaults by Portugal, Ireland and possibly even Spain. Some fear, in this nightmare scenario, that even Italy could default (although I doubt it).
Similar fears of a Greek default and the scenario described above weighed heavily on the global stock markets last summer. This eventually led to the ECB bailout loans of €1 trillion in January. Now the equity markets are again under pressure.
Will the ECB pony up even more taxpayer money for Greece this time around? Most agree that this will be decided largely by Germany. And speaking of Germany, it is reported that President Obama went out of his way to have a private meeting with Germany’s Chancellor Angela Merkel at the G-8 summit over the weekend in Chicago about this very issue (more below).
Is An Orderly Default by Greece Possible?
Without Merkel’s consent, the ECB is unlikely to make any more loans to Greece, and Greece is literally broke. Bank runs are underway as this is written. If the Greek elections go as expected on June 17, Greece could officially default as early as this summer (unless Merkel has a change of heart).
There is no shortage of predictions on how badly a Greek default would roil the financial and investment markets around the world. Some feel it would surpass the financial crisis of 2008. Last week, however, one well-known analyst, Nouriel Roubini, suggested a detailed plan for Greece to default and exit the euro without causing chaos around the world.
Roubini is a professor of economics at New York University and co-founder of RGE Monitor, an economic consulting firm. Roubini is best known for his predictions that the US housing market was going to collapse and spark a severe recession. Those calls led to his nickname, “Dr. Doom.” But not anymore.
Roubini admits that his plan involves lots of risks and would have to be managed very carefully. Here is the plan Roubini outlined on Friday.
The Greek euro tragedy is reaching its final act: it is clear that either this year or next, Greece is highly likely to default on its debt and leave the eurozone…
Greece is stuck in a vicious cycle of insolvency, lost competitiveness, external deficits, and ever-deepening depression. The only way to stop it is to begin an orderly default and departure, co-ordinated and financed by the European Central Bank, the European Union, and the International Monetary Fund (the troika), that minimises collateral damage to Greece and the rest of the eurozone.
Greece's recent financing package, overseen by the troika, gave the country much less debt relief than it needed. But, even with significantly more public-debt relief, Greece could not return to growth without rapidly restoring competitiveness. And, without a return to growth, its debt burden will remain unsustainable. But all of the options that might restore competitiveness require real currency depreciation.
The first option, a sharp weakening of the euro, is unlikely, as Germany is strong and the ECB is not aggressively easing monetary policy. A rapid reduction in unit labour costs, through structural reforms that increased productivity growth in excess of wages, is just as unlikely. It took Germany 10 years to restore its competitiveness this way; Greece cannot remain in a depression for a decade. Likewise, a rapid deflation in prices and wages, known as an "internal devaluation", would lead to five years of ever-deepening depression.
If none of those options is feasible, the only path left is to leave the eurozone. A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth.
Of course, the process would be traumatic – and not just for Greece. The most significant problem would be capital losses for core eurozone financial institutions. Overnight, the foreign euro liabilities of Greece's government, banks, and companies would surge. Yet these problems can be overcome. Argentina did so in 2001, when it "pesofied" its dollar debts. The United States did something similar in 1933, when it depreciated the dollar by 69% and abandoned the gold standard. A similar "drachmatisation" of euro debts would be necessary and unavoidable.
Losses that eurozone banks would suffer would be manageable if the banks were properly and aggressively recapitalised. Avoiding a post-exit implosion of the Greek banking system, however, might require temporary measures, such as bank holidays and capital controls, to prevent a disorderly run on deposits.
The European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) should carry out the necessary recapitalisation of the Greek banks via direct capital injections. European taxpayers would in effect take over the Greek banking system, but this would be partial compensation for the losses imposed on creditors by drachmatisation.
Greece would also have to restructure and reduce its public debt again. The troika's claims on Greece need not be reduced in face value, but their maturity would have to be lengthened by another decade, and the interest on it reduced. Further haircuts on private claims would also be needed, starting with a moratorium on interest payments.
Some argue that Greece's real GDP would be much lower in an exit scenario than it would be during the hard slog of deflation. But that is logically flawed: even with deflation, real purchasing power would fall, and the real value of debts would rise (debt deflation), as the real depreciation occurs. More importantly, the exit path would restore growth right away, via nominal and real depreciation, avoiding a decade-long depression. And trade losses imposed on the eurozone by the drachma depreciation would be modest, given that Greece accounts for only 2% of eurozone GDP.
Reintroducing the drachma risks exchange-rate depreciation in excess of what is necessary to restore competitiveness, which would be inflationary and impose greater losses on drachmatised external debts. To minimise that risk, the troika reserves currently devoted to the Greek bailout should be used to limit exchange-rate overshooting; capital controls would help, too.
Those who claim that contagion from a Greek exit would drag others into the crisis are also in denial. Other peripheral countries already have Greek-style problems of debt sustainability and eroded competitiveness. Portugal, for example, may eventually have to restructure its debt and quit the euro. Illiquid but potentially solvent economies, such as Italy and Spain, will need support from Europe regardless of whether Greece exits; indeed, without such liquidity support, a self-fulfilling run on Italian and Spanish public debt is likely.
The substantial new official resources of the IMF and ESM – and ECB liquidity – could then be used to ringfence these countries, and banks elsewhere in the eurozone's troubled periphery. Regardless of what Greece does, eurozone banks now need to be rapidly recapitalised, which requires a new EU-wide programme of direct capital injections.
The experience of Iceland and many emerging markets over the past 20 years shows that nominal depreciation and orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness, and growth. As in these cases, the collateral damage to Greece of a euro exit will be significant, but it can be contained.
Like a doomed marriage, it is better to have rules for the
inevitable divorce that make separation less costly to both sides. Make
no mistake: an orderly euro exit by Greece implies significant economic
pain. But watching the slow, disorderly implosion of the Greek economy
and society would be much worse.
The problem I see with the scenario Roubini proposes is that it requires the coordination of the European Central Bank, the European Union member states and the International Monetary Fund – the “Troika” – and a LOT of their money. It would also have to be signed onto by Germany, and the German people are opposed to any additional bailouts.
Now I’m not saying that Roubini is wrong. He may be correct that it will take such a costly and coordinated effort to usher Greece out of the euro with the least amount of collateral damage (ie – financial crisis). But how different, really, is Roubini’s plan from just another large bailout?
Then there is the question of just how much more the ECB can expand its balance sheet. As of the end of February, the ECB’s balance sheet stood at a record €3.02 trillion ($3.96 trillion). At $3.96 trillion, the ECB’s balance sheet is larger than the entire German economy ($3.28 trillion). The ECB’s $3.96 trillion compares to our own Fed’s balance sheet at $2.9 trillion. These numbers are simply staggering!
Greece’s Upcoming Elections Look Grim
Turning back to Greece, polls now indicate that the Left Coalition, “Syriza,” will sweep the elections on June 17. Their campaign promise is to renegotiate the loan terms that have been painfully negotiated with the eurozone lords and the IMF, and demand more bailouts. Yet they also want to roll back many of the austerity measures implemented by previous leaders to qualify for these very same loans. Apparently, they believe the eurozone lords and the IMF will blink. We’ll see.
In the interim, money is gushing out of Greek banks and being converted to the hard currency of choice in other countries. You don’t hear too much about this because you don’t have to stand in line at a bank to get your money these days. You can open a new account(s) at the bank of your choice in another country and simply wire the money out of the bank you are fleeing.
At the end of the day, no one knows what will happen next with Greece. All eyes will be on the June 17 elections, even though it is pretty well assumed that the Syriza party will win. What these new leaders will do remains to be seen, and this uncertainty will, in my opinion, keep a lid on global equity markets. Or worse, it could send them sharply lower, depending on what happens.
G-8 Summit Members Ambush Germany’s Merkel
The latest meeting of the Group of Eight (US, Britain, Canada, Japan, Germany, France, Italy and Russia) was held in Chicago last weekend. It is now clear that President Obama orchestrated a pre-summit strategy among the members to pressure Germany’s Chancellor Andrea Merkel to agree to back off on the austerity demands on European countries including Portugal, Ireland, Italy, Greece and Spain (the so-called PIIGS).
Instead, Obama called on the G-8 leaders to implement new stimulus spending in an effort to jump-start economic growth and create jobs. After all, these same policies have worked so well here in the US (tongue in cheek) that the Europeans should do the same. But from all accounts, Chancellor Merkel held her ground.
As a result, Obama insisted on a private meeting with Merkel on Saturday evening after the summit had adjourned for more arm-twisting. There is no way to know what the two leaders actually said, but it appears clear that Obama didn’t get his wish. Merkel said after the meeting that she would not object to more measures to spur economic growth, but she also insisted that austerity measures aimed at balancing budgets must continue.
One wonders if Merkel reminded Obama that his economic plans have added $5 trillion to our national debt since he took office, the US unemployment rate remains above 8% and the economic recovery is tepid at best. Not exactly a prescription for pulling Europe out of recession!
The point I think that Obama and other sympathetic leaders fail to realize is that Merkel is simply following the statutes of Germany’s Constitution. She does not have unlimited power to print money to bail out the struggling nations of the European Union. As noted above, the German people are steadfastly against more bailout loans, especially to Greece. I applaud Merkel’s refusal to agree to Obama’s demands.
(c) Halbert Wealth Management