Greece Euro Zone Exit Seems Unlikely

By Win Thin

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The euro took another leg lower in thinned afternoon North American markets after Der Spiegel online reported that Prime Minister Papandreou is contemplating a Greek exit from the euro zone and that the EC is calling a "confidential" meeting in Luxembourg tonight to discuss this urgent matter. European officials have of course come out and denied the report, including Juncker and Schaeuble. Our view still remains that the costs of a euro exit would be too much for Greece and the euro zone to bear, and that such action will be avoided at all costs. Consider what might happen. There would likely be a run on Greek banks which in turn would lead to a collapse of its new currency that feeds into higher inflation, while those banks and the sovereign would most likely be blocked from capital markets, sending Greek interest rates even higher. On the other side, we think some sort of Greek default would go hand in hand with a euro exit. Since German and French banks are the largest holders of Greek debt, this could certainly lead to some sort of systemic banking crisis in the EU. No one wins under this scenario, in our view.

Considering the favorable terms of the Portugal package just announced, it seems more likely that Greece may be playing a game of chicken with euro zone policy makers in order to negotiate a more favorable aid package, with perhaps an extension of duration on its debt, or loosening up of tough austerity measures. In other words, Greece is using the threat of a potential collapse of the euro zone as a means to get concessions from the core euro zone in attempt to quell the rising complaints of the Greek people. Both Greece and the euro zone will be worse off if they choose the scorched earth solution. From a game theory perspective, the question is whether the two sides can come up with a cooperative solution.

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With that said, no one really knows the actual thought processes going on in official circles on both sides, but it seems clear that the political will to stick with austerity is breaking down in Greece and that some kind of drastic action, no matter how unlikely it actually is, is being threatened. This political aspect has always been the debate at the heart of previous EM debt defaults/restructurings. At some point, policy-makers in Greece, Ireland, and Portugal too will face the decision of whether austerity is worth the political cost domestically. Hence, that is why Greece is perhaps using threats to ease those terms.

If the debate really moves from one of orderly Greek debt restructuring (that markets have priced in) to one of disorderly Greek default (not priced in), then risk off trading seems likely to come back with a vengeance, despite some small measure of feel-good trading coming from this morning’s jobs report. It will be important to see how Asian and European markets digest this news come Monday. We will be monitoring developments over the weekend to see if any new details emerge regarding Greece, but continue to feel that a Greek debt restructuring and renewed peripheral stresses could be a major offset to divergent monetary policies in euro zone and US that has so far boosted the euro.

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11 Comments
  1. Stephan Ewald says

    “Considering the favorable terms of the Portugal package just announced,”
    What exactly are you talking about? Portugal is expected to reduce public spending by 3.4% of its GDP this year and raise an extra 1.7% of GDP by raising taxes on cars, tobacco and electricity and getting rid of income and corporation tax loopholes. Dear Portugal, we will give you a €78bn bail out plus austerity terms attached to throw you in a recession. That’s the message from the IMF, EU and ECB.

    Don’t you understand that these austerity terms mean a leakage from the expenditure stream. Econ 101: your spending is the income of somebody! The only thing that will happen is that the automatic stabilizers will go to work and increase the deficit. Can we please confine the experiment whether contractionary fiscal policy is expansionary to the UK? These people at least had a chance to vote upon it.

    1. DavidLazarusUK says

      The UK election was not in support of austerity. No party was given a mandate for austerity. The coalition agreement was not voted on by the public and the publics reaction to that was to devastate the LibDems in the council elections.

      Austerity will cause the UK to return to recession. We have already seen poor GDP figures recently and the cuts will only make things worse. In fact many of the cuts will also slash demand. I doubt that they will follow cuts through as things deteriorate as they will want to retain power.

      1. Stephan Ewald says

        David. Your economic assessment: agreed! Although it seems to me this is a minority opinion given that Ed and his friends think the austerity terms handed over to Portugal are fantastic favorable. Now I’m not a British citizen. I’m an ÜBER mercantilist living in Germany constantly thinking how to gain more Lebensraum without sending tanks. But my impression was the Tories made it quite clear what their main concern is: the alleged unsustainable debt/deficit. Whatever “unsustainable” means in regard to the UK budget.

        Given your objections all I can say: OK. But you still have the option to change course and next time election looms make up your mind and throw these crazies out. The Greek, Irish and Portuguese don’t have this option. They can’t vote away our ECB dictators.

        1. Edward Harrison says

          Stephen, have you been reading this blog accurately. Who has said the austerity terms are fantastically favourable? I certainly haven’t done. In fact, we are saying exactly the opposite.

          “Portugal has received a better bailout package than Greece because it is more clear now that the terms given to Greece won’t work. Nevertheless, it is likely that even the terms Portugal have received will not work for Greece as austerity and internal devaluation set out an impossible task for Greece in reducing deficits and growing enough to reduce debt.”

          Explain to me how that is saying that the austerity terms are ‘fantastic favorable”?

          http://pro.creditwritedowns.com/2011/05/heres-how-much-german-banks-are-on-the-hook-to-the-periphery-for.html

          1. Stephan Ewald says

            Ed: “Explain to me how that is saying that the austerity terms are ‘fantastic favorable”? I can’t. And I did read your blog and hopefully also understand it. This was a rhetoric exaggeration. Because it seems to produce bad vibes my apologies. That said however let me explain it:

            How to phrase subjects matters a lot! It can change the perception of the reader in either direction given his prejudices. So here we have the wording “Considering the favorable terms of the Portugal package just announced,”. What sticks with the average reader? “favorable terms”! It could have been written “Considering the less devastating terms of the Portugal package just announced,” which would produce a complete different assessment of the issue by the average reader although saying basically the same thing. Now you might call me paranoid :~) But well this happened also in the US: there were polls on health-care. Call it a “public plan”. Great! Name it a “government plan”. Booh!

          2. Edward Harrison says

            fair enough. Stephan, you make a valid point. Cheers.

        2. DavidLazarusUK says

          As Edward has just commented the Portuguese deal is still unworkable. Ultimately this will just kick the can down the road. There are three objectives with this deal. One is to deter others from defaulting, hence the emphasis on freezing the debtor nations out of the capital markets. The other hope for Germany is that they can recover as much as possible before the eventual default. Lastly, the German government hope that the banks will be strong enough to cope with the eventual collapse. This is unlikely as the german banks have been lending recklessly throughout the entire eurozone for a decade. They will probably be sunk by a tsunami of losses once the defaults start coming.

          Austrian banks have the same problem with eastern european debt. The core nations are being bailed out by the taxpayers. All governments can change course, it is a matter of political will. Germany is able to impose austerity because it has a strong balance of trade, though once the defaults occur if the government bails out the banks then Germany will have a deficit to dwarf all but the US or Japan. Germany will then struggle as capital flight will become the order of the day, as has happened in Greece, Ireland and Portugal. We are a long way from this crisis being over. All that has happened is that governments have managed to paper over the cracks. The cracks are still there but just waiting to break again.

          I personally think we have more than a decade of pain. No incoming new government will be able to blame the previous government because they will have made tremendous errors of their own. The UK coalition have consistently blamed the previous government for the deficits yet their policies will only make matters worse.

          1. Stephan Ewald says

            Hmmm … David. You might be right with your Armageddon scenario. But I’m a hopeless optimist and believe in people to come up with solutions to obvious problems/shortcomings. So here’s my take how to solve the Euro crisis:

            The €zone as we’ve set it up does not work. Dissolving the €zone going back to where we were before will only create a big mess. So let’s just simply dump the word “single” from the €zone charta. The Greek government can issue its own currency in addition to have €s as legal tender. The government of Greek issues the Drachma 2.0, accepts tax payments only in Drachma and government expenditure only happens in Drachma. The new Drachma is free-floating versus the €. The new currency Drachma follows the logic and rules of MMT. Thus no need for the Greek government to worry about the bond market. And for all inflation paranoid citizens there’s still the safe heaven €.

            But we must deal with Greek € denominated debt. The Greek government can offer all bond holders a conversion deal into Drachma bonds. Which certainly means a haircut. Bond holders not happy with the deal can be compensated by its government which instead of being in a permanent bail out loop simply accepts to be repaid by the Greek government in Drachma. I personally would nationalize all banks which fail upon a Greek haircut just because of incompetence and being broken anyway. But well, this is a political judgement.

          2. DavidLazarusUK says

            Any bailout of greek bond holders needs to be one that can allow Greece to start afresh. If the deal is too good for bond holders then there will be future problems. Look at the mortgage modifications in the US. More than 70% fail after modification. Which means that the original modifications were inadequate to start with. It needs to be resolved permanently. Personally I think that all non top tier bonds get wiped out completely. With prime bonds facing a serious haircut of 70% to 90%.

            Dont forget that bond holders bought greek debt for the higher income accepting a higher risk. Let them take the consequences of that risk now. They also bought CDS protection so would get paid anyway. Let the financial markets take the strain of CDS claims. After all they are the ones that crippled many of the periphery economies anyway. Moral hazard I say.

            As for the single market the long term solution is transfers within the eurozone. This will mean permanent transfers to the periphery as compensation. The US does the same within the country. Many US states are practically permanent beneficiaries to government funds, recieving much more than they pay in. That principle should apply in the eurozone.

          3. Stephan Ewald says

            “Moral hazard I say.” OK. I’ve no objection to this line of reasoning. But if our Angie thinks it is no good idea to watch Joe suffer she might compensate him. Nothing I can do about it. I can’t even vote her out of office.Transfers? Forget it. Won’t happen. Read BILD for one week and you know everything about the future of fiscal transfers. Europe isn’t a federation and I don’t think I will live long enough to see it becoming a federation of states. Wishful thinking is not helping to solve the problem.

          4. DavidLazarusUK says

            If banks collapse or bond holders lose their money that is their problem. As for a banking system you nationalise the branch networks, even break the banks up so that there is far more competition. That way the ordinary worker in the banks will still have jobs, and companies can pay for goods and wages.

            If the economy collapses then governments should step in with spending programs. To maintain employment and economic activity. Though what should also happen is a return to regulation. If banks were regulated so that mortgages were capped in relation to personal incomes the chances for property bubbles evaporate. This was the case in France and Germany. If asset bubbles are taxed highly through high capital gains taxes then this also reduces the incentives for such speculation. There may also be a case for capital controls to stop cheap foriegn money distorting domestic banking, that would have saved Spain and Ireland from its property bubbles. Ending universal banking is essential and no universal bank should have access to state protection or lender of last resort. There may also be a case for capping the numbers of branches and deposits so that banks cannot get too big. The banking and real estate sectors of the economy grew too large in relation to the rest of the economy. This imposed extra costs on new businesses. It becomes far more expensive to start a new business if property is expensive. Keep these costs down and the vibrancy of an economy can be maintained. Also with rising property prices it drains consumers of money that is otherwise used to pay rents or mortgages. That is the case in the US, UK, Ireland and Spain.

            As for fiscal transfers within Europe if there are none then there must be much tighter controls on spending and taxation, as without it these problems will repeat. If the periphery are driven out of the Eurozone it will have adverse impact on Germany. The euro will be considered much stronger and that will make german exports much harder. Greece has done a wonderful job in keeping the euro weak. Without it the euro will climb. German exports will fall and unemployment will rise in Germany.

  2. Stephan Ewald says

    “Considering the favorable terms of the Portugal package just announced,”

    What exactly are you talking about? Portugal is expected to reduce public spending by 3.4% of its GDP this year and raise an extra 1.7% of GDP by raising taxes on cars, tobacco and electricity and getting rid of income and corporation tax loopholes. Dear Portugal, we will give you a €78bn bail out plus austerity terms attached to throw you in a recession. That’s the message from the IMF, EU and ECB.

    Don’t you understand that these austerity terms mean a leakage from the expenditure stream. Econ 101: your spending is the income of somebody! The only thing that will happen is that the automatic stabilizers will go to work and increase the deficit. Can we please confine the experiment whether contractionary fiscal policy is expansionary to the UK? These people at least had a chance to vote upon it.

    1. Anonymous says

      The UK election was not in support of austerity. No party was given a mandate for austerity. The coalition agreement was not voted on by the public and the publics reaction to that was to devastate the LibDems in the council elections.

      Austerity will cause the UK to return to recession. We have already seen poor GDP figures recently and the cuts will only make things worse. In fact many of the cuts will also slash demand. I doubt that they will follow cuts through as things deteriorate as they will want to retain power.

      1. Stephan Ewald says

        David. Your economic assessment: agreed! Although it seems to me this is a minority opinion given that Ed and his friends think the austerity terms handed over to Portugal are fantastic favorable. Now I’m not a British citizen. I’m an ÜBER mercantilist living in Germany constantly thinking how to gain more Lebensraum without sending tanks. But my impression was the Tories made it quite clear what their main concern is: the alleged unsustainable debt/deficit. Whatever “unsustainable” means in regard to the UK budget.

        Given your objections all I can say: OK. But you still have the option to change course and next time election looms make up your mind and throw these crazies out. The Greek, Irish and Portuguese don’t have this option. They can’t vote away our ECB dictators.

        1. Edward Harrison says

          Stephen, have you been reading this blog accurately. Who has said the austerity terms are fantastically favourable? I certainly haven’t done. In fact, we are saying exactly the opposite.

          “Portugal has received a better bailout package than Greece because it is more clear now that the terms given to Greece won’t work. Nevertheless, it is likely that even the terms Portugal have received will not work for Greece as austerity and internal devaluation set out an impossible task for Greece in reducing deficits and growing enough to reduce debt.”

          Explain to me how that is saying that the austerity terms are ‘fantastic favorable”?

          http://pro.creditwritedowns.com/2011/05/heres-how-much-german-banks-are-on-the-hook-to-the-periphery-for.html

          1. Stephan Ewald says

            Ed: “Explain to me how that is saying that the austerity terms are ‘fantastic favorable”? I can’t. And I did read your blog and hopefully also understand it. This was a rhetoric exaggeration. Because it seems to produce bad vibes my apologies. That said however let me explain it:

            How to phrase subjects matters a lot! It can change the perception of the reader in either direction given his prejudices. So here we have the wording “Considering the favorable terms of the Portugal package just announced,”. What sticks with the average reader? “favorable terms”! It could have been written “Considering the less devastating terms of the Portugal package just announced,” which would produce a complete different assessment of the issue by the average reader although saying basically the same thing. Now you might call me paranoid :~) But well this happened also in the US: there were polls on health-care. Call it a “public plan”. Great! Name it a “government plan”. Booh!

          2. Edward Harrison says

            fair enough. Stephan, you make a valid point. Cheers.

        2. Anonymous says

          As Edward has just commented the Portuguese deal is still unworkable. Ultimately this will just kick the can down the road. There are three objectives with this deal. One is to deter others from defaulting, hence the emphasis on freezing the debtor nations out of the capital markets. The other hope for Germany is that they can recover as much as possible before the eventual default. Lastly, the German government hope that the banks will be strong enough to cope with the eventual collapse. This is unlikely as the german banks have been lending recklessly throughout the entire eurozone for a decade. They will probably be sunk by a tsunami of losses once the defaults start coming.

          Austrian banks have the same problem with eastern european debt. The core nations are being bailed out by the taxpayers. All governments can change course, it is a matter of political will. Germany is able to impose austerity because it has a strong balance of trade, though once the defaults occur if the government bails out the banks then Germany will have a deficit to dwarf all but the US or Japan. Germany will then struggle as capital flight will become the order of the day, as has happened in Greece, Ireland and Portugal. We are a long way from this crisis being over. All that has happened is that governments have managed to paper over the cracks. The cracks are still there but just waiting to break again.

          I personally think we have more than a decade of pain. No incoming new government will be able to blame the previous government because they will have made tremendous errors of their own. The UK coalition have consistently blamed the previous government for the deficits yet their policies will only make matters worse.

          1. Stephan Ewald says

            Hmmm … David. You might be right with your Armageddon scenario. But I’m a hopeless optimist and believe in people to come up with solutions to obvious problems/shortcomings. So here’s my take how to solve the Euro crisis:

            The €zone as we’ve set it up does not work. Dissolving the €zone going back to where we were before will only create a big mess. So let’s just simply dump the word “single” from the €zone charta. The Greek government can issue its own currency in addition to have €s as legal tender. The government of Greek issues the Drachma 2.0, accepts tax payments only in Drachma and government expenditure only happens in Drachma. The new Drachma is free-floating versus the €. The new currency Drachma follows the logic and rules of MMT. Thus no need for the Greek government to worry about the bond market. And for all inflation paranoid citizens there’s still the safe heaven €.

            But we must deal with Greek € denominated debt. The Greek government can offer all bond holders a conversion deal into Drachma bonds. Which certainly means a haircut. Bond holders not happy with the deal can be compensated by its government which instead of being in a permanent bail out loop simply accepts to be repaid by the Greek government in Drachma. I personally would nationalize all banks which fail upon a Greek haircut just because of incompetence and being broken anyway. But well, this is a political judgement.

          2. Anonymous says

            Any bailout of greek bond holders needs to be one that can allow Greece to start afresh. If the deal is too good for bond holders then there will be future problems. Look at the mortgage modifications in the US. More than 70% fail after modification. Which means that the original modifications were inadequate to start with. It needs to be resolved permanently. Personally I think that all non top tier bonds get wiped out completely. With prime bonds facing a serious haircut of 70% to 90%.

            Dont forget that bond holders bought greek debt for the higher income accepting a higher risk. Let them take the consequences of that risk now. They also bought CDS protection so would get paid anyway. Let the financial markets take the strain of CDS claims. After all they are the ones that crippled many of the periphery economies anyway. Moral hazard I say.

            As for the single market the long term solution is transfers within the eurozone. This will mean permanent transfers to the periphery as compensation. The US does the same within the country. Many US states are practically permanent beneficiaries to government funds, recieving much more than they pay in. That principle should apply in the eurozone.

          3. Stephan Ewald says

            “Moral hazard I say.” OK. I’ve no objection to this line of reasoning. But if our Angie thinks it is no good idea to watch Joe suffer she might compensate him. Nothing I can do about it. I can’t even vote her out of office.Transfers? Forget it. Won’t happen. Read BILD for one week and you know everything about the future of fiscal transfers. Europe isn’t a federation and I don’t think I will live long enough to see it becoming a federation of states. Wishful thinking is not helping to solve the problem.

          4. Anonymous says

            If banks collapse or bond holders lose their money that is their problem. As for a banking system you nationalise the branch networks, even break the banks up so that there is far more competition. That way the ordinary worker in the banks will still have jobs, and companies can pay for goods and wages.

            If the economy collapses then governments should step in with spending programs. To maintain employment and economic activity. Though what should also happen is a return to regulation. If banks were regulated so that mortgages were capped in relation to personal incomes the chances for property bubbles evaporate. This was the case in France and Germany. If asset bubbles are taxed highly through high capital gains taxes then this also reduces the incentives for such speculation. There may also be a case for capital controls to stop cheap foriegn money distorting domestic banking, that would have saved Spain and Ireland from its property bubbles. Ending universal banking is essential and no universal bank should have access to state protection or lender of last resort. There may also be a case for capping the numbers of branches and deposits so that banks cannot get too big. The banking and real estate sectors of the economy grew too large in relation to the rest of the economy. This imposed extra costs on new businesses. It becomes far more expensive to start a new business if property is expensive. Keep these costs down and the vibrancy of an economy can be maintained. Also with rising property prices it drains consumers of money that is otherwise used to pay rents or mortgages. That is the case in the US, UK, Ireland and Spain.

            As for fiscal transfers within Europe if there are none then there must be much tighter controls on spending and taxation, as without it these problems will repeat. If the periphery are driven out of the Eurozone it will have adverse impact on Germany. The euro will be considered much stronger and that will make german exports much harder. Greece has done a wonderful job in keeping the euro weak. Without it the euro will climb. German exports will fall and unemployment will rise in Germany.

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