Running through Greek eurozone exit scenarios again
Crisis has returned to the eurozone with talk about a Greek sovereign debt restructuring rife. There is even talk of Greece being forced out the eurozone. With Greek stocks plummeting and sovereign yields rising, we should take this talk seriously and start examining worst case scenarios. I will run through a few below. The exercise will show it may be difficult to prevent contagion. The EU has to proceed carefully if it wants to avoid another full-blown eurozone-wide crisis. I see an appreciating currency as a big risk.
Here’s the setup in brief. Greece has gone through a Great Depression scenario in the past five years as a result of the policy framework the eurozone chose. Leaks have revealed the strategy was to make an example out of Greece and inflict pain. Here’s the transcript of Tim Geithner’s comments on the matter:
Geithner: I remember coming to the dinner and I’m looking at my Blackberry. It was a fucking disaster in Europe. French bank stocks were down 7 or 8 per cent. That was a big deal. For me it was like, you know, you were having a classic complete carnage because of people [who] were saying: crisis in Greece, who’s exposed to Greece?….
I said at that dinner, that meeting, you know, because the Europeans came into that meeting basically saying: “We’re going to teach the Greeks a lesson. They are really terrible. They lied to us. They suck and they were profligate and took advantage of the whole basic thing and we’re going to crush them,” was their basic attitude, all of them….
But the main thing is I remember saying to these guys: “You can put your foot on the neck of those guys if that’s what you want to do. But you’ve got to make sure that you send a countervailing signal of reassurance to Europe and the world that you’re going to hold the thing together and not let it go. [You’re] going to protect the rest of the place.” I just made very clear to them right then. You hear this blood-curdling moral hazard-y stuff from them, and I said: “Well, that’s fine. If you want to be tough on them, that’s fine, but you have to make sure you counteract that with a bit more credible reassurance that you’re going to not allow the crisis to spread beyond Greece and that’s going to require, you’ve got to make sure you’re putting enough care and effort into building that capacity to make that commitment credible as you are to teaching the Greeks a lesson….”
But more recently Greece has turned around. With Greece seeming back to health, yields started to fall. In June, yields were 5.48% on the ten-year and the Greek government started talking about returning to the market. The ratings agencies upgraded Greek sovereign debt. And though capital investment and production are still falling, GDP is now rising, unemployment is falling, we have seen Greece develop a current account surplus and the government has a primary budget surplus. In the third quarter, Greece even led the way in the eurozone with 0.7% growth.
But a lot of this is just a basing effect. In reality, Greece’s debt burden is unsustainable. If Greece wants to grow and leave the interminable depression it’s now in, a restructuring is necessary.
The problem is that the Greek government started to believe the opposite. And when the Greek government said it wanted to leave the Troika’s grasp free and clear like all of the rest of the bailed out periphery, the market panicked and yields began to rise again. In September, I wrote that this was the beginning of the second round of crisis. And indeed for Greece it is.
If President Samaras doesn’t get 26 votes more than his coalition controls in parliament, he will have to call snap elections. And the polls are saying he would lose those elections and Syriza would come to power. Syriza knows that the debt burden is unsustainable. And they have promised voters they would look to change the governing conditions of Greece’s agreement with the Troika or risk default and potentially even a eurozone exit. Now Angela Merkel is known to have contemplated allowing a Greek exit in 2012. But the contagion was too much and she relented, supporting the initial inadequate restructuring we saw for Greece back then. But we are likely about to go through that exercise all over again.
Scenario #1: Samaras wins vote
The first question is whether Samaras can get the votes necessary to stave off snap elections. If he does, then he will be willing to work with the Troika and I believe we will see a deal that ends the immediate crisis. Greece will go back to where it was, with over a quarter unemployed and production still declining but with the prospect of GDP rising in 2015 and potentially rising further afterwards. The problem with this scenario is it doesn’t address any of the fundamental questions.
As I wrote yesterday, Karl-Otto Pöhl, Bundesbank President from 1980 to 1991, has died. And he is the man who told German Chancellor Kohl that allowing the DDR to unite with West Germany at a 1-1 currency parity would be an economic disaster given the massive productivity differentials. This proved true and the Germans have learned some hard lessons from reunification, while pouring $2 trillion into the eastern states. See my 2010 post on lessons we can learn on how stimulus and jobs programs failed in eastern Germany.The general consensus in Germany is that structural reforms are paramount and that wage/productivity competitiveness is indispensable. We are not there yet in Greece. And so the Germans are not going to relent and allow Greece to go free and clear unless we see labor market and pension reforms that have not been forthcoming, to say nothing of need for tax collection and corruption reform.
At the same time, most of Greece’s debt is held by the Troika now given the massive hit that private investors took in the initial restructuring. With government debt just under 175% of GDP, the interest charges are a crushing burden for the economy. There is no QE in place yet and Greece doesn’t have an implicit ECB backstop anyway. The scenario that sees Greece growing out of this debt burden requires a Herculean level of change and reform that is unrealistic given an economy that has already shrunk by a quarter and where a quarter are unemployed. Eventually a default that bails in the Troika is coming. The question is timing.
From a contagion perspective, there would be none. This is the most benign scenario from a markets perspective.
Scenario #2: Samaras loses vote, Syriza strikes deal
If Samaras loses, I don’t see him staying in power. Syriza would come to power. And then the question would be how much compromise would we see in working out a deal that keeps the Troika in power as an overseer. The Germans want reforms to pensions and the labour market. Syriza wants debt relief. There may be a deal which allows both to get what they want. So the best case scenario here is where we see minimal commitments to reform to labour markets and pensions. We see tax collection and corruption promises too and this satisfies the Troika. But then we have to get a debt restructuring as well. And that is the sticky wicket here because the ECB is loath to take a loss. A deal that lengthens maturities and lowers rates is the only way we get there. But is that even legal under the ECB government financing rule? I don’t know. The institutional challenges here are big.
Scenario #3: Samaras loses vote, Syriza defaults
If Samaras loses and Syriza are unable to come to agreement with the Troika, they could default. This looks like an option that has a high likelihood of occuring and is the main reason the Greek yield curve is inverted with 3-year debt more expensive than 10-year debt. Syriza and the Troika are just so far apart that its hard for them to reach a deal. And the negotiating tactics the Troika has are not going to be as effective here. They got the Irish into a program by promising to pull the ELA for Irish banks. But Yiannis Mouzakis argues that the Greek banks’ dependence on ECB funding is not so great that this is an existential threat. And Greece now has a primary surplus, which means that it doesn’t necessarily need fresh funding to maintain itself. It could simply default and meet non-interest obligations indefinitely until the existing debt obligations get restructured. This was always going to be the trump card for Greece.
Greece is relatively unique and I think the contagion from this scenario would be manageable. So even here, we wouldn’t necessarily see Armageddon.
Scenario #4: Samaras loses, Greece exits the eurozone
This is the scenario that is the most fraught with peril. The problem for Greece as it was for eastern Germany is that at the prevailing currency level, the country’s productivity levels are too low. In a currency union with western Germany, the only route to success is a combination of transfer payments and internal devaluation i.e. wage and price suppression. The eastern states in Germany were able to do this over a 20-year period because of a net migration to the west and huge transfer payments through the solidarity tax. Even then, the unemployment rate in the east has been crushingly high for most of that period. Germany has been in a soft depression.
But the labor migration opportunities within Germany are greater than they are within the EU because of language and culture and the fiscal transfers are not going to occur. Mind you, I lived in Germany during this period and remember that western Germans initially thought of the easterners as odd and lazy. And the easterners had a great deal of resentment toward the westerners, who they called “Besserwessis”, a play on the term Besserwisser, which means know-it-all. And the neo-Nazism that developed in the east was a direct result of the large number of able-bodied young males who were unemployed. So the transition has not been easy within Germany. I think an internal devaluation tactic across the eurozone is impossible from a social and political perspective.
So we are looking at a eurozone exit then. I went through the scenarios in 2011 and 2012. So I won’t develop them again here. The scenarios are just as valid today as they were during the initial round of crisis.
What the exit scenario brings to light is how much this is a currency question. If Greece needs a lower exchange rate level to bring itself into a position where it can grow, then I would expect the euro to rise in value as tensions in Europe rise. The euro is slipping now, and that should aid Europe to the degree it wants trade with countries outside of the eurozone. But if the Greek crisis grows in magnitude, then a Greek exit from the euro becomes a viable talking point, which makes a Portuguese, Spanish and Italian exit a viable talking point. That’s a situation that is disastrous for the euro then. Without the southern bloc, the euro would rise significantly in value and Germany would lapse back into its soft depression again.
I think the Germans know they have benefitted greatly from a weak euro. And so it behooves them to maintain the euro intact, even if it means giving ground in negotiations with Greece. Right now, Greece markets are in a panic. 10-year yields are above 9% and the stock market has fallen 20% in 3 days. This could even threaten the Greek recovery. The danger is that the Germans come to believe Greece can be isolated without spillover into the rest of the periphery. This could tempt them to play chicken with Greece. And the potential for a eurozone-wide crisis increases as a result.