IS GREECE GOING TO DEFAULT?

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved.”

– Mises

Nouriel Roubini calls Greece “the tip of the iceberg”.  PIMCO’s El-Erian says Greece is likely to default.  Greece is the news story that keeps on giving.  Unfortunately, the problems in Greece are persistent because the Euro has been a persistently flawed currency system.  Much like the gold standard, the single-currency-under-multiple-governments simply does not work in the best interest of all involved.  I have been racking my brain for several weeks now attempting to think of a good outcome in the Greek debt crisis.  As John Mauldin recently wrote, there really are no good solutions here.  I keep coming back to the same conclusion – Greece should leave the EMU and default on their debt.  It sounds quite extreme and could cause some very serious near-term panic, but in the long-run I believe the Greeks must do what is in THEIR best interest and that involves bringing back the drachma and taking control of their currency.   No country should ever relinquish the power to control their own currency and be their own banker.

Martin Feldstein believes the default in Greece is inevitable and like myself believes this has been essentially self imposed by the handcuffs that come along with being a member of the EMU.  Feldstein writes:

“Greece will default on its national debt. That default will be due in large part to its membership in the European Monetary Union. If it were not part of the euro system, Greece might not have gotten into its current predicament and, even if it had gotten into its current predicament, it could have avoided the need to default.

There simply is no way around the arithmetic implied by the scale of deficit reduction and the accompanying economic decline: Greece’s default on its debt is inevitable.”

By joining the EMU Greece essentially handcuffed themselves.  They are not their own banker and have no control over the issuance of the local currency. As I mentioned above the problems imposed on Greece by being a member of the EMU are similar to what nations have gone thru under the gold standard in the past.  A single global currency under differing governments simply does not work equally for each nation because each of those nations has different economies, different trade needs and differing monetary and fiscal policy needs.  Feldstein elaborates on the current errors in the EMU:

“Greece might have been able to avoid that outcome if it were not in the eurozone. If Greece still had its own currency, the authorities could devalue it while tightening fiscal policy. A devalued currency would increase exports and would cause Greek households and firms to substitute domestic products for imported goods. The increased demand for Greek goods and services would raise Greece’s GDP, increasing tax revenue and reducing transfer payments. In short, fiscal consolidation would be both easier and less painful if Greece had its own monetary policy.

Greece’s membership in the eurozone was also a principal cause of its current large budget deficit. Because Greece has not had its own currency for more than a decade, there has been no market signal to warn Greece that its debt was growing unacceptably large.

If Greece had remained outside the eurozone and retained the drachma, the large increased supply of Greek bonds would cause the drachma to decline and the interest rate on the bonds to rise. But, because Greek euro bonds were regarded as a close substitute for other countries’ euro bonds, the interest rate on Greek bonds did not rise as Greece increased its borrowing – until the market began to fear a possible default.”

While I believe default would be the most beneficial situation for Greece I am not so certain that they will be allowed to default.  The BIS shows that European banks have almost $190B in Greek exposure and would be unlikely to get more than about 30-40 cents on the dollar – that is an intolerable hit to already fragile European banks.  But I am certain that there is no pretty solution to the current problems.  After all, these are fundamental problems in the structure of the EMU.  It’s simply impossible to coordinate mutually beneficial monetary and fiscal policy under one currency when you have such differing governments and economies.  As a highly indebted trade deficit nation, Greece has substantially different needs than a country such as Germany.  By not controlling their own currencies these nations are unable to properly target the needs of their own economies and best service their citizenry.

Greece might agree to a bailout package, but this would likely result in years of painful austerity.  In addition it would do nothing to solve the structural problems of their monetary system – the fact that they cannot control their own currency.  This greatly increases the likelihood of future problems.  The next recession is likely to result in one or more nations confronting similar issues.   In that case, we haven’t solved anything.  We’ve simply kicked the can down the road.  Lastly, a Greek bailout assumes that these same problems won’t be confronted in the near future with Ireland, Spain, Italy or Portugal.  If Greece gets the rumored bailout it’s only a matter of time before other countries demand assistance.  JP Morgan estimates that a bailout of Greece, Spain, Portugal and Ireland would cost €600B or 8% of Eurozone GDP.

There really is no good solution here.  It was a mistake for so many nations with such vastly different economies to enter the EMU and this crisis is a glaring example. If I were the Greeks I would be looking into the cleanest and least damaging way to defect from the EMU, bring back the drachma and ensure that a foreign central bank never controls my people’s money again.  These are problems that Greece will confront again if they do not confront them now.  But let’s be honest here.  We live in a bailout world.  It’s highly unlikely that Greece will be allowed to default and that is perhaps the scariest scenario in all of this.  While it would alleviate near-term fears it does nothing but kick the can down the road.  In addition to years of a very weak and painful Greek economy it will also set the table for future bailouts and inevitable future problems within the EMU.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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