The Greek Comedy

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The Credit Strategist

This essay is excerpted from the most recent version of The Credit Strategist (formerly the HCM Market Letter).  To subscribe directly to this publication, please go hereThe Credit Strategist is on Twitter - @credstrategist

“Comedy is tragedy plus time.”

Woody Allen

It is no longer prudent to dismiss the possibility of a worst-case outcome for the Greek debt crisis. Greece is not only laying bare the flawed structure of the European Union, but the fragility of the global financial system. Monetary union without political union is increasingly untenable and leaves global financial authorities with one hand tied behind their back. Furthermore, three years after the financial crisis, little has been done to reduce systemic leverage or strengthen regulation where it is most needed. Inexcusably, derivatives remain unregulated – the latest news is that the CFTC will delay the implementation of derivatives rules until the end of 2011. The failure to impose meaningful reforms on derivatives is largely due to the intense efforts of the financial sector to fight regulation. Moreover, the interconnected nature of global financial markets render Europe’s problems the world’s problems. What happens in Europe – or anywhere for that matter – can no longer stay in Europe. And what happens in even a minor player in the European Union – Greece accounts for a mere 2.6 percent of the European Union’s GDP – can no longer stay in Europe. An interconnected and networked global economy cannot ignore problems on its so-called periphery because there is no longer any periphery. Derivatives and other counterparty relationships have seen to that.

Accordingly, investors should hope for the best but plan for the worst. While there are signs this morning that Greece will receive the funds needed to avoid an imminent default, nothing has been done to solve Greece’s or Europe’s long-term problems. Of greater concern is what is happening on the political front in Europe. The New York Times described the political headwinds gathering force in Europe in this morning’s edition (“As Europeans Wince at Austerity, Markets Fear Turmoil,” June 16, 2011, p. A1):

“European officials are also worried that if Greece’s politicians bow to popular anger and reject the austerity route, other countries might follow, with potentially dire consequences for Europe’s banks and the common currency. So concerned were European Union officials about the potential for trouble that the bloc’s top financial official, Olli Rehn, hinted in Brussels on Thursday that Greece might get the new financial aid even if European finance ministers failed to approve the loan at a meeting this weekend.

In recent months, the governments of Ireland and Portugal have been ousted over efforts to cut budgets and benefits. Students have rioted to protest tuition increases in Britain, and young people who feel shut out of their own futures have held nationwide sit-ins in Spain, where the governing Socialists are in trouble in the polls. Rightwing political parties are gaining strength, tapping, in part, the populist rejection of austerity plans.”

So it seems we may be moving from an Arab Spring to a European Summer of dramatic political changes as the European populace revolts against the hegemonic powers that have guided their failed economic union.

The example of Iceland also looms large (at least to us). Iceland took over the domestic units of its broken banks and left private creditors to take their losses. The country saw its currency collapse by 80 percent against the Euro (which led to a trade surplus) and instituted budget cuts to rein in its budget. It also asserted its sovereignty as a reason for refusing to repay creditors of its broken banks. Iceland returned to the global debt markets last week, raising 5-year debt at slightly more than 3 percent. If weaker nations are forced out of the European Union, what is to stop them from following a similar route? This scenario is not as outrageous as it may seem. After all, the route that Europe is taking offers little hope for Greece or other countries of a light at the end of the tunnel.