A Greek Tragedy Averted - for Now

Greece and the European Union (EU) have bought themselves four months before they must re-engage their negotiations. The reprieve is welcome, and shows a clear desire by both sides to reach an accommodation; but a Greek exit, even an unraveling of the common currency, remains a possibility. Arduous negotiations are still ahead for Greek prime minister Alex Tsipras and finance officials from other eurozone nations. And the potential for failure in the next round of Greek–EU talks carries immense risks, including a financial crisis that would spread quickly across the Atlantic, east to west.

Still, probabilities presently favor some accommodation among these negotiators to hold together the eurozone and buy still more time to resolve the Continent’s ongoing fiscal–financial crisis. The terrifying nature of such a prospect alone—and other narrower calculations of national interest as well—make it clear to all that they have too much to lose from failure. Still, investors need to know the downside—if not only to brace their portfolios for it immediately but also to make plans for such adjustments should the probabilities shift.

The Disaster Scenario
If the only problem were Greece, Europe would have little reason for fear. Greece is, after all, small. Its economy amounts to little more than 6.0% of the German economy and much less of the entire eurozone.¹ All Athens’s public debt amounts to barely 1.0% of European bank assets.²But a great threat remains nonetheless because a Greek–European rupture could start a chain reaction of defaults or restructurings among the rest of the Continent’s beleaguered periphery.

Even if Greece or these other nations were to stay in the common currency, a denial of support would force Athens to default on or reschedule its existing debt. Creditors in such a case would naturally lend less freely to all the troubled countries of Europe’s periphery and demand higher interest rates to cover the perceived risk. Such difficulties would raise the demands for EU aide, perhaps to unsupportable levels. Higher financing costs and less credit availability could then force defaults on, or reschedulings of, these countries’ debts, whatever other EU aid was available and whatever their former commitment. Were Italy, say, or Spain, and perhaps France and Belgium to default or restructure, the loss of wealth among financial institutions and other creditors would reach proportions that could threaten the stability of the European financial system and so threaten a still deeper economic decline than already exists in Europe. These events also would threaten the world financial system and the global economy, for though U.S. banks, for instance, own little Italian, Spanish, or Greek government debt, they do hold a lot of the obligations of financial institutions that do own a substantial amount of such sovereign debt.

The ensuing crisis would be large and unmanageable even if these questionable credits were to remain inside the currency union. If those reneging on their obligations were expelled from the eurozone or choose to leave, the crisis could get infinitely more severe. At the very least, such a move would create tremendous administrative confusion. If Greece, for instance, were to return to the drachma, how would Athens treat its outstanding euro-denominated debt? Given the state of that country’s economy and its public finances, an effort to honor the obligation in euros would certainly present a dubious prospect. The same concerns would emerge with Spain, Italy, and others. If Greece or one of these other countries were to convert the debt into their revived national currencies, the losses from depreciation would immediately destroy still more wealth and continue to do so with further depreciations going forward. Europe’s financial system would then become still weaker, deepening any crisis there and around the world.

Although Possible, Such Disasters Are, However, Improbable
If such terrible prospects alone will likely motivate Greek and EU negotiators to avoid a rupture, there also are narrower, more calibrated interests that will prompt both sides to come to an accommodation or at least paper over differences in a muddle for which the EU has become infamous during this crisis. It may have been a mistake for Greece to even join the euro, but having done so, it has much to lose by leaving it now—something Athens knows could easily follow from intransigence. Other nations involved—Italy, Spain, France, Belgium, et al—have similar benefits to lose from an unraveling of the union, or their place in the union, even if at the start it may have been a bad idea for them to join as well. Nor do the Germans—crucially important because they are Europe’s paymasters these days—want to see the euro threatened.

Greece offers an illustration of what all the poorer countries on Europe’s periphery stand to lose. For one, the union and the eurozone have brought it huge wealth transfers for the rich regions of Europe. The EU and the eurozone have largely paid for highways, bridges, ports, and other important pieces of economic and social infrastructures that had not existed and would not exist were it not for membership. The ability of people to move freely across the union’s borders has provided a great benefit as well. Greece has relatively few sources of income, but the nation benefits greatly from remittances from its nationals living and working elsewhere in the more prosperous areas of the EU and particularly the eurozone. An end to the affiliation would close down these important transfers as well. A return to a depreciated Greek drachma or Italian lire, or whatever, might help exports, but savers in these countries would quickly lose global purchasing power, a loss of wealth, potential credit, and investment that would weigh on the economy. To be sure, Greece’s new government probably does not count these savers as constituents, and so cares little for them, but it does care deeply about the more general economic hardship that would surely accompany such a wealth loss. Italy, Spain, and others could make very similar calculations.

The Germans also have narrow pro-euro interests. It is surely ironic that Berlin, of all European governments, was most skeptical of the common currency, and yet Germany has benefited especially from it. To see why, consider where the German exports would be if the country still used its deutschmark. Money is pouring into Germany, as the only large and viable economy on the Continent. Such flows would have pushed the deutschmark up to astronomical levels, pricing German exports off global and even European markets. Especially because the euro encompasses many weaker economies, it has declined in value and certainly stayed lower than a German deutschemark would have, protecting German producers by allowing them to price their products much more competitively than they otherwise could. Berlin, no doubt well aware of the effect, has every interest in protecting the eurozone, and, what is more, keeping its membership broad. It needs an agreement to secure this arrangement.

A Tentative Conclusion
Risks remain, and great risks they are. For that reason alone, it is fair to say that danger for American investors comes from the east. But for all the reasonable fears and concerns, the interests of all involved argue that the eurozone will avoid such a disastrous outcome, even if it involves endless negotiations and a glossing over of differences. No doubt, the Continent’s fiscal–financial crisis would then remain ongoing, but that is better than the alternative. If investors need to remain aware and wary of the potential downside, the probabilities at the moment do look more benign.