September 2011
Greece
It is looking more and more likely that Greece will default on its debt obligations sometime late this year or early in 2012. Unnamed sources at the IMF have begun commenting on the likelihood of default before Spring 20121 and the Royal Bank of Scotland (RBS) expects to see default in December during Greece’s next IMF review.2 RBS has noted a lack of promised reform, unrealistic austerity targets, increasing difficulty in getting the Greek parliament to pass laws, and an increasing unwillingness of the IMF and European Union to compromise on their demands of Greece as the reasons default is likely this winter.
Greek default will have a negative impact on European banks – most heavily upon German and French banks. The German government is already preparing for this development and will help German banks hurt by a Greek default.3 Helping banks affected by default is seen as a much more sound long-term fiscal policy than continuing to help a government mired in mismanagement. We are also likely to see Greece ejected from the EU as member nations tire of Greece’s inability to manage government finances. German lawmakers in particular have been quite vocal in calling for Greece’s expulsion.4
Greece has never had a reputation for competent government management. It became a nation in the modern era in 1829, but did not transition to a modern economy until war pushed it to do so in the era of WWI and its aftermath. Greece has seen major economic crises play out almost every decade since 1900. While one would expect to see negative effects on European economies from WWI, the Depression, and WWII, Greece has also seen a civil war from 1944-1950, a coup d’état in 1967 that lead to dictatorial rule through the early 1970′s, inflation almost 20% (3 times the EU average) in the 1980′s5, and triple digit debt-to-GDP ratio in the 1990′s5. While Greece was able to do much to improve finances and meet EU eligibility requirements for stability during the late 1990′s, that position has not been the norm in the economic history of Greece. It cannot, therefore, be a shock that the country is having problems.
The effects of Greece, Italy, Spain, Portugal, and Ireland on the Euro has already been felt and priced into the value of the Euro. I visited Italy in September of 2002. I recall the Euro being worth slightly less than the dollar at that time. Now we see a Euro worth about $1.40 U.S. as of September 9th. Just a few months ago the Euro was even trading at about $1.50 to the U.S. dollar!6 As Greek default becomes more sure we are likely to see the Euro drop closer to parity with the dollar. The consensus estimates from what I have been reading seems to be parity within 2-3 years as the sovereign debt situation in Europe plays out over the near future.
The good news in this situation is that Greek default has been seen as a likely outcome within economic circles for quite some time now and is already mostly priced into the market. While we have not seen reports regarding certain Greek default in the general media, this has been an issue widely noted and followed by economists and analysts for some time now. A portion of the market volatility we have seen this summer has been directly linked to this issue and it being priced into the general markets. Analysts of European banks have known for some time now that banks holding Greek bonds would not be getting back 100% of principal invested. They have already priced in a default to their analyses, so a default will not be a shock to the system. I would also note that default does not mean Greek debt holders receive nothing. They are expected to see a partial repayment of debt. What is unknown is the rate of repayment that can be expected. That rate is likely to become more clear as we reach the December IMF review of Greek finances.
I would note that a Greek default is not without precedence. Argentina saw economic collapse (extreme currency devaluation and hyperinflation) in the late 1980′s and then outright default on debt in 2001. It has recovered from these events and at $370 billion now has a GDP about 20% greater than Greece’s7. There is no reason why Greece cannot similarly recover from default.
A number of analysts see Greek default as a positive development. It will allow for resolution to the situation for the Greek people, provide certainty (and calm) to the markets, and allow European banks and governments to regroup and move towards the future. Knowing when to cut one’s losses and move on is part of a leader’s job. EU countries like Germany and Finland have recently been quite vocal about their willingness to end the Greek crisis by allowing default. I agree that it is time to make this call.
U.S. Outlook
I don’t have much to add to my analysis of the U.S. economy in the August newsletter. I have not seen much change in the U.S. situation over the past few weeks and the points I made then are still valid. I did read an interesting article on CNBC this week that made a useful analogy. It included commentary on the U.S. economy from Stephen Schwarzman, the CEO of the private equity firm Blackstone.8 Mr. Schwarzman compared the U.S. economy to the body of an out-of-shape athlete. He noted that the U.S. government spending has historically been about 20% of GDP. (This would be true since the early 1950′s.9) That level has now risen to 25%. I would elaborate on the analogy a bit. Like an athlete that has allowed their waistline to grow and muscles to contract we have allowed spending to grow and infrastructure to shrink. We need to see some combination spending reductions and tax increases on the part of government. The Bush era tax cuts that may be allowed to expire are worth about $70 billion. You may recall that S&P asked to see $4 trillion in deficit reduction when they downgraded U.S. debt. So, while $70 billion would help the fiscal picture, government spending needs to be reduced.
In addition to discussions around spending cuts, we need to see a discussion about spending priorities from governmental leaders. What is clear to me, and the business community members I interact with, is a need to focus more on the infrastructure spending. We have water mains, bridges, air traffic control systems, a national electrical grid, and other such basic systems that are in great need of repair and/or updates. Spending on these types of projects is really needed and the nature of the work would provide better paying jobs. A reprioritization of spending with an eye towards the infrastructure needs of the country would seem to be more productive endeavor for the administration to focus on.
1) http://www.businessinsider.com/senior-imf-economist-expects-hard-default-for-greece-soon-2011-9
4) http://www.reuters.com/article/2011/09/08/germany-finmin-idUSL5E7K80CK20110908
5) Elisabeth Oltheten, George Pinteras, and Theodore Sougiannis, “Greece in the European Union: policy lessons from two decades of membership”, The Quarterly Review of Economics and Finance Winter 2003
6) http://www.x-rates.com/d/EUR/USD/graph120.html
7) http://en.wikipedia.org/wiki/Economy_of_Argentina
8) http://www.cnbc.com/id/44437298
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