Why Europe wants Greece to remain in the euro

Why Europe wants Greece to remain in the euro

The Euro currency experiment

Politics rather than economic matters drove the creation of the single euro currency just over 10 years ago. The euro was conceived as a glue to bind Europe more closely together and prevent armed conflict on the Continent. But there were some engineering flaws.

The single euro currency fed the illusion that Greece, Spain and Italy were as creditworthy as Germany or the Netherlands, propelling a decade long economic boom driven by increased borrowings in Europe’s less developed nations. As we’ve noted before, interest rates (monetary policy) in the European Union were set centrally, but each country could control its own budget expenditure.

To work effectively, the Eurozone needs a central treasury. Tax and spend policies must match centrally imposed monetary policy. A permanent solution to the euro therefore requires a shift in Eurozone democracy away from individual nations towards the centre and the engendering of trust.

Why Greece may leave the euro

On 6 May, Greek voters punished the main political parties for agreeing to austerity measures with the EU. Greece now faces further elections on 17 June after no party was able to form a governing coalition.

Greece is a country of just 11 million people representing only 2.5% of the Eurozone economy. But the country is in depression.

The following graph shows the Greek and US sharemarket downward trajectories for the first 1,000 days from their respective peaks in December 2007 and September 1929. They mirror each other, but Greece is actually fairing slightly worse.

Why Europe wants Greece to remain in the euro 

Source: MoneyGame

Without the ability for the Greek economy to improve productivity with a depreciation of its currency, it will be difficult for the country to turnaround. But the prospect of leaving the euro remains an intimidating prospect. With depreciation comes inflation and possibly further social unrest due to the perilous state of the banking sector and the inability to fund the social, medical and educational sectors.

Argentina has been down a similar road before

Against the punishing austerity demanded by Germany, an exit from the euro — followed by a sharp devaluation of its currency — might not seem too bad a proposition for Greece.

Countries have taken a similar path before.

In 2001, Argentina dropped their peso’s decade-long peg to the US dollar, resulting in the currency dropping 70% and virtually wiping out the savings of Argentine citizens.

Banks went belly-up. Real wages plummeted. Foreign investment dried up after the country defaulted on its foreign debt, and the government had to slash spending to live within its means. Its GDP (economic output) declined by nearly 20% in four years and unemployment reached 25%.

But from 2003 onwards, the Argentinian economy started to grow. For the next 5 years, it grew at 9% pa – equivalent to the current growth of the Chinese economy.

Why Europe wants Greece to remain in the euro

Many of the most painful steps of the Greek bailout have already been completed. After sharp cuts, Greece’s budget deficit excluding interest payments is close to balance. The deficit is down from 10.6% of GDP in 2009 to 2.2% last year.

Greece has already negotiated with debt holders to halve the value of their bonds, and most of its debt is now held by Eurozone governments.

If Greece did exit the euro (thereby defaulting on its remaining debt) and adopted its own currency, its domestic government spending and revenue would be roughly in line.  However, the rest of Europe would incur losses on Greek debt and markets would start speculating on other countries leaving the euro.

The European nations want stability as much as the global financial markets.  In recent days, messages from European leaders have been clear – they want Greece to remain in the euro.

Unless the domestic political situation demands it, Greece appears unlikely to exit the euro.

Possible effects of Greece’s exit on the global economy and financial markets

Foreign banks have already reduced their exposure to Greece considerably – most Greek debt is held by European governments – so the likelihood of a global banking crisis is low. The current situation is unlike September 2008 when Lehman Brothers collapsed.

Financial markets have had two years to prepare for the possibility of Greece leaving the euro, and money markets in the US and Asia remain open and liquid. In July, a new $645bn European Stability Mechanism rescue fund also becomes available.

It is likely that the Federal Reserve, International Monetary Fund (IMF), and European Central Bank (ECB) would firewall Portugal, Spain, Italy and Ireland from a possible contagion occurring.

Perhaps the greatest threat from a Greek exit would be a failure of the Greek state. The political situation is already chaotic and will become much more so in the event of departure. If a broken political system can’t manage to improve tax collection or reform public finances, then covering the government’s obligations will require money printing. That may lead to hyperinflation that will only exacerbate problems. Should this dynamic develop, conditions will be significantly worse for the Greeks outside rather than inside the euro area.

What should investors do?

Stockmarkets may be volatile over the remainder of 2012 as political matters in Europe are resolved, but certainty of outcomes will eventually help investor’s confidence.

There have been large inflows of foreign investments into our local market, which reflects investor’s views that Australia is a ‘safe haven’.

Investors should always have a plan in place to deal with the possibility of volatile markets.

We continue to recommend our clients, particularly those with no regular income from employment, maintain at least 5 years worth of cashflow requirements in high quality and liquid cash and fixed interest securities to protect against the possible need to sell stocks at distressed prices.

Author: Rick Walker

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.