The "Grexit"?

In case the list of things keeping you awake at night isn't long enough already, you might want to put Greece and the Euro Area back on your list of serious economic concerns. On January 25th, Greece will hold national elections. The mere fact that elections are being held is problematic, but the outcome might well be far worse.


The problems of the Euro Area and the origins of the European debt crisis are myriad, been written about far more articulately, and need not be repeated here. By far the best diagnosis of the challenges facing the Euro Area and the European Union generally was produced by The Economist back in 2009 in special report called "Holding Together: A Special Report on the Euro Area." (Since the link is dead, I hope The Economist will forgive me for providing access here.) Part of the punchline is that the Euro Area is beset by a series of problems arising from the incomplete pooling of sovereignty that has permitted divergent and misaligned policy outcomes among members. In an earlier post, I wrote about some of the sovereign trade offs with integration that would have confronted Scotland had they voted for independence last fall. In the case of Europe, The Economist was fairly sanguine about resolving the most serious of these challenges, and even suggested expansion was still a strong possibility.

The optimism about expansion was perhaps misplaced, at least in the near term, as the Greek debt crisis gripped Europe through much of 2011-2012. As the scale and scope of a possible Greek debt default on the rest of Europe (especially private French and German banks), talk of "contagion" gripped the markets as Europe's leadership grappled with what to do. The solution was deep austerity for the Greeks, a restructuring of its debt, and new debt financing from the rest of the Euro Area. It got pretty ugly. Yet, over the past two years, Greece and the Euro Area have stepped back from the precipice.... sort of. The restructuring of Greek debt and the government austerity measures have balanced the Greek budget and put the country on a more positive footing. Yet, none of it positioned Greece for a quick rebound. Greece's problems were long in the making and would entail long-term pain to undo. The Greek economy has contracted by more than 20% since 2010 and unemployment hovers around 25%-- hardly a recipe for social and political stability.

With the Greek state on its knees financially and beholden to the rest of the Euro Area (especially Germany), it is hardly surprising that a vigorous political debate has ensued in Greece over the merits of austerity as a condition of Euro Area membership. While the political and economic brinksmanship of 2012 has returned in the run-up to Greek elections, many analysts seem relatively calm about prospects for a "Grexit" to foster contagion. I hope they are right.

Contagion?

In the years since 2010, several things have happened that suggest the happy talk about the low risk of contagion from a "Grexit" will be borne out, most of which are anchored in the assumption that most institutions with financial ties to Greece have had time to immunize themselves from its potential effects. Markets hate surprises even more than uncertainty. The severity of the Greek crisis in 2010 was a surprise to many. In 2015, the thinking goes, it would not be. Moreover, many assume that France and Germany have far too much at stake in European integration to allow the Euro's credibility to crumble.

Yet, in reading such talk I am reminded of 2008 and the collapse of Lehman Brothers. In the spring of 2008, the U.S. Federal Reserve engineered the forced sale of Bear Stearns, a relatively small investment bank, to J.P. Morgan. The reason? Concerns about financial contagion. Hence, many assumed that someone would engineer a similar rescue for Lehman Brothers since it, unlike Bear, was "too big to fail." The ensuing market chaos in the weeks and months following Lehman's collapse outstripped everyone's capacity to manage. A victory in January 25th's Greek elections by a coalition of anti-austerity parties could usher in a period of great uncertainty about Greece's willingness to continue on the financial path set for it by the rest of the Euro Area.

Yet, uncertainty about the merits of Greek membership in the Euro Area is not restricted to Greece. Germany, and the German tax payer in particular, has been experiencing significant Greece-fatigue. In a recent public opinion poll, a full 61% of Germans said they'd favor throwing Greece out of the Euro Area (link) if January 25th's electoral mandate suggests abandoning austerity. As the strongest economy in Europe, Germany has taken the lead on the Greek mess and will do so in the event of a "Grexit." In 2012, The Economist penned a hypothetical memorandum to German Chancellor Angela Merkel outlining the trade-offs and challenges of a Greek exit from the Euro zone. It's worth a read since the implications of even a "smooth" exit by Greece are profound. The lousy prognostications of financial analysts in 2007-2008 have probably primed me to doubt those saying the Euro Area is ready for a "Grexit." We'll just have to wait and see.

Bonds as Barometers of Risk

In reporting about the nerves raised by Greek elections, we often read about the impact on the bond markets. I am not expert here, but one way to read bond market activity is as a kind of barometer of risk (and or fear). Consider the way in which bond markets treat U.S. Treasuries. Because the U.S. economy has been on a steady, albeit anemic, path to recovery since 2008, U.S. treasuries are considered highly safe places to park one's money. In other words, no one thinks the U.S. is going to go bankrupt any time soon. Your money is safe in treasuries. As a result, the price of Treasuries in the secondary market is quite high while the yield, or interest they pay, falls inversely. On Friday, U.S. 10 year bonds were yielding just 1.95%. Such low interest rates on government bonds are a huge advantage for the United States when it comes to borrowing to finance its own, rather large, debt. In other words, to borrow money from abroad for 10 years, the U.S., in effect, need only offer 1.95% on that money. Cheap, cheap, cheap. Moreover, global capital markets are nearly 100% certain the U.S. will be able to pay out both the principal and interest on that bond in 10 years time.

This is not the case for Greece where yields on government bonds are roughly 10.30%. In other words, Greece has to offer up nearly 10.5% interest to convince foreign investors to lend the country money. That is both expensive, and a rough litmus test of the risk premium the market places on Greek bonds. As political uncertainty over Greece's willingness to adhere to its austerity program grows, the threat of Greek default on the debt held by foreigners rises as well. As that threat rises, Greece will have to offer even higher interest rates on bonds to convince investors to that Greek bonds are a worthy investment. In the aftermath of January 25's elections, watch Greek bond yields.

Check Your Serial Numbers

One of my curiosities in contemplating a "Grexit" is actually quite practical; how exactly do you "exit" a currency union, re-introduce your own currency, and what happens to the currency that once circulated? There are lots of examples of countries that have introduced, eliminated, and then re-introduced fiat currencies. The Euro Area itself is a good example of the relatively successful introduction of a viable currency. It takes planning, but can be done. Venezuela, on the other hand, seems to introduce new forms of the Bolivar every other week.

One interesting speculative phenomenon to watch out for with respect to a possible "Grexit" is what happens to the value of the Euros that are actually printed in Greece vs. those printed in France, Germany, or other countries. If you knew you had Euro notes that were printed in Greece, would you want to hold them relative to those printed in Germany? You can, evidently, determine with some accuracy where particular Euro notes were printed based upon the serial numbers that appear on each note. If your Euro note's serial number begins with "X," it was printed in Germany. If it begins with "Y," it was printed in Greece. In the event of the breakup of the Euro, would "X" notes fetch a premium relative to "Y" notes on the black market? Like the creation of the Euro itself, the breakup of the Area would amount to an interesting experiment.

However, before you run to the bank to get rid of your "Y" Euros, remember that Euros are Euros regardless of where they are printed or traded. U.S. Dollars are printed (officially, anyway) only in the United States, but circulate all over the world. Following a "Grexit," Greece would have to re-introduce its own currency (presumably the New Drachma), and would no longer print Euros. However, even Greek "Y" Euros, would continue to circulate around the world since their value would continue to be backed by the remaining membership and managed by the ECB.

Buckle up! You think declining oil prices are worrisome? Wait until the January 25th.....