The Greek drama continues to unfold. Greece has just made a €450 million payment to the International Monetary Fund, and although Greek finance minister Yanis Varoufakis has made assurances that Greece will honor all obligations to its creditors, fear continues to mount as we reach yet another “critical moment” (one of an endless series, it seems). A default would almost certainly inaugurate Greece’s exit from the common currency. Is that likely, and if it happened, how bad would it be?
In a few words, the answer to both questions is “not as much as you think.”
Why a Greek Euro Exit Is Not Likely
Economists like to talk about rational actors in markets, but the reality is that market participants and government officials are never totally rational. To understand European commitment to the Euro project, we need to appreciate some of that irrationality and its roots in Europe’s historical experience.
The common Euro currency has its roots in a process of European unification that began in the aftermath of the Second World War. However, if that war is linked, as it should be, with the political and economic consequences of the First World War, we can see the outline of a long “European civil war” that ran from 1914 to 1945 -- and laid waste to the continent, killing 100 million soldiers and civilians.
If you draw Russia into the picture, and see the Russian Revolution and subsequent slide into totalitarian barbarism as intimately connected to Europe’s 20th century “civil war,” that adds perhaps another 50 million casualties to the total. In this perspective, European disunity and the wars and revolutions it enabled was a catastrophe as severe as the medieval Black Death.
The Tragedy That the EU’s Founders Vowed Would Never Happen Again: Europe, 1945
Source: Wikipedia American observers, from this distance of time and space, often have a hard time appreciating the impact that the experience of this catastrophe had on the consciousness of Europe’s elites.
Foundations of the European Union
Here is some EU history which we feel is important for grasping Europe’s current situation.
In 1951, six European countries signed the Treaty of Paris, which created the first institutions that would grow into the present European Union. At the same time these leaders (of Germany, France, Italy, the Netherlands, Belgium, and Luxembourg) signed the “Europe Declaration,” which stated that they were “determined to replace age-old rivalries by a merging of their fundamental interests, to lay the first foundations, through the establishment of an economic pool, of a broader and deeper community between peoples long divided by cruel strife, and to prepare the ground for institutions capable of guiding a destiny henceforth to be shared in common.”
An earlier declaration of European leaders in 1950 had stated that “Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity.” The Euro currency, flawed though it may be, was a crowning achievement of half a century’s worth of efforts.
It wasn’t just political elites who felt these sentiments -- they ran deep in a European mind-set scarred by decades of war and suffering.
In brief, the Euro project is deeper than economics; it is about much more than easing commerce between nations that happen to share a continent. It represents the commitment of Europe to take a different path than the one that led to the cataclysm of the 20th century. We must also bear in mind that Germany, the “bad cop” in Greek negotiations, is the country that feels the greatest historical guilt for that cataclysm.
None of this means that efforts to keep the Union together are destined to succeed, but it does mean that the weight behind those efforts will be very great.
A Greek Exit From the Euro Would Probably Mean a Greek Exit From the EU
There is no legal framework for a country leaving the common currency. The legal consensus is that a departure from the Euro would mean a departure from the EU itself. Perhaps if “Grexit” came to pass, politicians could jerry-rig a solution that would keep the country in the EU… but the sense that EU membership is irrevocable would be mortally wounded. Psychologically, the EU would no longer be a “done deal.” The fear would enter that under tough circumstances, it could disintegrate. The prospect of such uncertainty would possibly work to undo the whole purpose of the political movement that started with the Europe Declaration in 1951.
In addition, a Greek exit would put a question mark in front of other troubled European economies, especially Portugal, but also Spain, Italy, and even France. If Greece can leave, so can they.
Is Greece Worth the Cost?
So from one important perspective, the price of keeping the whole European project secure is the price of keeping Greece in the Euro. Is that a price that other Europeans are willing to pay?
Greece’s debt currently totals about €315 billion. In 2012, when the Euro crisis last got hot, most of that debt was in private hands. Now the reverse is true; about €280 billion is in the hands of multinational institutions such as the International Monetary Fund and the European Central Bank. Private-sector exposure to Greek debt is therefore about €35 billion, or about 0.25 percent of Europe’s GDP. This makes sense, as the Greek economy represents only about 1.3 percent of the Eurozone’s economy.
From Greece’s perspective, its debts are daunting… from a larger perspective, they are actually quite small. The debt in institutional hands can be handled in any number of “creative” ways that will not be technical defaults.
In the last analysis, then, Greece’s economy is tiny and private-sector exposure to its debt is insignificant. So if it’s necessary to reach a creative accommodation with Greece that saves face for all concerned, and removes the specter of Europe’s disintegration, we think powerful forces will be working for that accommodation to be made. Of course, there will probably need to be public finger-wagging from Germany for decades to come as Greece stumbles towards small improvements in tax collection, government thrift, and fraud reduction.
Finally, we note Greece’s recent moves towards Russia, including visits to Russia by Greek lawmakers and now by the Greek Prime Minister Alexis Tsipras himself. At that meeting, Tsipras did not ask for financial assistance -- but did express his hope that Greece would be a major participant in a new pipeline project to bring gas to Europe across the Black Sea and through Turkey, the “Turkish Stream” project. For his part, Vladimir Putin said that Greece would become “one of the main power distribution centers on the continent.” These events must be setting off alarm bells in capitals around Europe, given Russia’s new aggressions against its neighbors and Europe’s keen consciousness of its dependence on Russian energy. We simply ask: will Europe’s leaders really stand by while Russia uses Greece to establish a political and economic beachhead in southern Europe? Does Germany’s Angela Merkel not view Greece as a pawn in a Russian game of chess? Vladimir Putin certainly does.
But What If It Happens Anyway?
As we often observe, though, when big things are travelling at high speeds, mistakes can happen. The management of the Greek crisis has been poor enough on the part of Greece and its creditors that a Grexit can’t be ruled out even if neither side wants it to happen.
How bad would that be? Initially, it would be very negative for European market psychology as well as for Greek citizens and companies; the latter would enter a period of hardship that would make the troubles of the last 6 years seem like a stroll in the park.
However, as we observed above, the real financial consequences for the rest of Europe would not be that severe, as most of the pain of a default would be absorbed by multinational institutions. European -- and probably global -- markets would be hit hard psychologically, but we think it would be a relatively short correction. The Euro would initially decline sharply. But when the European ship was righted, it would in many respects be better off than before. Greece itself would also ultimately be better off, since its debt would be largely written off and its new currency would be cheap enough to go far in restoring its competitiveness. (This, by the way, is how insolvent countries have cured their ills since the dawn of civilization.)
In the event of a Greek Euro exit, the lingering worry hanging over Europe would still be the other laggards… Portugal, Spain, Italy, and France. None of those economies, however, troubled though they may be, approach Greece’s level of dysfunction.
We do not doubt also that Grexit would bring the ECB out swinging -- with aggressive QE already underway, Mario Draghi has shown that he is capable of action, and in the event of such a crisis, the ECB would not stand idly by.
Investment implications: The European project runs deeper than just economics, and the commitment to keep the European Union intact is rooted deeply in Europe’s tragic 20th-century history. Since a Greek exit from the Euro would threaten the sense that EU membership is irrevocable, we believe that efforts on the part of EU officials to avoid a “Grexit” will continue to be robust and determined. The handling of the crisis has not been good on either side, however, and an “accidental” default and exit can’t be ruled out. In that event, the Euro and European markets would suffer for a time, but mainly for psychological reasons. We believe they would emerge stronger after any such correction. In the meantime, weakness from Grexit fears can offer investors an opportunity to increase their European exposure while the Euro QE bull continues to run. We have recommended the Deutsche X-trackers MSCI Europe Hedged Equity ETF (DBEU), which gives broad exposure to Europe, hedged for a declining Euro. If you simply wish to short the Euro without equity exposure, we recommend the ProShares Short Euro ETF (EUFX). We remain bullish on Europe. A Greek Euro Exit -- How Likely Is It, and How Bad Would It Be?