By Shanmuganathan Nagasundaram
Greece, at less than 3 percent of the eurozone GDP, is not a very large economy. It’s smaller than many of the individual states of the US and their deficits are also comparable to (both in size and as a percent of GDP) states like California.
Even taken together as a group, the deficits of the eurozone (at 7 percent of GDP) are much smaller than that of the US (at 10 percent plus) and if one were to add the contingent and unfunded deficits (estimated at $5 trillion instead of the official $1.6 trillion), the US story gets much worse as compared to that of the eurozone. Of course, given the lack of political integration within the eurozone, maybe these comparisons are not all that valid. But then, all that a political integration means is an innate ability to use the printing press to pay off the debt – which necessarily is not a positive, as the world will recognise in the next few years.
However, despite the not-so-great importance in the scheme of worldly affairs, Greece would be a closely watched situation, for it indicates the direction in which future bankruptcies of countries would be dealt with (and there will be plenty in the years to come).
There are not a whole lot of options in front of Greece – either they stay within the eurozone or leave it. But what makes the situation interesting is the mechanism of defaults/rearrangement of credit subsequent to the above decision. Given the complex nature of how the situation will eventually play out, some explanations will stand in good stead before we proceed further.
There are two types of defaults when it comes to sovereign credit. The first, honest and rarely practiced mechanism, is when the government throws in the towel and acknowledges its inability to pay off the debt. The second, and more ubiquitous mechanism, is the use of the printing press to pay off the creditor (poor fellow receives the money, but it’s worth far less in terms of purchasing power).
For ease of reading, I will refer to the first as default through bankruptcy (DTB) and the latter as default through inflation (DTI). DTI is very commonly practised in the payments governments make to their citizens on a daily basis, but also happens between countries under special situations. The most publicised, nevertheless misunderstood, case of DTI would be Nixon closing the gold window in 1971 (though the US would refuse to use the phrase “default” in describing the event).
So the relevant question is not whether Greece returns to its old currency, the drachma, or stays within the eurozone, but the subsequent mechanism it chooses to default within the ambit of the above currency options. So potentially we are looking at four options: euro-DTB, euro-DTI, drachma-DTB and drachma-DTI. A brief note explaining each of these options is given below before we go on to explore the road ahead.
Euro-DTB: Greece stays within the eurozone and undertakes “real” austerity measures (austerity is when the government expenditure shrinks as a percent of the GDP — and for those who still believe that the euro has undertaken austerity measures, I should point out that government’s share has actually increased from about 44 percent in 2000 to about 49 percent of GDP today). There would be extensive defaults/haircuts to creditors, perhaps to the extent of 90-95 percent.
The euro would strengthen as a result, but this would result in a severe deflationary spiral, bank runs and recessions for Greece – essentially instant retribution for prolonged fiscal excesses.
Euro-DTI: Greece stays within the eurozone with Germany agreeing to loosen the purse strings. This would allow the European Central Bank (ECB) and other institutions to fund the Greek profligacy, though in a much more limited way than what the Greeks would like. We will still see defaults, but perhaps much less than the 90 percent number in the first scenario and the euro bureaucrats would get to pick and choose who gets how much (still wondering why they are pitching for keeping Greece within the eurozone?).
So Greeks gets subsidised by the holders of the euro and within the eurozone, the more sound economies of Germany, Holland and Austria fund the Greece bailout. In some sense, what we have been witnessing in the recent past is the euro-DTI scenario playing out. The EFSF (European Financial Stability Fund) with a lending capacity of €440 billion is nothing but a glossy version of Euro-DTI.
Drachma-DTB: Greece leaves the eurozone and, as part of the settlement, Greece would want the debt denominated in drachmas while the creditors would insist on a euro-denominated debt. Given the inevitability of litigation and other issues, a mid-way settlement is the most likely outcome. Irrespective of a euro or drachma settlement, Greece would default on its loans – perhaps a greater percentage of the euro loans than the drachma-denominated one.
Either way, we would be looking a severe deflationary depression. The main difference between a euro-DTB and the drachma-DTB would be the extent to which the euro would strengthen. By sending a signal that there’s no place within the union for fiscal excesses and that the ECB stands for monetary integrity, the euro is likely to strengthen far more in the euro-DTB scenario than under the drachma-DTB case.
Drachma-DTI: This is not very unlike what happened to Germany after WW-I (and incidentally, the main reason why Germany wants the ECB to behave much like the yesteryear Bundesbank), where the reparations were used as an excuse to inflate the currency. So even if the debt is denominated in euros or gold, inflation would be used as a policy tool by the political class for rearrangement of assets. With the likelihood of the far-Left coming to power (or being in a position to calls the shots, anyway) in Greece, we could witness the traditional anti-business/pro-freebie rhetoric to intensify and this easily could lead to a hyperinflation of the drachma within a year or two of Greece leaving the eurozone.
The Road Ahead
There are many ways to see the future – in terms of what is most likely, in terms of what is most desirable, etc. Before proceeding further, it should be recognised that the losses are real and cannot be made to disappear by any of the above mechanisms. The only discussion is about who pays for the losses and how.
The most desirable outcome: Drachma-DTB
From a long-term financial soundness perspective, this would be the most desirable outcome as it places the losses at the doorsteps of the people who made the mistakes – i.e. the people who borrowed the money, and even more so, the people who recklessly lent the money. This would ensure that sovereign debts are no longer viewed as a safe option and citizens would be careful to lend money to their governments in future.
This would also send a strong signal to the other nations – especially the PIIS (PIIGS minus Greece), or should I say PIIFS, which might include France? – that living beyond their means has dramatic consequences and that they can no longer rely on the printing presses to fund their excesses.
For sure, there would be contagion effects. But these effects are coming anyway – the only question is whether we choose to deal with the situation today under conditions of relative stability or at a later date when it’s forced upon us by the markets under much more strenuous conditions.
The least desirable outcome: Euro-DTI
This, of course, is the worst possible outcome. It kicks the can down the road in terms of addressing the imbalances, sends the wrong message that fiscal profligacies would be tolerated/condoned. Also, it encourages reckless depositor behaviour where creditworthiness is not even a factor in decision-making. Of course, it socialises the losses amongst holders of the euro, and, not surprisingly, this is also the option that most bankers would prefer. The recent €100 billion loan to Spain is just an example of the euro-DTI option being exercised.
The most likely outcome: Drachma-DTI
It is becoming increasingly clear that the austerity levels already imposed on Greece are not sufficient to cover the losses incurred (if you can call the increased government share of the GDP as austerity in the first place). Given the inability to impose further austerity in a democratic system and the unwillingness of Germans to further fund the Greek profligacy, Greece would be forced to leave the eurozone. The new leaders of Greece (especially if they are from the Left) would ratchet up the rhetoric for a bailout till the euro-DTI option would threaten the stability of the eurozone itself and Germany would have no option but to let Greece leave. That’s the inevitable outcome though it may not be imminent.
So what does it mean for Investors?
The problems in the eurozone have given a temporary reprieve to the dollar as it’s quite incorrectly perceived as a risk-off trade. In fact, the problems of Greek sovereign debt should have indicated that the biggest risk-on trade is that of the US dollar/treasuries. Perhaps we are still a year or two away from the average investor realising that. Nevertheless, once a solution is reached to the Greek crisis (in whatever form), the world’s attention should squarely return to the US dollar and, coupled with the usual charade of the debt-ceiling limit drama and the US presidential elections, we should witness a resurgence of gold by the fourth quarter of this year.
From a longer-term perspective though, what is happening in the eurozone is incredibly bullish for gold. When I wrote my analysis for $10,000 an ounce for gold for the current decade Gold – Ending 100 Years of Solitude, April 2009, I had assumed far more responsible actions from the ECB than what they have undertaken so far.
Given that they are more or less likely to follow the footsteps of the US Fed, it implies that the currency units of dollars and euros that are likely to be printed over this decade would run into the tens of trillions, if not hundreds. So the $10,000 per ounce target for gold is going to really look like a conservative estimate (Current price: $1,626 per oz).
Shanmuganathan “Shan” Nagasundaram is the founding director of Benchmark Advisory Services – an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted at firstname.lastname@example.org