The real threat that a Greek exit poses to the eurozone

I was on holiday last week, and out of touch with the office.

Just before I left, my colleague Merryn sent me an email saying: “I can’t believe you might miss Grexit!”

I’ll admit that I felt a stab of anguish. I’ve been covering this interminable story for three years or more now, and I’d hate to miss the denouement.

I needn’t have worried. The Greeks have yet another ‘last-minute’ deadline this week. And it’d be a braver man than me who bets on it being the final one.

But are we all getting a little too complacent?

Another day, another crisis in Greece

There’s a eurozone emergency meeting (funny how that phrase just trips off the keyboard these days) today. It’s yet another ‘11th hour’ attempt to reach a deal with Greece. I have no interest in running through the arguments again, and I’m sure you don’t either. But just in case, here’s the potted version.

Greece can’t pay back the money it owes. To get debt relief from the rest of Europe, it needs to reform its economy. But Greece doesn’t want to reform its economy. Nor does it want to leave the euro, which is very likely to happen if it defaults on its debts.

So either one side or the other blinks first, or Greece leaves the eurozone. Same story as it’s been for the last three years or so.

And markets, apparently, really couldn’t give a damn what Greece does either way. As John Authers notes in the FT, the euro is “virtually unchanged since January’s Greek election sparked this phase in the crisis”.

Is that wise?

What could trigger a ‘Minsky moment’?

Markets are complacent for the reasons I outlined last Monday. The simple truth is that we’ve been through any number of potentially nasty scenarios since the recovery from the financial crisis began in March 2009. So far none of them has made a dent in the bull market.

Investors have gone from raging scepticism to a belief that central banks can walk on water. Even the bears now exude a sort of resigned acceptance – things look ugly, but it’s hard to see what can upset the apple cart while central banks remain in control.

Given that backdrop, how are you meant to invest? You can argue that the market is irrational, but shorting it is financial suicide when the world’s central banks remain in printing mode. The market saying: “Don’t fight the Fed” has never been proved so right as over the last six years.

And you can fret all you want about Grexit, but Greece has been on the point of abandoning the eurozone for at least three years now. If you’d spent all that time sitting in cash, say, waiting for the next big one, you’d have missed out on plenty of gains.

Markets can be forgiven for feeling a bit of crisis fatigue – lord knows I’m most definitely at the stage where I just want it to be over with so we can talk about something else.

Trouble is, as I also pointed out last week, this is why Hyman Minsky was right. It’s all about psychology. After a crash, we’re all jumping at our own shadows, and every time the market cries ‘wolf!’ we rush for safety.

But the market keeps calling ‘wolf!’, and nothing happens. And eventually we find ourselves ignoring the cries of ‘wolf!’ – instead, we start to head for the most dangerous patches of pasture we can, because they offer the best pickings.

Then one day, the market cries ‘wolf!’ and this time it isn’t wrong. And by that point we’ve all wandered so far from safety that the result is sheer carnage.

Is there any problem that central banks cannot fix?

So let’s think about a potential trigger. The next crisis has to arise from something that is tricky for central banks to deal with.

Another ‘Lehman Brothers’ probably wouldn’t cut it, because we know now that the Fed would just print money and organise a recapitalisation – a bailout. The strategy for dealing with major financial institution blow-ups has been established by LTCM (the big hedge fund blow-up in the late 1990s) and Lehman. They should be able to contain that sort of thing.

But a far more ‘tricky’ problem for central banks to deal with is sovereign debt. If it becomes clear that your country cannot repay its debts, and you print money to allow it do so, then you are ‘monetising the national debt’. Central banks aren’t allowed to do that. In other words, bailing out a whole country is much trickier than bailing out a bank.

(In case you’re wondering, the current quantitative easing programmes are ostensibly all about driving up the money supply, not financing government spending. You can argue that this is all semantics and perception, but semantics and perception matter in this case.)

Let’s say Greece leaves the euro. Greece itself may not be a problem. Grexit has been on the cards for so long, that anyone with exposure has had plenty of time to hedge it.

But maybe the real problem is that a Greek exit reveals the euro as an exchange-rate mechanism, rather than a currency union.

That matters because then markets start to look at other eurozone countries that might be at risk of failing to repay their debts. They start to push the issue by selling off bonds in peripheral countries.

In effect, the market poses the hardest question for the eurozone to answer: are you a union, where liabilities are shared and the strongest members cough up as and when needed to bail out the weaker members, or are you a group of disparate countries united only by an agreement to stick to a one-size-fits-all exchange rate?

Fellow British readers know exactly what happens when the market loses faith in an economy’s ability to stay within an exchange rate mechanism. It forces a change, as per 1992’s ‘White Wednesday’ for sterling.

In the case of the eurozone, it’s likely to start with bond yields diverging again. In other words, the interest rates weaker countries are charged will rise compared to German bunds, say.

And this isn’t something the European Central Bank (ECB) can defend against without pushing its mandate beyond the limits. This is all about politics. And the fundamental problem with politics in the eurozone is that the people in charge tend to be going against the wishes of the voters. So further integration of the sort that would allow the ECB to ‘save’ the eurozone is likely to be hard to drive through.

The democratic deficit that lies at the heart of Europe was always its biggest weakness. The euro is slowly but surely revealing the scale of that deficit.

So while Grexit itself might be nothing to fear, the fact that it could lead to worries about Spain or Italy leaving the euro may trigger that domino effect that everyone worries about. And those countries are certainly significant enough to rattle global markets.

We’ll have more on this in the next issue of MoneyWeek magazine, out on Friday. If you’re not already a subscriber, get your first four issues free here.

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  • Ninebobnote

    White Wednesday? Are you for real?

  • DAS01

    I agree that there is a “democratic deficit” in the EU, even though it is less than before.

    But who is responsible? It is the Council of Ministers, i.e. our dear governments, who refuse to let the European Parliament become more democratic.
    Thus let’s not point fingers at Brussels, but at London, Paris…

  • Impromptu

    The Greek clock has 12 11s around the dial.

  • Anthony Hawkins

    Roger Bootle’s take that if Greece were to leave and down the road its economy did pick up due to the ability to control its exchange rate, then maybe countries like Italy would recognise that it could also benefit from a devalued currency to fuel its northern industrial and commercial base. Perhaps that is the real threat of ‘contagion’?

  • Good King Richard

    Very well written, John Stepek.. Excellent.