Europe faces a world of pain – even if Greece stays in the euro

published 3 November 2011

"Greeks punch gift horse in the face"

That headline on the satirical website, The Daily Mash, summed up the angry reaction of Europe's leaders to Greek prime minister George Papandreou's call for a referendum on the next bail-out.

No wonder. Merkel and Sarkozy and the rest stayed up until four o'clock in the morning last week trying to hammer out a deal. They were probably stunned when their blatant fudge still managed to persuade ever-optimistic investors that everything was going to be OK.

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And now Papandreou pulls a stunt like this?

While their fury is understandable, what they may not yet appreciate is that this referendum could be the best chance that the eurozone has of remaining intact.

The trouble is, even if it does, Europe still faces a slump of massive proportions

The Greek referendum is a gamble, but it's a smart one

Asking your voters if they'd like to submit to another round of painful wage cuts, rioting in the streets, and general economic stagnation, doesn't sound like the smartest political strategy.

But in Greece's case, it could be the best option available.

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The situation in Greece sums up the key problem with economies and voters in general. No one complains during the good times. Even if a boom is clearly unsustainable, very few people want it to end. Politicians have every incentive to take the credit for the good times. The last thing they want to do is to stop everyone's fun.

Of course, after the boom, you get the bust. That's often when the boom-time politicians lose their jobs. Whoever takes over gets to blame the previous mob for the bust. Then, as long as recovery comes quickly enough, they get to take credit for that.

The population won't like putting up with the pain of the bust. But they will. After all, they've slung out the previous incumbents. Whatever the new guys do, they voted for them. And if they do a bad job, they can get rid of them next time.

The problem in Greece is that the pain is being imposed by someone else. Other Europeans might feel that they're being very decent in stumping up for this bail-out package. But all the Greeks see is the fall-out, the cutbacks, the rioting. And they don't feel as though they signed up for that. They feel as if it's being dictated to them by high-handed German officials, or some other unaccountable European bureaucrats.

With Papandreou's government already in a very shaky position, his best chance of political survival is to force the electorate to take some responsibility for what's happening to them. As my colleague Merryn Somerset Webb points out in the latest issue of MoneyWeek magazine (out tomorrow), the population needs to buy into this sort of pain if austerity and reform are to have any hope of succeeding.

But is there any chance that the Greeks will vote 'yes' to the bail-out package? Well, that depends on exactly what you ask them. According to the FT, the Greek population won't be asked about the bail-out specifically. Instead, they will be asked a broader question on whether to remain part of the euro or not.

That's a much tougher choice: stick with the euro and suck up the austerity; or ditch the euro, return to the drachma, and accept the uncertainty and chaos that will certainly result, even if only in the short term.

There's a good chance that enough people would rather stick with the devil they know, than risk the alternative. Yes, it's a gamble. But it may also be the best chance anyone has at this late juncture of keeping Greece on board.

The euro will fall further against the dollar

As far as markets are concerned, this latest move has introduced yet another set of tripwires, just when investors thought that things could only get better. But the most important thing to understand is that even if Greece sticks with the euro, the region faces a world of trouble. This is a situation where even the best-case scenarios aren't pretty.

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Why? Because, as James Ferguson points out in the next issue of MoneyWeek, Europe's banks haven't even started dealing with the hangover from the global financial crisis. While British and American banks have made at least some progress, European banks remain highly leveraged and in need of extra capital.

We've already seen how efforts by banks in both the US and the UK to improve the state of their balance sheets have resulted in stagnation. Europe - which is already having a pretty miserable time has more of that to look forward to.

James reckons the end game will be the launch of quantitative easing (QE) by Europe as the European Central Bank is forced to worry more about deflation and depression than inflation.

There may be a way to go before that happens. But one thing that all this points to is the dollar rising against the euro. Monetary policy in the States can't get a lot looser the Fed is leaving the door open to QE3, but judging by Ben Bernanke's speech last night, it's not in a hurry to do it. So if monetary policy gets looser in the eurozone, then the euro is likely to shed some of its surprising strength against the US currency.

We have some suggestions on how to play this in the latest issue. But if you can't wait to read that, my colleague David Stevenson also highlighted some FTSE 100 stocks that should profit from a stronger dollar in a cover story a few months ago.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.