Greece, Europe and the US
Posted by Rick Miller on June 1, 2012
The financial crisis in Europe, with a focus on Greece, which we’ve been discussing for the last two to three years, appears to be coming to a head. I’ll provide a brief summary of past events, then describe some potential outcomes.
How did we get here?
- Greece has very poor economic infrastructure. The public sector is very large (many people are employed by the government). The tax system is very inefficient, and collects relatively little in taxes. As a result, the Greek government has run, and continues to run, large deficits. That is, it spends much more than it takes in.
- Greece owes a lot of money. At the beginning of the crisis, Greece’s sovereign debt, the amount owed by its national government was over two times its annual national income.
- Greece uses the Euro as its national currency. Because Greece can’t just “print more money,” it has no ability to inflate its currency. Inflating its currency, or reducing the value of that currency, would reduce the value of its debt in purchasing power terms, making it easier for Greece to pay, and also making Greek products and services more attractive on international markets, which would also make it easier for Greece to pay.
- Greece made commitments to other Eurozone governments.In return for a reduction in the value of its debts, and ongoing loans from other European governments and institutions, Greece promised to reduce its deficit – to spend less as a government and to take in more in tax revenue. These promises collectively are considered to be an implementation of “austerity.” In addition, Greece is paying interest and principal on its remaining (still growing) debt.
- Austerity has produced very difficult economic times for the Greek people. Many public sector employees have lost their jobs. The government has reduced subsidies and retirement benefits. The economy has contracted significantly. Some have compared the economic difficulties in Greece to our own Great Depression of the 1920s and 1930s.
- There is increased political support for breaking Greece’s commitments to the Eurozone. As the economy has worsened, more and more Greeks have become unhappy with “austerity.” The Syritsa political party has become a focus for this view.
Now what? There are basically three possibilities:
- More of the same. The Greeks could complain a lot, but keep their commitments, at least for now. In the near term, it is likely that economic conditions in Greece would continue to worsen. It is also likely that popular support for breaking Greece’s commitments would continue to grow.
- The Eurozone could relax its terms. Greece might obtain permission to soften some of the austerity measures it has imposed. This might allow more time for the remaining austerity measures to take effect, reducing the Greek government’s deficit, and giving lenders more confidence. In addition, economic conditions might improve, and political support for Greece’s remaining commitments might increase.
- Greece could break its commitments. This is the scenario which causes the most concern, because its implications are so uncertain. However, likely implications include (with the first two very likely):
- Greece would default on its remaining debt. The holders of this debt – mostly Greek and other European banks – would take very large losses.
- Greece’s lenders would refuse to lend Greece any more money. Greece would then have an enormouslydifficult time economically. Its banking system would likely fail. Economic activity would slow even more. Greece would almost certainly have to issue its own currency to meet its internal requirements such as paying government employees and government benefits. The transition costs would be extremely large.
- The banking system in the remaining Eurozone countries would likely require government support to offset their losses on Greek debt. These bailouts would impose costs on Eurozone taxpayers. Essentially, they would pay off the loans that bank depositors (through their banks) had made to Greece, and that Greece defaulted on.
- Lenders might become increasingly doubtful about their loans to other Eurozone countries in financially difficult situations. This so-called “contagion” would most likely affect Portugal, Spain and Italy. Interest rates on the debt of each of these countries would rise, making it more costly for them to borrow (we are seeing some evidence of this now in Spain (especially) and Italy). At the extreme, these so-called peripheral countries might also be forced to default on their debts, and to issue their own currencies. This would have a much larger negative impact on both the European and world economies.
What should you do?
- Remember that Greece is a small country. While life in Greece would be enormously unpleasant if Greece breaks its commitments and leaves the Euro, the immediate effect on the rest of the Eurozone is likely to be manageable, although there will be much wringing of hands and gnashing of teeth.
- Remember that Greece is in Europe. While the US and Europe are highly integrated, and poor economic performance there will affect our economy, the impact will be less here than there.
- Continue to manage your own financial affairs in a sensible way. Focus on the actions and decisions that you can control. Live within your means. Keep your investment risk within your risk capacity. Limiting your investment risk includes both keeping your exposure to stocks at a level that is appropriate for your financial situation and maintaining a diversified portfolio.
- Contact us if you still have concerns. Greece’s problems pose very significant financial issues for itself and for Europe. I think it is important to keep them in perspective – I do not mean to minimize them.