Greek exit: Good or Bad?

Most politicians and fund managers would have you believe that this is a question with an obvious answer (the kind bloggers love) but it is enlightening to envisage some of the different scenarios that might play out and their effects. While it is unlikely that Greece would leave the Euro without defaulting on its debt (one might ask: why did they even leave) it does raise some interesting economic concepts. There is no orderly protocol for a nation leaving the Euro (fine planning by politicians there) so no-one really knows how it might happen.

First of all, why might Greece decide to leave the Euro? We’ve already discussed one reason, so it can go back to the Drachma, and be in control of its own printing press. This way it can lower interest rates by printing money to stimulate the economy. Running the printing press will also depreciate the Drachma on the foreign exchange markets. This occurs because, all else being equal, the lower interest rates will lessen the demand for drachma by savers who would prefer the currency of other countries with higher interest rates (wouldn’t you?). Banks of countries like Australia, who have high interest rates, will only accept Australian dollars as deposits, requiring anyone with Drachma to sell them for Australian dollars so they can deposit them here. The upshot of this is that Greek exports will become cheaper which will stimulate growth. Greece’s tourism industry stands to gain immensely from exiting the Euro (about as much as it suffered from entering the Euro).

Quick recap:

and my quips run low like a deflated bag of Homer Simpson's potato chips.

So why not exit you ask? Might it be easier to pay the debt back with a depreciated currency and a booming export sector. Probably not. If Greece leaves the Euro its debt would still be denominated in Euros, and every percentage point drop in the exchange rate will result in a percentage point increase in the Drachma value of the Greek government’s debt. Instead of reducing the real value of the debt, as we talked about in the Wall Street investor accomplishes what the alchemist could not, printing money actually works against you when the debt is denominated in another currency. If the Greek government promised a fifty Euro coupon (or interest payment) per year when they issued bonds and borrowed money (have a look at The wonderful Central Bank of Oz for a recap on how bonds work) holders of Euro denominated Greek debt will still want fifty Euros. However, once the Drachma has fallen in value, the Greek government will need more Drachma to trade for each Euro, in order to pay the coupon.

How far it falls is anyone’s guess, but Russia’s debt default and peg removal resulted in the Rouble losing sixty percent of its value in a month and in Mexico in 1994, abandoning the US dollar peg resulted in roughly a fifty-five percent plunge in the Peso. Differences between these crises and Greece’s abound, the primary one being that in 1994 Mexico was the only economy that required saving. Default was only avoided when the US provided loan guarantees and this path to a happy ending seems unlikely with most governments already mired in debt. In addition, Russia and Mexico had been running the printing press that Greece doesn’t have for years, which is a positive for the Drachma. However Russia and Mexico were also oil exporters, who benefited from the punished exchange rate in this way (and arguably from oil price recoveries thereafter). Greece is an oil importer, which brings us to more downsides from exiting.

The newly demoralised and devalued exchange rate for the Drachma that Greek people use to purchase goods overseas will be, well… devalued. The price of everyday items will soar. Not everyone realises that oil is used in a lot more than just your car these days (it would be easier to list what doesn’t contain oil). There’s petroleum in everything from frozen food packaging to your toothpaste! Plus of course oil is involved in getting these goods from A to B. Needless to say Greece’s dependence on foreign oil (priced in US dollars) renders it extremely vulnerable to inflation from a depreciating currency.

The ultimate result of an exit will depend on the relative strengths of these basic economic flows as they compete with each other. How they pan out exactly will depend on millions of different variables (most of them running around Greece) which is much too complicated for my humble brain to comprehend. Making money will be about going one step further than these basic economic tools, and seeing the frictions that result in their breaking down. Are the tourist spots that stand to gain so much in remote areas where the government will have trouble enforcing the tax laws (I’d be interested in people’s opinions and knowledge)? Higher incomes for Greeks don't necessarily mean higher income taxes for the Greek government.

Be wary of hidden bias in the opinion of those who focus on the negatives of a Greek exit, and tout that the only happy ending involves Greece remaining in the Euro. Vote hungry politicians and leveraged up hedge funds will take most of the short term pain when Greece exits. Those in cash have the most to gain. People often forget the obvious advantage of defaulting on your debt, and that is that you are now debt free. And investors have short memories: our traumatic economic cycles and repeated mistakes are a testament to that. The episodes in Russia and Mexico are now confined to the history books, rarely bought up but for the nostalgic pleasure of stuffy old blogs. Sure the fallout from the Greek default and Euro exit will be painful in the short run, but I just can’t see us talking about it in five years time, let alone the twenty-five it will conservatively take Greece to get its debt levels under control. Some savvy investors are salivating over the possibility of a debt default, so they can swoop into the resulting carnage and enjoy purchasing good businesses at great prices. In five years time this will just be a rarely quoted episode in history for most and a fond memory of excellent investments for others.

“…the Wall Street investor accomplishes what the alchemist could not – creating gold from dross, real wealth from mere paper…”

A clever and insightful quote from William Greider in his book “Secrets of the Temple” but not entirely true. As we have learnt, in the long run money is worth not the number that is printed on it, but what it can be traded for, which gets smaller over time. A printing press has value not because it can print valuable money, but because it can reduce the value of money.

Paradoxical, scary, and true. One of the primary reasons that the Eurozone is in trouble of breaking apart is that each individual economy doesn’t have its own printing press with which to create its own currency. Is gold a good hedge against inflation and The Wonderful Central Bank of Oz highlight how increasing the money supply can stimulate the economy by reducing interest rates. But with some countries booming (like Germany) and others in recession (like Greece) how much money should you print? The Germans are worried about inflation while Greece is worried about deflation. The reason that Germany can’t have high interest rates while Greece has low ones is actually the same reason that China can’t have high interest rates while America has low ones. When Greece uses the same currency as Germany , it is the same as the both of them using different currencies, but having them pegged to each other at a rate of one for one (see What have China’s money supply and America’s money supply got in common).

Vast economies like America have the same problem of booming states and floundering ones, but taxes are just paid to the government and California doesn’t care if their tax dollars are used to help stimulate Ohio. German taxpayers on the other hand are much more apprehensive about their tax dollars being spent to help the Greek economy, particularly when accusations of tax evasion are so rife in Greece.

The printing press has a less well publicised part to play for indebted governments. Part of the reason why the US has thrown the inflation textbook out the car window and printed copious amounts of money is because even if inflation gets out of hand, it will erode the value of the government’s debt. This was illustrated in Can the Federal Reserve “Really”affect interest rates. If the government borrows $50 billion (in debt) then spends it, it has an incentive to induce inflation. Once money is printed, fast forward to all else being as it was, except prices are now higher (see What’sthe scariest thing out there at the moment for a quick look at what we’ve “yada yada’d” here). Sales taxes are now higher because they are based on the actual prices of goods. You might not think of your wage as a price, but they are most certainly the price of your labour to your employer, and wages rise with money printing too (think lobbying labour unions). This means your income is higher so you pay more income taxes. So the government’s income is higher, but the one thing that has not changed is the value of the government’s debt, $50 billion, and its interest payments. This makes it easier to cover the interest payments and the real value of the debt has fallen.

Without a printing press however, Greece is doomed to be accountable for its actions and honour the full value of its debt. Unless of course it just plain defaults.

Don’t worry, we’ve just begun digging around in this tangled forest of politicians and summits for the real economic deal.

Euro-zone
Government debt
Greece
Inflation
Taxes

How many light bulbs does it take to change sentiment in the Euro-zone?

Meeting after meeting has transpired since the beginning of the Euro-zone crisis (whenever exactly that was) and very few original ideas have emerged. For all the first class airline tickets to Brussels, all that we really have are statements like, “We will not let the Euro-zone fall apart,” and “We will concoct a plan for Spanish banks.” Yet that is all the market seems to need for a rally. It’s about time to write an article on Greece.

When you’re listening to the hyperactive news presenters on sky news business in the morning screaming about non-events that occur in time frames of months, weeks or even days, it’s easy to forget that the real economic events unfold over years, decades, and generations. The outcome of the next taxpayer funded Eurozone gabfest in a few days isn’t that important, but it is important to step back and realise that the best case scenario they are talking about (Greece remaining in the Euro and paying back all its debt) will not occur over a timeframe of months, but we will still be talking about it in TWENTY YEARS! It really puts into perspective the talk you heard this morning, the sell off on Monday, the slight recovery over the rest of this week, and is almost enough to make you turn off the television and wonder why you should care. The fact is you probably shouldn't.

The real point of the title is just another reminder that sentiment will always rule the market, and real game changing ideas and plans will be very far and few between (especially when politicians are involved). Do not get side tracked. Let’s say that tomorrow the Greek economy starts growing at three percent. If spending by the Greek government doesn’t grow at all (except to account for the different amounts of interest it pays as the debt levels change) then at the 3.5 percent interest rate associated with the last bailout package, Greece will have a more acceptable debt to GDP (or income) ratio of sixty percent not on Monday, not by October, or by the end of the year, but in 2035. As the media tries to convince you that day to day affairs are so important that you must switch on every night to hear the latest developments, it is often omitted that the real timescale of the current crises is measured in decades, not minutes. This is exactly what Warren Buffett has alluded to: that if you buy the right stocks, you should be able to switch off for a decade and be reasonably safe, or more precisely: if the stock market closed for ten years you should feel comfortable holding the stocks you’ve bought. The numbers are purposely oversimplified to exaggerate the conservatism and so that the broad message is easy for you and me to understand: the time frames involved are huge.

Of course there is one thing that could abruptly alter this time frame, and that is if the best case scenario doesn’t play out, and Greece defaults on its debt and/or leaves the Euro. With all the government intervention and media attention one might wonder whether economics is playing a part in markets at all, but the mess will still provide us with plenty of intellectual economic stimulation.

Greece
Euro-zone
Bailout package
Mainstream media