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.