A Greek Tragedy with No Written Final Act

Image of a building with a Greek flag

In 2011, John Mauldin, an influential Texas-based financial advisor, went to Europe to meet local market experts, hoping to get a handle on the Greek sovereign debt crisis. At a dinner party hosted by a Swiss banker, he asked everyone at the table to raise a hand if they thought the euro would be higher in value in one year’s time. Six arms shot up. Mauldin then asked about a euro decline and 12 hands were raised. A total of 18 votes were cast from a group of 15 guests, not including Mauldin, which meant that three professional market watchers could not make up their minds and had voted both ways.

The only thing everyone agreed about on Mauldin’s opinion-finding trip was that Greek support for austerity measures tied to so-called bailout funds didn’t really matter much beyond the short term because the nation would eventually default. Now that a default has technically occurred, there is still no consensus surrounding what it all means to the world economy.

In early July, Greek Prime Minister Alexis Tsipras promised his government would quickly suggest a “fair and viable” solution. The Greek definition of what’s fair in this situation is important because massive write-offs will eventually be required to put an end to this crisis and German voters do not see that as fair (despite the fact that Greece agreed to an European reconstruction plan that cancelled 50 per cent of Germany’s crippling war debts in 1953).

Simply put, the Greeks could argue that what was good for Germany in 1953 is good for Greece today. Or Tsipras could blink and put forward a short-term solution that meets demands for unpopular reforms previously tabled by Greece’s creditors. According to media reports on July 10, Athens appears to be taking the latter course despite the results of the recent referendum that gave the Greek government a mandate to oppose creditor demands for tougher austerity measures such as sale tax increases and pension cuts. But as AP reported, in return for this about-face, Greece plans to seek a commitment from creditors to negotiate a further restructuring of its long-term debt.

It is easy to claim that the Greeks should pay back borrowed money. But as pointed out in “Budget Crisis: Who Should Bear the Burden of Reducing the Deficit and Debt?”— an Ivey case study on Uncle Sam’s flirtation with defaulting on his financial obligations in 2011—there is never a clear answer when people start asking who should be responsible for a nation’s debt when it becomes unmanageable. And the question is far more complex when it involves a member of the eurozone.

Keep in mind that Greece does not have its own currency to devalue to gain economic relief. And so you can’t solve the nation’s debt problem by issuing more debt with conditions that kill economic growth. If truth be told, the bailouts seen to date have never been designed to bail out the Greeks. The aid issued to date has been all about buying time to play musical bondholders.

As everybody in the sovereign debt game knows, few countries ever pay back principal in the international financial system as it runs today. And when Greece entered the eurozone with cooked books, European banks were more than happy to lend the nation billions of dollars that will never be repaid, much of which returned to Germany in the form of export sales. As a result, a Greek default once threatened to be a material event for the global economy.

The direct exposure of Canadian banks to Greek debt has always been relatively low. But when Mark Carney ran the Bank of Canada, one of the reasons he held back on interest-rate hikes was the possible exposure of North American banks to the exposure of European banks holding Greek bonds via financial derivatives that function like insurance. Since then, billions of dollars in Greek debt have been transferred from European financial institutions to European taxpayers. And that means the global financial system gained at least some insulation from this crisis along with the French and German banks.

According to Barry Bannister, Chief Macro and Portfolio Strategist at Stifel Nicolaus, the Greek referendum was a good strategy because, as J. Paul Getty said a century ago, “If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” Simply put, Bannister argues the Greeks have significant leverage to push for more debt write-offs because it can default and leave the Eurozone, which might just be the best thing for Greece since it should have no problem obtaining loans from other creditors (think Russia or China). Meanwhile, losing Greece would be the worst thing for the European Central Bank, which “cannot afford the hit to its credibility and the great unwind of its raison d’être, which is the euro, by allowing the precedent of an exit door.”

As Ivey associate finance professor Michael King pointed out in a Globe and Mail op-ed, even the IMF has concluded that Greece needs to write down their debts by more than 30 per cent. So if Greece plays its hand right, which will be difficult considering the short-term pain involved in playing chicken with its creditors, there is a chance that the nation will eventually be allowed to default on a significant amount of debt and remain in the euro club. If that happens, and it is seen as a precedent that other troubled E.U. countries try to follow, then eurozone could still implode and send the global economy into turmoil. Nevertheless, the risks to the global economy have been reduced.

As things stand, the big concern for Canada, on the European front at least, is that continued economic weakness in the eurozone will help keep commodity prices down, notes Ivey Business School economist Mike Moffatt, adding, “Continued weakness in the oil patch may cause the Bank of Canada to once again cut interest rates.”

If an agreement between Greece and its creditors is reached and accepted by all concerned, Bill Witherell, Chief Global Economist with Cumberland Advisors, notes the euro will likely strengthen versus the American greenback, but only modestly, because “such an outcome is largely priced in.” If not, the former OECD official says negative currency market reaction could be strong because “such an outcome has not been priced in; the euro would likely be viewed as a more fragile currency subject to the possibility that other (and larger) heavily indebted countries will eventually leave the currency; and, most importantly, the prospect that the European Central Bank (ECB) would have to increase its quantitative easing as it seeks to avoid contagion across the rest of the Eurozone.” But the overall economic fallout would likely be ring-fenced, even in the case of “Grexit.”

Nobody knows what is going to happen long-term, especially if a deal is reached that does nothing to address Greece’s debt problem. So when making investment decisions today, it pays to recall the misplaced confidence of former U.S. Federal Reserve Chairman Ben Bernanke in March 2007, when he told his political masters that the subprime mortgage crisis didn’t appear to be spreading, so “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

It is also important to note that more than a few market watchers think the risks posed by the Greek financial crisis is nothing compared to the global threats stemming from the stock market crash in China, where equity markets lost a third of their value between mid-June and early July while most people focused on the situation in Greece.

But if China doesn’t spark a global crisis, Greg Newman, a director of wealth management with ScotiaMcLeod, a division of Scotia Capital, sees potential for a decent market buying opportunity emerging for Canadians who are patient enough to wait for markets to digest the Greek default. “I think investors might want to be prepared for a period of uncertainty,” he says. “While investors believe the ECB has the tools it needs to ring fence contagion, which is very important for the bull market to endure, it does not mean that the market will be stable. Keep in mind that in the past, market volatility related to Greece was followed by the can getting kicked down the road. And that very well may not happen this time. As such, I think investors should be patient and wait for a bigger pull back before adding any money to the market.”

Everyone in Canada—where Ontario has just been downgraded—should also take note of the fact that excessively spending money you don’t have always eventually comes back to haunt you.