It was Greece’s call for a referendum, and then the outcome, that increased the risk of a Greek exit from the monetary union. Many now assume that a Greek exit is the most likely scenario.
We suspect that many misunderstand the incentive structure, and under-estimate the political will to ensure EMU remains irreversible. We argue that there are no pleasant choices left for either the creditors or the Greek people.
Some kind of debt relief is going to take place. It can come either in an uncontrollable and disorderly way or it will be negotiated and managed. The Greek people may have voted against creditors’ conditions, but are going to face years of hardship and a wrenching of the social fabric regardless of the monetary arrangement. Greek banks will need to be recapitalized whether Greece is in or out of monetary union.
In 2011-2012, the betting odds that Greece was going to leave EMU were reportedly as high as 70%. We argued then and continue to believe that there are key considerations outside of the financial and economic calculus investors are so familiar. Many observers do not appreciate Draghi’s insight that monetary union is first and foremost a political union. There is much determination at the highest levels of Europe to preserve the integrity of the monetary union. Of course, there are dissenting voices in nearly every country, and many are exasperated with the Greek drama.
However, the commitment toward the European Project, for the lack of a better name, is palpable. There is no Plan B. There is either continued progress toward integration or European nationalism returns threatening a return to pre-modern times. It is, as we are fond of noting, as Benjamin Franklin told the thirteen colonies on the eastern seaboard of North America as they fought the world’s greatest empire of the day, “We hang together or we hang separately”.
There are some who argue that Greece is like a cancer and by removing it the body is stronger. Yet Greece is not a cancer. It problems essentially a debt overhang and a lack of a sufficiently competitive economy, are shared by many other eurozone members.
Neither Greece’s hardships nor the economic recovery in Spain has undermined the appeal of Podemos, which performed well in the recent local elections. The debt overhang and need for structural reforms will have to be addressed whether Greece is in EMU or not. Giving Greece debt relief may embolden Podemos and others to seek debt relief as well. It can be addressed on a case-by-case basis. The best way to steal Podemos’ thunder, if that is the purpose, is for European officials to accept that debt servicing costs can be adjusted. One need not throw the baby out with the bath water. Debt relief can be achieved within the system.
The market has been hit with two blows over successive weekends. However, the pessimist impulses have begun giving way to a more cautious optimism that a Greek deal can be worked out to avoid an imminent Greek exit and a collapse of the banking system. The euro has found a bid and Italian and Spanish (10-year) premium over Germany has fallen. US Treasury yields have recovered from the earlier decline to 2.17%, the lowest level in a month.
This cautious optimism is not enough to reverse US stocks, which opened more than 1% lower. US earnings seasons kicks off formally today with Alcoa after the markets close. The 200-day moving average in the S&P 500 is seen just above 2055 today. Although it traded below the average yesterday, it reversed sharply and posted an outside up day. The lack of follow through may be a bit disconcerting, but another break, and especially a close below that average today, would sour sentiment further.