Rumors And Denials

On Friday the US stock market at first attempted to resume the party in the wake of a better than expected US payrolls report. As others have noted (a comprehensive overview of the US jobs report is regularly provided by Mish), the unemployment report was less great than it appeared on the surface. Notably, a better then expected reported gain of 244,000 jobs in the payrolls survey contrasted with a loss of 190,000 jobs according to the household survey and an increase in the jobless rate to 9% as a result of growth in the labor force (this effect will continue to bedevil the unemployment rate should economic recovery continue). Moreover, the BLS birth-death adjustment to the payroll data was far larger this year than last.


Consequently it is difficult to say why the stock market rallied. Was it due to the upside surprise in payrolls? Or was it a result of the underlying weakness in the report, which should keep a prospective tightening of monetary policy at bay?

In any event, the rally was soon cut short by renewed rumors regarding new developments concerning Greece. Nearly every day, Greek politicians are confronted with this or similar images:



Anti-austerity demonstration in Greece. The focus of these demonstrations is turning increasingly anti-euro and anti-EU.



The German news magazine Der Spiegel published a report late on Friday  which asserted that the Greek government was pondering whether to leave the euro and reintroduce its own currency. The euro itself, as well as 'risk assets', i.e. stocks and commodities,  immediately sold off again. Gold bucked the trend, as it always does when sovereign debt related problems rear their head.

According to the Spiegel report:

“Greece's economic problems are massive, with protests against the government being held almost daily. Now Prime Minister George Papandreou apparently feels he has no other option: SPIEGEL ONLINE has obtained information from German government sources knowledgeable of the situation in Athens indicating that Papandreou's government is considering abandoning the euro and reintroducing its own currency.

Alarmed by Athens' intentions, the European Commission has called a crisis meeting in Luxembourg on Friday night. The meeting is taking place at Château de Senningen, a site used by the Luxembourg government for official meetings. In addition to Greece's possible exit from the currency union, a speedy restructuring of the country's debt also features on the agenda. One year after the Greek crisis broke out, the development represents a potentially existential turning point for the European monetary union — regardless which variant is ultimately decided upon for dealing with Greece's massive troubles.

Given the tense situation, the meeting in Luxembourg has been declared highly confidential, with only the euro-zone finance ministers and senior staff members permitted to attend. Finance Minister Wolfgang Schäuble of Chancellor Angela Merkel's conservative Christian Democratic Union (CDU) and Jörg Asmussen, an influential state secretary in the Finance Ministry, are attending on Germany's behalf.”


(our emphasis)

It is probably significant that the information emanated from unnamed 'German government sources'. The 'highly confidential meeting' was evidently not confidential enough not to be leaked to the press beforehand. However, it was confidential enough to manage to embarrass the euro area nations not invited to attend. On Friday a spokesman of Luxembourg's prime minister Jean-Claude Juncker vehemently denied that a meeting was taking place at all. Spokesmen for both the Austrian and Slovakian governments let it be known that they were unaware of the meeting as well. Apparently a meeting did take place though, with  only the biggest euro area members in attendance. On Sunday, politicians from the Netherlands announced their displeasure over the country's exclusion from the talks:

“Former Dutch government ministers and a prominent eurosceptic MP criticised the exclusion of the Netherlands from talks over Greece's debt situation, calling it an insult to the Dutch government.

Ministers from the euro zone's biggest economies met on Friday to discuss Greece's debt situation, after which Athens and senior EU officials denied that the Greek government had raised the prospect of leaving the 17-member euro zone.

"It is a humiliation and an insult that the Netherlands is being bypassed for talks about Greece," Geert Wilders, leader of the anti-immigration and eurosceptic Freedom Party, told news agency ANP on Sunday.

Wilders, whose Freedom Party supports the minority Dutch coalition government on various issues, said the Dutch government should not accept this and immediately stop paying Dutch taxpayer money to countries such as Greece.

Former development aid minister Bert Koenders, speaking on radio, was also critical about the Netherlands being excluded, while former foreign minister Jaap de Hoop Scheffer said all euro zone ministers should have been invited to the talks. Dutch finance minister Jan Kees de Jager was assured by the French and German finance ministers, however, that nothing was decided upon on Friday and that the Netherlands will have input in any future decisions, a ministry spokeswoman said.

De Jager was briefed about the talks on Saturday.”


In short, the assertions by Juncker's spokesman that no meeting was taking place were plainly untrue. In light of this,  the concomitantly issued vehement denials regarding Greece mooting the plan of dropping the euro and returning to the drachma should be taken with a grain of salt. Very likely such a threat was at least mentioned, if perhaps only as a negotiation ploy. From the Globe and the Mail we learn that

“Greece’s Deputy Finance Minister Filippos Sachinidis denied the report, suggesting it played into the hands of currency traders. The euro fell slightly against the dollar in response to the report before recovering most of its losses. “The report about Greece leaving the euro zone is untrue,” Mr. Sachinidis told Reuters. “Such reports undermine Greece and the euro and serve market speculation games.”

Jean-Claude Juncker, head of the group of euro zone finance ministers, also said the report was wrong. “I totally deny that there is a meeting, these reports are totally wrong,” Mr. Juncker’s spokesman, Guy Schuller, told Reuters by telephone. A European official source told Reuters that the Luxemborug meeting was reviewing a range of issues such as the economic situations of Portugal and Greece as well as the future leadership of the European Central Bank.

He said there were no plans for a restructuring of Greece’s debt. Last May, the country obtained a €110-billion bailout from the European Union and the International Monetary Fund, but it has been struggling to cut its budget deficit as fast as planned amid a deep recession.

A German government official told Reuters that a Greek exit from the euro zone “is not planned and was not planned”, while a spokesman for the Austrian finance ministry said a breakup of the bloc would be “absolutely unthinkable”.


We should remember here that a bailout of Greece was held to be 'unthinkable' until about one week before it was officially announced – the very same thing happened with the bailouts of Ireland and Portugal – 'unthinkable' one moment, reality the next. The eurocrats apparently think the unwashed masses are as a rule not ready for the truth. Nothing is 'unthinkable' – countries have dropped out of currency unions before after all. As we have pointed out before, the problem of Greece's government debt load is of a dimension that makes it extremely difficult – though not impossible –  to tackle without a currency devaluation. Greece will be forced to go through an extended period of deflation and a massive retrenchment in government spending to restore its competitiveness and bring its debt and deficit back to the euro area treaty levels, which may simply prove politically impossible. After staging selective strikes on May Day, Greece's unions are planning a nation-wide work stoppage on May 11. Clearly, austerity is a hard sell in Greece.



The sovereign debt of selected countries vs. economic output and tax revenue as at end 2010, via Der Spiegel.  Notably the euro area as a whole seems still in reasonably good shape compared to the US – click for higher resolution.



The Root Of The Problem

Greece has experienced a boom on account of too low interest rates after the ECB dropped its target rate to an extremely low level following the Nasdaq bust. It must be remembered here that before Greece joined the euro, its interest rate always reflected a very large price premium to account for inflation, as well as a large risk premium to account for government's traditional profligacy and historically well documented tendency to default on its debts. When the country seemingly fulfilled the entry requirements necessary to join the euro, it appeared momentarily as though both these premiums were no longer necessary. For one thing, inflation would henceforth be subdued as monetary policy was in the hand of the supranational ECB. For another, the government could no longer expand its debt and deficits willy-nilly if it was to adhere to its treaty obligations.

However, this view overlooked that in Greece as well as elsewhere in the euro-area's periphery, the fractionally reserved banking system was and remains able to expand circulation credit and concomitantly increase the amount of extant deposit money. Once euro area member interest rates had converged toward the interest rates of Germany, the banks in these nations were suddenly able to ratchet up credit expansion commensurately. However, nothing had changed with regards to consumer time preferences and savings, or with regards to government spending. In fact, the artificially bloated tax revenue that accrued on account of the inflationary boom seduced governments into vastly increasing their spending.  In effect, the governments spent illusory revenues from taxing illusory profits.

As a result of the old enmity between Greece and Turkey – mainly over the disposition of divided Cyprus – Greece traditionally overspends on its military. Moreover, the Greek government provides overly generous pension and welfare benefits and the country is notorious for corruption inside and outside of government that leads to wasteful spending and often outright theft of taxpayer funds (the famous case of the Athens hospital employing 45 gardeners while lacking a garden stands as a great example for this waste).

Plainly, Greece was particularly unsuited to handle a sudden easy money boom and its subsequent fallout (the same is true for other members of the 'PIIGS' stable). Even now, Greece sports an estimated current account deficit of 8% of GDP – a sign that over-consumption remains a salient feature of the Greek economy. It is no wonder that the markets continue to disbelieve the claims of the ECB and others that a Greek default and debt restructuring are 'out of the question'. The current cumulative default probabilities assigned by the market to Greek debt  via CDS pricing as well as the Greek yield curve and bond prices are depicted below.



From a recent Commerzbank report – cumulative probability of a Greek default based on CDS pricing – click for higher resolution.



From the same source, the Greek government bond yield curve and bond prices – click for higher resolution.



Assuming that Greece remains a member of the common currency area, what is going to prevent the same problem from recurring? Should Greece be prepared to go through the wrenching adjustments required to restore its competitiveness – which seems a dubious proposition in light of the political pressures the government faces – this would not alter the fact that its fractionally reserved banks could once again expand credit and fiduciary media and ignite another boom if the ECB's administered interest rates once again proved inappropriately low for Greece, as they have in the period 2002-2007.  At present, Greek banks are entirely dependent on the ECB for their funding, as they have bled deposits and can no longer access interbank funding markets  (the same holds for Irish and Portuguese banks, and to some extent for Spain's banks). Given the steep losses on the roughly € 40 billion in Greek government bonds the banks hold, they are probably not too keen on expanding credit at the moment. It seems also likely that these losses are not going to be fully recognized until such time as an official default makes the 'haircuts' on Greek government bonds permanent. 

Should the government's efforts to reduce the public debt via austerity measures prove politically impossible and the hitherto 'unthinkable' – namely leaving the euro-area and readopting the drachma – become the only viable option, the nation's banking system could be bankrupted overnight. German finance minister Schäuble's office has painted the following nightmare scenario (according to the 'Spiegel' report quoted earlier) if the Greek government were to take this fateful step:

“It would lead to a considerable devaluation of the new (Greek) domestic currency against the euro," the paper states. According to German Finance Ministry estimates, the currency could lose as much as 50 percent of its value, leading to a drastic increase in Greek national debt. Schäuble's staff have calculated that Greece's national deficit would rise to 200 percent of gross domestic product after such a devaluation. "A debt restructuring would be inevitable," his experts warn in the paper. In other words: Greece would go bankrupt.

It remains unclear whether it would even be legally possible for Greece to depart from the euro zone. Legal experts believe it would also be necessary for the country to split from the European Union entirely in order to abandon the common currency. At the same time, it is questionable whether other members of the currency union would actually refuse to accept a unilateral exit from the euro zone by the government in Athens.  What is certain, according to the assessment of the German Finance Ministry, is that the measure would have a disastrous impact on the European economy.

"The currency conversion would lead to capital flight," they write. And Greece might see itself as forced to implement controls on the transfer of capital to stop the flight of funds out of the country. "This could not be reconciled with the fundamental freedoms instilled in the European internal market," the paper states. In addition, the country would also be cut off from capital markets for years to come. In addition, the withdrawal of a country from the common currency union would "seriously damage faith in the functioning of the euro zone," the document continues. International investors would be forced to consider the possibility that further euro-zone members could withdraw in the future. "That would lead to contagion in the euro zone," the paper continues.

Moreover, should Athens turn its back on the common currency zone, it would have serious implications for the already wobbly banking sector, particularly in Greece itself. The change in currency "would consume the entire capital base of the banking system and the country's banks would be abruptly insolvent." Banks outside of Greece would suffer as well. "Credit institutions in Germany and elsewhere would be confronted with considerable losses on their outstanding debts," the paper reads.

The European Central Bank (ECB) would also feel the effects. The Frankfurt-based institution would be forced to "write down a significant portion of its claims as irrecoverable." In addition to its exposure to the banks, the ECB also owns large amounts of Greek state bonds, which it has purchased in recent months. Officials at the Finance Ministry estimate the total to be worth at least €40 billion ($58 billion) "Given its 27 percent share of ECB capital, Germany would bear the majority of the losses," the paper reads. In short, a Greek withdrawal from the euro zone and an ensuing national default would be expensive for euro-zone countries and their taxpayers. Together with the International Monetary Fund, the EU member states have already pledged €110 billion ($159.5 billion) in aid to Athens — half of which has already been paid out.

"Should the country become insolvent," the paper reads, "euro-zone countries would have to renounce a portion of their claims."


If this step were taken, it would probably happen quite suddenly, without warning. The government would likely announce a bank holiday, the introduction of capital controls and the currency conversion all at once over a weekend, shutting the door to all remaining depositors with the Greek banks, effectively confiscating and destroying a large part of their deposits and savings. We have a fairly recent example that shows how such a scenario plays out in the form of Argentina's default and peso devaluation in 2001. When in doubt, the government will tend to protect the banks by springing a confiscatory deflation on depositors and savers. As it were, Argentina was in an analogous situation to Greece prior to its default. It no longer had an independent monetary policy, instead entrusting the currency's fate to a currency board that in theory was to ensure that every extant Argentine peso was backed by one US dollar. In this way it was thought that the hyperinflation episodes that had plagued the country in the past could no longer be repeated, and for a while this system appeared to work well. The guaranteed convertibility of the peso at a one to one rate to the US dollar amounted to a de facto currency union with the United States – the peso was suddenly 'as good as the US dollar', which at the time was quite strong. This feature enticed foreign creditors to lend far more money to Argentina's government, at much lower interest rates, than it would otherwise have been able to borrow.

No-one gave thought to the fact that inside Argentina, a fractionally reserved banking system remained perfectly capable of vastly expanding circulation credit and fiduciary media on top of this influx of dollars, helping to ignite an inflationary boom. Similar to Greece, Argentina saw its external indebtedness pile up into the blue yonder. The credit expansion and the attendant phenomena of over-consumption and capital malinvestment over time led to a sharp deterioration in the country's balance of payments, making the country vulnerable to the withdrawal of external financing.

Greece is only different insofar that contrary to Argentina, it has the backing of the EU in addition to the backing of the IMF. As the report prepared by Schäuble's ministry correctly notes, its exit from the euro-area would be attended be enormous legal complications . It appears likely that Greece would have to unilaterally re-denominate all euro-based Greek debts into drachma if it wanted to avoid a nation-wide insolvency not only of the government but also nearly every other Greek debtor – a step of dubious legality that would inevitably lead to confrontation with the rest of the EU.

Moreover, it seems clear that an exit of Greece from the euro area would immediately provoke 'contagion' effects, as investors would correctly perceive that a number of other countries may be tempted to follow suit. This would inflict considerable damage on the euro area's banking system. Below we show a recent estimate of the exposure of German banks to the nations concerned.



Exposure of German banks to Greece, Portugal, Ireland and Spain, graphic from the Spiegel – click for higher resolution.


As we have previously noted, the direct exposure of German banks to Greece pales compared to the exposure of French and Swiss banks, which amounts to about € 55 billion – approx. $80 billion – each (for the exposure of other countries, see this table). We suspect that specifically the exposure of Swiss banks to Greece represents a bit of a 'black swan', as it seems a relatively little known fact. The Swiss Franc has for quite some time been a beneficiary of both the euro area's problems and the weak US dollar. This has left it in an extraordinarily overbought and overvalued position. A reappraisal of how the Greek debt problem might redound on the Swiss banking system could conceivably put pressure not only on the euro, but also the Swiss Franc – especially vs. the US dollar.

The euro has sold off late last week, after rising relentlessly for several months on the notion that the ECB has embarked on a prolonged rate hike campaign. This is no longer seen as likely following the ECB rate decision and press conference last Thursday. The Swiss Franc too may have put in at least a short term top against the US dollar – alas, it remains quite strong versus the euro.



The dollar-euro rate, daily – after falling sharply following less than hawkish comments by ECB chief Trichet on Thursday, rumors about Greece lead to further selling on Friday – click for higher resolution.



The US dollar-CHF rate, weekly. After rising strongly for about a year, the Swiss Franc may finally be running into some selling – click for higher resolution.



The CHF – euro cross rate, daily. The CHF is now almost back at the highs achieved at the turn of the year – click for higher resolution.



It seems evident that the problem of how to deal with Greece's debt load is soon coming to a head. At a minimum we would expect this to bring back a certain degree of uncertainty and volatility to up until recently buoyant 'risk asset' markets. It is also worth noting that there is a growing constituency in Germany in support of the idea that Greece should simply leave the euro area. The well-known bailout-skeptic, German Free Democrats MP  Frank Schaeffler, a member of the finance committee in the German Bundestag (parliament) whose views are supported by a number of other MP's from both within and without his party,  told Reuters over the weekend that 'Berlin should help Greece to leave the euro'. In his view the short term upheavals this would likely cause should prove manageable in the long run.

“If Greece wants to leave the euro zone, that is its own autonomous decision," Frank Schaeffler, an FDP member in the finance committee of the Bundestag, told Reuters.

"And Germany should accompany them constructively."

Greek Prime Minister George Papandreou earlier on Saturday denied there was even unofficial discussion over Greece quitting the euro zone and asked that his troubled country be "left alone to finish its task. On Friday, influential German weekly Der Spiegel reported talks were held to discuss the possibility, raised by Athens, of Greece withdrawing from the 17-member euro zone, as well as the idea of restructuring Greece's 327 billion euro ($470 billion) sovereign debt.

Schaeffler agreed that bringing back the drachma would spook markets and cause problems for the entire euro zone, but only for the short term.

"I believe, however, that we could cope with these problems in the end."

Schaeffler recently gathered a dozen of the party's Bundestag MPs around him to pressure Chancellor Angela Merkel's CDU-FDP cabinet into taking a harder stance against euro zone bailouts in an early sign of internal opposition that has since gained support.  Many Free Democrats share the views of economists that Greece's debt trajectory is unsustainable and action needs to be taken sooner rather than later before the long-term cost becomes far greater. Senior FDP official Hermann Otto Solms, a vice-president of the Bundestag and an economy committee member in parliament, said German taxpayers should no longer be held liable for the obligations of other euro zone allies.”

Meanwhile, the prominent president of Germany's 'IFO' institute (Institute for Economic Research), economist Hans-Werner Sinn, thinks 'Greece should readopt the drachma for its own good'.

“If Greece were to exit the euro, it would be able to devalue its currency and thus become competitive once again," Hans-Werner Sinn, head of the Munich-based Institute for Economic Research, said in the Sunday edition of the Frankfurter Allgemeine newspaper.

According to Sinn, heavily-indebted Greece was heading for a banking crisis whether it kept the euro or not. If Athens, however, stayed with the euro, the economist claims, there would be no way to rescue the economy in the long run.

"If Greece decides to attempt a so-called internal devaluation – that is by cutting salaries and prices within the country – it would risk setting off civil war," Sinn said. "Greece is heading for economic crisis in either scenario. But if it stays in the eurozone, Athens will kill off the companies that make up its economy.”


We would note to this that the experience of the Baltic countries shows that an 'internal devaluation' can indeed be achieved, even though it involves a great deal of short term economic pain. As we previously remarked in this context, the Baltic nations have a very strong motive that impels them to seek closer ties with the EU, a plan that includes adoption of the euro. The historical reason for pursuing this course is provided by the annexation of these nations first by Sweden, then by Russia and later still by the Soviet Union after a brief stint of independence in the inter-war period. Close ties with Western Europe are likely regarded as providing a guarantee against any future designs Russia may have. Consequently Estonia has joined the euro at the end of 2010, while Latvia and Lithuania have stubbornly defended their currency pegs to the euro in spite of the economic hardship this course has imposed on them in the period following the 2008 bust. Reportedly their future euro banknotes have already been designed, with official introduction of the euro merely awaiting the meeting of all criteria for joining.

Whether Greece has the stomach for the same bitter medicine is highly questionable, but Sinn is wrong when he declares it to be 'impossible' as such. It is certainly difficult politically, but it would be a mistake to think it is not possible economically or that lasting economic damage would be the certain result. On the contrary, the liquidation of malinvested capital such a course implies would likely be a salutary development for the Greek economy in the long term. However, Sinn's opinion is highly regarded in Germany and is quite representative of the growing popular discontent with respect to the German government's bailout strategy.



Hans-Werner Sinn, president of Germany's IFO Institute thinks Greece should leave the euro for its own good.



Further grist on the mills of the euro-skeptics and bailout opponents has been provided by a recent strike of public employees in Portugal in protest against the austerity measures imposed as a condition for that country's ESM/IMF bailout. The increasingly intractable problem from the point of view of EU politicians is how to convince their electorates of the need for fiscal austerity on the one hand and the provision of bailout guarantees on the other – as both the politicians in the fiscally stronger 'core' and in the fiscally weak periphery are faced with growing opposition to the whole enterprise.  This was recently brought into sharp relief by the gains the euro-skeptic 'True Finns' party has made in Finland's elections. The 'True Finns' remain so far implacably opposed to bailouts, including the recently approved (in principle) bailout of Portugal. It seems that in coming weeks and months, we will see the next phase of the crisis erupt, just as we always expected would eventually happen. The bottom line remains that  there is too much debt and that no viable long term strategy to deal with it is in sight as of yet. The propping up of unsound credit is certainly a mistake that the EU will eventually come to rue. In addition, the ECB – which as a central economic planning agency is already faced with the insurmountable calculation problem  – can not possibly devise a monetary policy that is even remotely appropriate for all the member nations of the euro-area. In the previous low interest rate regime, it ignited a boom in the periphery even as the 'core' languished – while now, as the economic weakness in the periphery keeps it from raising rates, its policy has ignited a boom in Germany that should ultimately prove just as unsustainable. The current monetary arrangement of the euro area thus remains a guarantee of future economic instability, even though the ECB has managed to retain a measure of credibility up until now.


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4 Responses to “Will Greece Leave The Euro-Area Roach Motel?”

  • designerhandbagsoutlet:

    This is a great post. you got cheap handbags online .I like cheap designer handbags as well give you designer handbags outlet

  • Pierre:

    “The Euro acting as a gold standard ”
    Martin Armstrong, from behind prison bars, had the same idea.

    On J. Rogers.
    Well, if Greece defaults, other countries in the Euro Zone may very well default too. Which ones? Think of Ireland, Portugal, Spain and may be Italy. Hence a big chunk of the EU GDP.

    Furthermore, this would be in the interest of the Bundesbank Lobby, the most powerful entity behind shaping the future of the Euro.

    In conclusion, the Euro might very well rise when the weaker EU states will leave the Euro. But I do not expect this to happen tomorrow…Think of out of money call option on the Euro …

  • TriggerPoint:

    I haven’t a chance to read the full post right now, but I was listening to an interesting lecture by De Soto. This clip… is about the Euro acting as a gold standard on the periphery nations. Perhaps a Greek default or leaving of the EU would actually cause the Euro to rise after the initial reaction downward?

    On top of that and on a related basis, Jim Rogers was on CNBC the other day talking that he still owns the Euro. He is thinking that Greece and Ireland are only a small fraction of total GDP of the Euro area, so it might not be as dire as many think if they default, much like a US state defaulting. I m not so sure though. Yes GDP is one thing, but Irelands banking liabilities are much larger than GDP, as are most banking systems in all countries.

    The whole De Soto lecture is fantastic by the way.

    • You are correct, it is not the size of the respective economies that is the decisive factor here, but the amount of debt involved and the exposure of the euro area banking system to this debt.
      And yes, from a long term perspective, the strong euro is actually a good thing for the suffering periphery, as it hinders the formation of fresh malinvestments and forces massive restructuring. In that sense, it is indeed akin to a gold standard for them.
      I also agree with the comments regarding a possibly even stronger euro in the future in the event of peripherals exiting the currency union. One must definitely acknowledge that the ECB has so far remained remarkably firm in its commitment to a strong euro – even though it remains of course a deeply flawed central economic planning agency nonetheless.

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