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Greece has had a rough week (as well as month, year, and decade), but it looks like things are finally beginning to look good for the Hellenic Republic. Assuming this week's private bond swap goes through, and Greece is able to successfully return to fiscal normality, we can expect some stability in the near future, but I must ask at what cost to the European Union's fiscal structure(s)?
From Schism to Economic Unity
Following three major wars in a 70-year span, Europe was in financial and political ruins. Desperate to regain world respect and contain future German aggression, Frenchman Robert Schuman set out an ambitious goal to unite Europe. Together with the initiative's architect Jean Monnet, Schuman announced on May 9th, 1950 plans to place "the whole Franco-German coal and steel production under a common High Authority, within the framework of an organization open to the participation of other countries in Europe." Accepting the new German Republic as an economic partner, and maintaining French national security through the external control of the most important economic resources of the day, the European Coal and Steel Community (ECSC) was established in 1951 (together with the European Defense Community and the European Political Community). In 1957 the Treaties of Rome established the European Economic Community (EEC), and the union was born.
In 1979, amid wildly fluctuating exchange rates (culminating in the collapse of the Bretton Woods fixed-exchange rate system), rapid inflation, pricing discrepancies, and exceptionally slow, post-war, economic growth, the European Monetary System (EMS) was established to address these threatening economic changes. In the early 1980's there was again a feeling that deeper economic integration could benefit the member states, and talk of a single market became frequent by François Mitterrand and his finance minister Jacques Delors]. Europe signed the Single European Act (SEA), a major revision to the Rome Treaty, and it quickly became a pillar to the European Community's (EC) metamorphosis by preparing the grounds for the European Monetary Union (EMU). The collapse of Communism, the end of the Cold War, and the reunification of Germany were all major catalyzers in the birth of the European Union. The challenge of overcoming old fears of a united and strong Germany, absorbing the (relatively) weak East Germany into the new EC, and maintaining Germany's commitment to the EC were all major challenges that the EMU was established to deal with. Europe witnessed extreme currency fluctuations and attacks, and member states began fixing their local currencies to the Deutsche Mark. It became a prominent argument that a single currency would solve these problems. In reality, within the constraints of the EMS, a single currency was a necessity.
Difficulties in Implementation
In a rather quick response to the profound political and economic changes that Europe was experiencing, member states negotiated the Maastricht Treaty - the treaty that established the European Union. The Maastricht treaty formed the European Central Bank (ECB), and modeled it after the German Central Bank (Deutsche Bundesbank), which emphasized price stability, and had a narrow mandate to combat inflation. The ECB would be prohibited from purchasing a member state's bonds, as well as from bailing them out of financial insolvency. The architects of the 1991 Maastricht Treaty also recognized that among other things, European people, goods, services, and capital must be mobile to allow for a single market to be a reality, and the treaty provides for such free movement. However, cultural and language barriers still persist. The treaty's initial guidelines mandating that the budget deficit be below three percent of GDP and the national debt be below 60 percent of GDP served well as guidance, but in practice were rarely maintained. Such standards were adjusted initially to allow for "improving states," but later were overlooked as Germany and France strayed significantly from their own hard-pressed goals. The treaty also mandated an inflation rate of no more than 1.5% above the three best preforming member states and some other similar provisions, yet they, too were loosely enforced.
While strict guidelines are common in EU treaties, enforcement of such guidelines is somewhat less common. Nonetheless, the Germen-modeled ECB has been relatively consistent in interpreting its narrow mandate, and has been reluctant to act as a lender-of-last resort to European member states. Spreads on European member state's bonds regressed during the 1990's to match a low, single-market yield expectation, essentially representing a similar credit risk among all member states. As member states had control over their currency, and could print as much as needed to cover any debt obligations, low and consistent spreads were justified. However with a single Euro currency, member states are no longer able to cover their obligations by inflating their local currency, and bond yields have recently skyrocketed for states in economic peril, such as Portugal, Italy, Ireland, Greece, and Spain (PIIGS). Unlike the perceived exchange-rate risk of the 1970's and 1980's, current spreads represent the 'real' credit risk (sovereign risk premium) of member states, as they are no longer have fiscal autonomy. Whereas markets would once correct such discrepancies, a single currency does not allow for such prospect, and certain countries surely feel the pressure of the aforementioned limitations.
Can the Eurozone Survive Without Greece?
Greece could surely survive without the Euro. The New Drachma would be highly devalued, and the Greek economy would be in peril for some time to come. However, they are already in peril, and an independent currency would allow them to attract new speculative investors that would spur growth in the local economy as well as increase competitiveness. Long term recovery under such a scenario and would be dependent on Greece's willingness to enhance its own competitiveness, with market forces doing the rest. This does sound optimistic, but clearly there are disadvantages to cutting off the life-line of cash that Greece currently enjoys, and it is unclear that this would be beneficial overall. Unlike Greece's options, the Union cannot suffer the loss of Greece, as such a loss would completely undermine the currency. If Greece were to leave the eurozone, similar attacks would be launched on other PIIGS currencies, and soon all will have no choice but to leave as well. This would be the end of the eurozone, and it's not the PIIGS banks that will be left alone with the bill, so to speak. Exposure to PIIGS banks is immense among member states, and anything but a recapitalization of distressed banks, or providing a window for lending directly by the ECB would end with grave economic repercussions.
I would like to point out that I have set aside for the sake of this post the far-reaching political implications to the EU in case of such chain of events. It is clear that such implications would also have a secondary financial effect that cannot be ignored. However, I will leave that topic for future discussion. German Chancellor Angela Merkel and French President Nicolas Sarkozy have been trying to negotiate an impossible solution. Germany has been reluctant to assume financial responsibility for member states' failure to adhere to fiscal responsibility, and rightfully demand that such countries show willingness to increase competitiveness and manage a conservative budget. However, ignoring history and the historical pattern of lack of adherence to, and enforcement of the provisions set forth in the Maastricht Treaty does grave injustice to Greece and other PIIGS countries. The ECB could technically interpret its mandate in a broader manner, such that purchase of government bonds is essentially needed to prevent future price instability for the entire eurozone, however this is a politically charged debate. Nonetheless, the EU rescue package is clearly at odds with the historical framework, which, we have seen, has proved to be more dynamic than one would have thought.
The €750 billion recent EU rescue package, in the form of facility loans and guarantees, is clearly a deviation from the conservative stance we have seen from the EU in the past, and it is clear that any other action would have led to extreme economic conditions throughout the eurozone. It also clear that recent measures will not suffice (to say the least) to prevent economic conditions from deteriorating, and future action will surely be needed soon. It is worth noting that the ECB's strategy of purchasing member states' bonds on the open market (as such action is not prohibited) has also been rather ineffective, and has been costly as well. It is undoubtedly far from what the architects of the EU and ECB intended, but clearly necessary under the circumstances to preserve the future of the union.
"In our seeking for economic and political progress, we all go up - or else we all go down" -Franklin D. Roosevelt
Barring a miraculous set of circumstances, the EU is faced with few options. Even a drastic reduction of Greek debt, surely coupled with extreme austerity measures that may have dire social and political implications, would have little overall effect, as it would take Greece a decade just to achieve a 120% debt-to-GDP ratio. A Greek default or departure from the eurozone would spell dire consequences for other member states, not to mention global exposure to European sovereign and private debt, and it seems unlikely that given the consequences discussed herein that such events would take place. The EU is therefore left with only one viable option, which is to provide extensive capital to distressed member states and allow them slowly to regain competitiveness with the aid of a depressed economy. This would allow Greece and other PIIGS countries to focus on internal development and for wages and other competitive measures to increase. This scenario seems most likely, and despite the social-political implications, seems the lesser of many evils. I believe recent events in Greece are proof that this is in fact the direction that the ECB, the EU, and ultimately Greece are heading in the right direction.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.