Is A Greek Exit From The Euro Really Impossible?

by: Desmond Lachman

Conventional market wisdom has it that Greece passed its test of fire last year and that Greece's European partners will simply not let Greece exit the euro. This conventional wisdom, which has been reflected in a marked decline in Greek government long-term bond yields to barely 8.5%, is all too reminiscent of the conventional wisdom about Argentina's commitment to its currency peg in the months immediately preceding that country's ignominious exit from its Convertibility Plan in December 2001. Sadly, in the months ahead, the current conventional wisdom about Greece never abandoning the euro is likely to be sorely tested as Greece's political and economic conditions continue to deteriorate.

Anesthetized by ample global liquidity, markets are simply choosing to ignore many warning signals emanating out of Greece about that country's troubled political and economic future. They certainly seem to be turning a blind eye to the current Greek government's insistence that Greece has reached the social and political limits as to how much more budget austerity and painful structural economic reform the country can tolerate. They also seem to be turning a blind eye to Greece's stalled IMF negotiations and to increased signs that patience is running out in Berlin about Greek foot dragging on real economic reform.

Markets also seem to be totally discounting the possibility that the Greek government could fall next year and that the far-left Syriza Party, which is not known for supporting the IMF-EU policy prescription for Greece, could be swept to power. They do so despite the deep divisions that are now clearly apparent in the Samaras coalition government, which has already seen its majority in Greece's 300 member parliament whittled down to only three members. They also do so despite the very real likelihood that the Greek government will suffer a humiliating defeat in the May 2014 European parliamentary elections that would make it difficult for it to continue governing.

Equally surprising is the market's apparent equanimity about Greece's dismal economic outlook, which seems to be driving its political fragmentation. Despite the fact that Greece's economy has contracted by almost a quarter over the past six years and that Greece's unemployment rate is around 28%, both the OECD and Moody's are forecasting another small decline in Greek GDP in 2014. It also has to be of concern that Greece is now experiencing outright price and wage deflation. That could very well thwart economic recovery within Greece's euro strait jacket and make it impossible for Greece to deal with its public debt mountain without substantial official debt relief.

In hoping that Europe will somehow endlessly ride to Greece's rescue no matter what happens in that country, markets might want to reflect on a couple of sobering precedents. Prior to Russia's July 1998 default, that country was widely believed in markets to be too nuclear for the G-7 to allow it to fail. And prior to Argentina's 2001 exit from the Convertibility Plan, markets thought that the IMF and the US Treasury would never allow that to happen.