I was traveling around Germany as a guest of the German government in 1997 in their quest to gain support for monetary union. I was the chief economist at Chase at the time and a skeptic, having written several papers to make the case that locking a disparate group of countries into the straitjacket of a single currency would come back to haunt policymakers and disrupt their economies. The Germans wanted to convert me to their cause. The trip did nothing to change my mind about the economic problems that would arise from sharing a single currency, but I came away impressed with the seriousness of the political commitment behind the project. This will translate into considerable pressure on Greece to get its fiscal house in order, while the single currency will emerge unscathed, despite the doubts expressed by some.
Much has been written about the limited flexibility of Greece to address their budget problems. Without their own currency and monetary policy, they can neither depreciate nor inflate their way out of their budget crisis. Their only options are to raise taxes or cut spending, neither of which will be popular or easy. A one day national strike has already occurred and more challenges to the government's budget tightening efforts are likely. So some have suggested that Greece should drop out of the monetary union.
I would bet against this outcome.
Dropping out of the Euro would solve nothing, while dramatically increasing the cost of finance to Greeks for many years to come. While the politically "easy" policy might be for Greece to inflate its way out of its budget problems, that isn't really the case, as every economist understands fully well. Inflation is no substitute for fiscal prudence, nor can it overcome poor government policy. Rather, it papers over one bad policy with another.
Greece may need the help of a lack of policy options to be forced to do the right thing, which is to become fiscally responsible. Thus, Greece has every reason to stay within the monetary union to enforce responsible behavior. Since a default is highly unlikely and because its bonds have become cheap relative to others in the E.U., Greek bonds are now among the most attractive in Europe, especially since they yield almost 300 basis points above comparable 10-year German debt.
The rest of Europe will help Greece stay in the common currency. The common currency is an economic union, but it is first and foremost a political policy, as I learned during my trip to Germany. Even though these countries haven't integrated politically, they are most assuredly more in bed with one another than ever. Most importantly, the political tensions that produced wars and turmoil in continental Europe in the first half of the twentieth century have largely been vanquished and the European Union and monetary union have institutionalized and solidified those political developments.
That accomplishment will be built on over time until a united states of Europe emerges, even if that project takes some decades to come to fruition.
In the meantime, don't expect the Germans to abandon the Greeks. The ECB and the Germans will offer vocal political support as long as the Greeks take steps to bring their fiscal house in order. Moral hazard considerations will deter European governments from lending directly to Greece, just as our federal government is unlikely to lend to fiscally imprudent states, such as California or New York.
Restrictive fiscal policies in Greece, Portugal, Ireland and Spain will slow economic growth in a Europe that is growth challenged under the best of circumstances. While Asia is likely to lead the global recovery, Europe is likely to lag. That performance will hurt the profitability of European companies and should continue to weaken the Euro, making European equities relatively less attractive. Emerging markets remain attractive, but US equities are also well placed to participate in the global recovery.