The prospect of a sovereign default and potential exit by Greece from the eurozone (EZ) has been a major source of the worldwide financial media speculation for over two years. Regardless of any grand announcements made on Monday regarding approval of a "rescue," the Greece issue will remain a major focal point of stress within global financial markets for some time to come.
The large amount of attention accorded to the Greek crisis has puzzled many analysts. Given the relatively small size of Greece's economy, it has been questioned whether a Greek default and/or exit from the eurozone even matters.
Indeed, from a certain point of view, the amount of attention devoted to Greece by the financial media seems silly.
For example, the total value of Greek commerce in goods and services in the EU amounts to less than 1% of annual EU GDP. Besides, Greece exports nothing of critical importance to the EU that cannot be easily be substituted by other suppliers.
Another example of the importance of Greece to the EU: Simply writing off 100% of the Greek sovereign and private debt held by European public and private institutions would cost about 3% of total European Union (EU) GDP.
These sorts of impacts on the wealth and productive capacity of the EU represent a mere rounding error from a global economic point of view. And financially, from the perspective the long-term temporal framework that asset values should presumably be based on, the importance of Greece's economy to global debt and equity markets is similarly negligible.
Yet, for some reason, people all around the world seem to care a great deal about Greece.
For example, on a single "bad news day" regarding Greece, more market value is wiped off of the value of global stock market capitalization than entire the par value of all of Greece's public and private debts is worth.
Does that make any sense?
In this essay, I will not address the question of whether Greece should matter to global financial markets. I am addressing the question of whether Greece is or will be of significant importance to the financial markets, and why this may be so.
Risks To Financial System
Comparing the quantity of Greek debt to aggregate economic figures such as EU or global GDP can be deceptive. As the US economic crisis demonstrated, it is not just the total losses that matter; it is how and where those losses are distributed.
For example, at the outset of the financial crisis in the USA in 2008, the prospective net losses from bad mortgage loans were not particularly high as a percent of US or global GDP.
The problem was that the prospective losses were distributed in such a way that posed grave risks to the US and global economies.
Mortgage assets were held mainly by systemically important financial institutions. Because these institutions were highly leveraged (high proportion of total liabilities and assets relative to shareholder equity), even modest losses in their total asset portfolios could result in insolvencies. Considering the interlocking credit and funding relationships amongst all financial institutions, the insolvency of a few banks essentially threatened the solvency of many and the liquidity of all. At the same time, given the central role that credit and financial institutions play in the modern economic system the illiquidity and insolvency of systemically important financial institutions threatened to devastate the entire financial and economic system.
This was the story of how prospective losses on bad mortgage loans representing a relatively modest portion of US GDP threatened to bring down the entire global economic system.
In theory, defaulted Greek debts could play an analogous role to bad US mortgage debt. European banks are even more highly leveraged than US banks were in 2008. If Greece entered into a hard default and European banks were forced to write down the value of the Greek sovereign debt that they hold in their portfolios, some of these institutions might become insolvent. Because of the close and interlocking relationships amongst financial institutions the insolvency of a few banks could jeopardize the integrity of the entire European and even global financial system.
Fortunately, European banks and policymakers have had well over two years to prepare for an eventual Greek default. Therefore, European banks, bank regulators and the ECB are more prepared today to deal with a Greek default than the US financial system was prepared to deal with the mortgage securities crisis in 2008.
For example, the ECB instituted LTRO, a vast funding mechanism for banks that did not have an analog at the time of the collapse of Lehman and several other major US and global financial institutions. Indeed, had the equivalent of LTRO existed in the US and Europe in early 2008 it is unlikely that the crisis experienced by the global financial system at that time would have been as severe as it turned out to be. Furthermore, today, European governments almost certainly have in place detailed contingency plans to deal with bank solvency issues caused by an eventual Greek default. TARP-like rescues or Swedish style takeovers of affected institutions can be expeditiously implemented to insure that the European financial system does not collapse to a the failure of a few "weak links."
All and all, it is my assessment that Europe's aggregate financial infrastructure is probably prepared to deal effectively with the direct impacts of a Greek default.
Still the losses incurred by several European banks as a result of an eventual Greek "hard default" will be difficult to digest, individually and systemically. The important thing to note is that such an eventuality would leave the European financial system quite weakened and exposed to any further shocks that could come from other sources of asset distress from areas such as Portugal, Ireland, Spain, Italy or Eastern Europe.
Greece as a Model For PIIGS
Ultimately, the economic relevance of the Greek crisis in the current historical context may not reside in the direct value of its economic output or consumption; its assets or its liabilities. Furthermore, the importance of Greece may not rest on how losses on Greek assets might impact the financial system.
The importance of the Greek crisis for the wider world may rest on how the evolution of events in the Hellenic nation can potentially influence the way financial market participants perceive the future evolution of other PIIGS nations and the EZ as a whole.
Greece will be a model. Notwithstanding the varying relevance of this model to other EZ nations, it will provide a crucial reference point for analyses and discussions regarding the ultimate fate of nations such as Ireland, Portugal, Spain and Italy.
It is important to bear in mind that in human psychology recency often trumps relevance. Humans have a strong tendency to extrapolate recent outcomes when cases can in any way be analogized - particularly when the model outcome in question is and/or was very psychologically impactful.
In this regard, the Greek experience will play a fundamental role in shaping expectations for the other PIIGS. Greece is widely perceived as one merely instance of a much broader fundamental problem within the EZ: Other peripheral nations such as Portugal, Spain and Italy are not competitive, are not able to grow sustainably within the euro framework, have too much debt, and are therefore essentially insolvent. Therefore, it is widely perceived that the same conundrum that currently faces Greece will sooner or later confront the other PIIGS: Whether to default and institute a new currency that can be devalued.
The way in which the Greek crisis evolves will therefore inevitably set a psychological and even institutional framework that will vitally affect the other PIIGS.
The Narrow Psychological Path For Europe
In the event of a default and/or exit of Greece from the EZ, the psychological path that averts a wider panic is relatively narrow -- and lies between two plausible extremes.
At one extreme, a sufficiently benign outcome for Greece - such as the one many analysts are currently attributing to Iceland recently and Argentina a decade ago -- might eventually be perceived by investors as an enticement to countries such as Portugal, Ireland Spain or Italy to follow suit (i.e. default on their debts and devalue). If a country, at a relatively low cost, can wipe away its debts and restore its trade competitiveness in one bold stroke, why not emulate this example?
At the other extreme, if Greece turned into a horror show in terms its economic, political and social consequences, a panic could ensue in the financial assets of other PIIGS nations. The reason is that investors would begin to discount a higher probability of a bad outcome and/or to upwardly adjust their estimates of the costs of a negative scenario for other PIIGS outside of Greece.
In other words, in order to avert increased contagion effects towards other PIIGS, the outcome of a Greek default and/or withdrawal from the EZ can neither be too benign nor too harsh. It has to be "just right."
The Greek outcome must be bad enough so as to be perceived as worse than a default and devaluation. At the same time, the outcome cannot be so bad as to overly scare investors with a scenario that is so horrific that it is unacceptable even at low probability thresholds.
European Demoralization: Loss of Nerve
The potential for a Greek calamity to fatally affect the morale of the eurocracy and the European citizenry with respect to the EZ should not be underestimated.
Historians and analysts of organizations often make reference to the crucial role of morale in sustaining a culture and/or set of institutions.
Sometimes, in the history of an organization (e.g. nation, company, church) an event so traumatic is experienced that its members suffer a collective "loss of nerve."
"Loss of nerve" refers to a sudden and generalized collapse in faith in an organization and/or the ideals/values that bind its members together and give the collective its worth it as a social entity.
When an organization experiences a loss of nerve, collapse can be extremely swift and unexpected.
The specter of former member of the EU disintegrating into economic penury and social chaos - arguably hastened to this state misguided EU policies - has the potential to deal a devastating blow to the élan of the eurocracy and to spark a fundamental reexamination of the EU project by European citizenry whose dissatisfaction with EU institutions has been simmering beneath the surface for quite some time. Even worse, this existential crisis will tend to arise - as they always do -- under conditions of economic, social and political stress.
An exit of Greece from the EU goes to the very heart and soul of the EU project. The institutional and psychological importance of this fundamental failure should not be underestimated.
I believe that Europe and the world at large is relatively well prepared for the immediate effects of a Greek default and eventual withdrawal from the EZ.
I am less sanguine about the effects in the medium term.
First, Europe's financial system may survive, but it will be debilitated. And this weakening will come at time when other major tests lie in wake.
Second, it is inevitable that comparisons with Greece will be drawn to the situations of Portugal, Spain, Italy and other peripheral nations. It will be very difficult to shake the lingering suspicion that the Greek fate may befall these other peripheral nations.
Third, a truly positive outcome for Greece of a default and devaluation would be bad for Europe. At the same time a very negative outcome for Greece would also be bad for Europe. The collapse of Greece needs to go "just right" in order for contagion not to intensify. The question is: Can investors bank on a disorderly Greek default and a Greek withdrawl from the EZ to go "just right?" The institutional and psychological path from a Greek secession and European salvation seems complex and narrow.
Finally, a chaotic Greek withdrawal from the EU has all the hallmarks of an event that could trigger an existential crisis and "loss of nerve" amongst leaders and citizens of the EU. Such a loss of nerve could lead to a collapse of the EU on a timeline that is far swifter than most can today imagine.
A final note to my readers: None of this alters my late April timeline for the commencement of another major down leg for global equities. Although I was one of the first financial analysts to write extensively on the problems in Greece, I have never made the Greek crisis a central pillar of my bearish thesis for Europe.
Far more important for investors considering positions in equities such as Exxon (NYSE:XOM), or Citigroup (NYSE:C) or equity index ETFs such as SPY, DIA, EWG, or EWQ is the rapid deterioration of the fiscal position of Portugal, Spain and Italy as well as the deteriorating electoral prospects of President Nicolas Sarkozy of France.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.