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Insituttions vs. Numbers: Greece and the Euro

|Includes: WisdomTree Euro Debt ETF (EU), EUO, FEZ

Greece and Crises

Tuesday, 23 February 2010, William Gamble, President - Emerging Market Strategies

A small country in southern Europe has caused a crisis.

Greece is a country with a population of only 11 million and its GDP makes up less than 2 per cent of the EU economy, but the potential default of Greek sovereign debt has caused stock markets to fall along with the Euro. Its budgetary problems are supposed to be a portent of a greater disaster.

The financial problems of Greece are predicted to infect countries faster than swine flu. Commentators have assured us that the sovereign debt of countries around the world will collapse like dominoes. The sovereign debts of other EU countries are also supposed to be at risk. Starting with the Eurozone, the bonds of Portugal, Ireland, and Spain will be next. After they default, Eastern Europe will follow and finally, the UK, Japan and even the US.

Should investors take these warnings seriously?

If you look at just the numbers, there is certainly cause for concern. But you have to consider something else beside the numbers to really determine the risk. You have to look at the institutions of the sovereign.

There is no question that the finances of Greece are daunting, but they are nothing new. Greek government debt is the highest in Europe at over 124 per cent. However it has been over 100 per cent since they entered the EU in 2001. If you look at their history, the country had been in a state of default for about 50 per cent of the time since its recognition as an independent country in 1832. Greece was bailed out in 1987 and threatened with expulsion from the EU in 1991.

The question is why these problems keep reoccurring. One answer might be found in Game Theory. Game theory divides systems into two types, relationship based systems and rule based systems. No country has one system or the other. It is more of a spectrum. Relationship based systems are sort of a pre law system based on networks and relationships. Rule based systems are based on rules.

How can you tell? One of the easiest ways is to look at political dynasties. In Greece the names really have not changed for the past 40 years. In the sixties the country was dominated by politicians named Constantine Karamanlis, George Papandreou, and Constantine Mitsotakis. Today the country is dominated by Constantine Karamanlis, a nephew of the elder Karamanlis, George Papandreou, grandson of the elder Papandreou, and Dora Mitsotakis Bakoyianni, the daughter of the elder Mitsotakis.

Like politicians everywhere, politicians in Greece like to maintain power. One easy way for politicians to establish and maintain power is through a patronage system by expanding the public sector. For example Greece has four times as many state schoolteachers per student as in Finland which is widely regarded as a model for public education.

Greece also has one of the most generous and most expensive state pension systems. Public sector workers get 96 per cent of pre-retirement pensions, far better than the average of 50-75 per cent, but less than Brazil where they get 100 per cent.

A large inefficient government bureaucracy riddled by patronage has other nasty effects. Since it encourages corruption with little transparency and irregular or unenforced rules, it is hardly surprising that there is a large underground economy estimated to be about 30 per cent of gross domestic product. Greece is notorious for its tax evasion. An estimated 30 per cent of VAT is uncollected.

Relationship systems are exceptionally hard to change. The reason is simple. For certain vested interests, the system works very well. If you have the proper relationships, you have access to opportunities and information not available to the rest of the market. With enormous economic advantages at stake, those groups with this relationship capital are going to do everything possible to protect it.

There is one thing that can stop them. The rules. The law. The reason why the risks of Greek sovereign debt will be contained is that Greece is subject to the EU rules. These rules provide hard incentives that force reform.

The proposed deal for Greece will require supervision of pensions, healthcare policies, public administration, labor markets, and financial sector regulation. The most important is supervision of official statistics to provide accuracy and transparency. This type of supervision has already been successful in restoring order to some financial basket cases like Hungary and Latvia, who were also predicted to cause collapse of sovereign debt all across Europe a year ago.

So contrary to the present hysteria, the probability is that when the rules are finally applied to various EU economies, their credit will become stronger not weaker. The crisis will be impetus for reform not the cause of default.

In contrast many developing countries are believed to be in a stronger position or so it seems. Without the institutions, transparency is even more of an issue than it is in Greece and reform is viewed as unnecessary. This will simply delay and exacerbate the issues. So there will be sovereign defaults, but not where the markets presently predict.

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William Gamble

Emerging Market Strategies

Baltimore, Maryland, US



Disclosure: No positions