Greece Moves to Become a Banana Republic

Here is a picture of what a real European leader looks like (Associated Press):

Greek politicians have overplayed their hand. "Give me more money, or I'll shoot myself!"  Let's say, in the eternal Euro-Optimist view, French mathematics are applied to Greek sovereign debt, i.e. stretched out to 40 years, with rates and face values TBD.  It is guaranteed that there will never be any meaningful economic reform in Greece, other than maintaining the current government employment/pension mess and taxing a small private sector into oblivion.  The European Union itself is the big loser, but Chancellor Merkel will earn the devil's horns, while the French and the French-led IMF will proclaim victory.  The ECB will live to waste capital another day.  Other peripheral countries, and perhaps some core members, will realize that there are no teeth in the rules of the EU.

We hear from private economists and a few think tanks that Greek sovereign debt risk has been "ring fenced."  If that is true, then the only real impact of Greece's ill conceived intransigence will fall on their own people, which may be appropriate and the best thing for their democracy in the long run. What comes after the debacle will bear watching, but the economic risk to the EU can be absorbed

Greek PM Tsipras has 61% of his electorate behind him.  If he really is leading his country down this path, he needs to accept the consequences, get driven from office eventually, and the body politic can repair itself.

The only European politician who has stubbornly and effectively tried to show leadership on key bilateral and multilateral issues, like Ruusian sanctions,  has been Chancellor Merkel.   Strong and effective leadership in Europe is something at which elitists crinkle their noses.

If Greece defaults, it is their medicine of choice, and a convulsive purging is much better than a 40 year, slow bloodletting, where spending trajectories don't change and economic growth will be minimal.

The EU and Greece Share a Cup of Hemlock

Since 2012, we have written about the inevitability of the events the European union are facing today, a Greek sovereign debt default, an exit from the euro currency zone, political chaos at home, and a fundamental failure of the grand European experiment.

To reach this conclusion, no complex economic models are needed.  The design of the system and the notion of divergence, along with the history of relationships within the zone, point the way.

To be sure, along the way, there were many false dawns, as European politicians do what they do best summit meetings and consultations with smiling faces and bowed heads, walking in some countryside.  Hedge fund managers used their tools to call a bottom in bond prices and got involved.

Fast forward to today, and there are no financial markets to impose any discipline on Greece.  Hedge funds have gone home chastened with their losses, and Greek sovereign debt is owed to the IMF and to the ECB, with the biggest chunk being owed to Germany.

For all the Ph.D.s among the Greek expat intelligentsia, for all the worship of game theory and Nash equilibria, Greek politicians have gone beyond brinksmanship to simple economic lunacy.  Asking the EU to wait for a Greek national referendum was irresponsible. Greek government pensioners don't want any changes in the status quo and blame outsiders, like the IMF, for their problems.  A "No" to acceding to further fiscal discipline may be a vote against the EU, but it is also a repudiation of failed Greek political parties.  It does no one any good, except to save face for the Tsipras leadership failure.

For Germany, not how French President Hollande is no longer at the Chancellor's side, as they were inseparable a few years ago, co-leaders of the European experiment, along with the IMF, now led by a French national too.  Chancellor Merkel is now by herself forcing Greece over the cliff.  Of course, she has no real choice.

The Greek alternative to fiscal austerity has been a plan in which, for example, pension payouts were guaranteed, and a plan dependent only on revenue raising through taxes on small businesses, with no more fiscal austerity.  No Ph.D. is needed to see how this plan would turn out.  So, any rational observer has to realize that Greece is no longer serious about reforming its economy to meet substantially higher growth targets.

But, since the Maastricht Treaty is silent about unilateral exits and the mechanics thereof, a Grexit really calls into question the whole value of the euro, the ECB, the ESM, and all the bureaucratic empire that has been created in Brussels.  Which peripheral member would be the next to take bitter medicine?

Although Plato took liberties with the poisoning of Socrates, in terms of describing symptoms and a drawn out death, it probably applies well to Greece and to European Union.  If Greece takes its bitter medicine and defaults, leaving the Eurozone, there will be great economic weeping and gnashing of teeth.  But, Greece will have made Europe pay a price too, finally exposing the emptiness and futility of the eurozone as it has been laid out and administered so far.

One Way Out for the Eurozone?

The capital markets have Eurozone fatigue.  Day after day, hour after hour, we await the same news: an answer is forthcoming from the next meeting of EU finance ministers.  There's a Monty Python sketch in which the characters play around with an innocent question, "How big is it?"  Well pundits at the IMF conference have suggested a rescue/bailout/fiscal equalization fund of 1.4-4.0 TRILLON euros would solve the problem.  There is no answer to "How big?"

A facility of that size is out of the realm of possibility, for a union in which the strongest member has a GDP of 2.5 trillion euros.  Eventually, Germany will have to deal with the reality that its interests diverge not only from the weaker members of the union, but from those of France as well.  Then, Merkel and Sarkozy will no longer be able to pose as figurative, "Brothers in Arms." 

Greece has announced that its austerity measures will not enable it to meet its budget targets in today's WSJ. So, really we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro.  We wrote way back in June about the likely fate of the euro and about the attractiveness of Treasuries despite all of our fiscal management issues. 

A country's exchange rate is the most effective market price for adjusting imbalances in merchandise trade and external capital  accounts.  With the euro, Greece or Italy don't  have an exchange rate for the market to devalue until their economises  adjust to a new equilibrium.  Playing with tax and fiscal policies are not primary tools for these adjustments, as Greece is finding out.  Italy is waiting in the wings, and I don't believe that the Berlusconi government would have any inclination to drive itself down a path as Greeece has done. 

Thinking back to the Lehman crisis, one of the justifications for the absurd bailout concocted by Treasury was the fact that nobody could really map out the complete counter party network for Lehman/AIG/Bear Stearns and the other SIFI's, along with the amounts at risk.  Nobody knew how bad it would get and whose hands would get blown off. So we implemented a really bad deal.

Likewise, the structure of the EU and the obligations of its members were built without contemplating the alternatives we're now facing, namely an exit from the euro.  However, if one member exits, the utility of the entire common currency mechanism is mortally wounded as an economic construct. I'm not sure anyone really knows how the default//exit scenario would play out in practice.  Markets need to adjust and move one, but that means a paralyzed Europe has to come to terms with the failure of the notion of their common currency union. 

It doesn't matter how many times the finance ministers meet and where they meet, there may only be "One Way Out."

"Ain't but one way out, baby,
  Lord, I just can't go out that door.
  Ain't but one way out baby,
  Lord, I just can't go out that door.
  'Cause there's a man down there,
  Might be your man, I just don't know."
 
  (Holland/Dozier/Holland) EMI