Forest Fire on the Way
As each week passes, the debt crises in the Eurozone become more and more like a dry forest where small fires that have broken out appear to be contained before the next larger fire is kindled. "Solutions" are put forward, only to prove inadequate. New prime ministers of Greece and Italy are hailed as capable of imposing needed disciplines to stave of a full blown forest fire. But even these (future scapegoats?) men realize they can contribute only a small amount to the problems.
The solution lies in the vigorous resuscitation of growth and re-capitalization of the banks and financial flows reaching the capillaries of the financial body of the Eurozone. But that seems beyond the capacities of the Eurozone nations and their political leaders. So we remain on fire watch in a very dry forest. The biggest fear in the developed world is that the small fires being fought in the Eurozone will catch a wind and cross into the U.S. and its banking system. We could be closer to that then we currently believe.
So it's wise to have a look forward to a full blown forest fire. The Greek bailout has been a failure so far, and while Italy is "too big to fail" it is "too big to bail". Its €1.3 trillion debt will swallow up even an unleveraged bailout fund. It will topple a leveraged one and bring down the Eurozone banking system as well. The ensuing forest fires will cross the Atlantic, already struggling to contain its own debt. If Greece leaves the Eurozone there will be two important facets of what then unfolds:
The Future for Greece
The departure of Greece from the Eurozone will have to mean the resurrection of the Drachma. In the light of the capital flights that have already taken place, expect to see a potential fall in its value of up to 60% or more. However, it would be irresponsible of the Greek central bank to allow this to happen. Take a look across the Atlantic in Argentina. There, Capital Controls are leading to the central bank taking control of dollar deposits to prevent them from leaving the country. We have discussed the possibility of a two-tier currency, one for capital transactions and one for trade transactions in Greece in earlier articles. Such a regime would be aimed at preventing any further flights of capital from the country. Certainly the Greeks have left it a little late for taking such actions, as a large percentage of its capital has already departed to E.U. members north of the country.
If Greece left the Eurozone it would see imports proving extremely expensive and difficult to acquire. This would be a softer version of the sanctions that were imposed in South Africa and Rhodesia in the last century. Those two countries found that they had a local 'boom' as import replacement provided so many opportunities. The big problem in Greece is the civil servants, a bloated section of the country. They would have to be cut back savagely and sent out to an alternative lifestyle.
This would create deep social problems there, but nevertheless there would be many opportunities in the private sector for much of the slack to be taken up. While inflation would run away there, the cost of imports would become exorbitant leading to a [J-curve] balancing of the Balance of Payments. Tourism would blossom as some of the cheapest holidays in the Mediterranean would become available alongside bargain prices for property. The inflow of euros from these two sources would do much to lift Greece back on top. With their debt levels having been taken below (well below) the 50% level, it would be a far shorter period of time for the Greek economy to resurrect itself. The harm done to Greece under austerity would be as great as Greece leaving the Eurozone. The big difference would be that the time it takes for Greece to recover would be far shorter if they left the E.U. than if they stayed in.
Under a two-tier currency system, as we have seen in other countries in the past, capital would be attracted to Greece to enjoy higher interest rates plus capital gains on the loans sent to Greece. We estimate that after five years, Greece's finances would be in good repair and the economy thriving.
Future of the Eurozone
The E.U. would have the major problem if Greece left the Eurozone by itself. The markets would fear that Portugal, Italy, and Spain would follow. The euro would take a major hit as investors ran for cover to the U.S. dollar, and E.U. leaders would have to rescue these nations quickly or see the euro drop like a stone.
You can be relatively sure that Eurobonds would then be issued to cover all the nations in the E.U. with limits on the weaker member's borrowings to ensure no repeat of the past. Fiscal Union could be on the table, if the weaker members agreed to a centralized E.U. tax collection system. The pressure brought to bear on the E.U. would force such changes. The scene would be similar if the northern members had conquered the southern members, without bloodshed. Expect to see the individual nation's gold holdings be forced into servitude if only as collateral (via Bank of International Settlement currency/gold swaps).
If all the weak Mediterranean members of the Eurozone left the E.U., then the picture would change dramatically. The E.U. would comprise the strong members of the Eurozone. Their Balance of Payments would either show a surplus or, at worst, be in balance. This would not be a simple matter because a political debate over each nation would ensue, causing turmoil in the European and international financial markets until the actual departure of these members.
Once they had gone, then the euro would soar against the dollar as money left the U.S. (in the midst of its own debt/political crisis) to return to Europe. Again this process would be harmful to international trade as the price of the euro would make many European nations exports uncompetitive overseas.
The temptation to impose protectionism would likely prove too much for the E.U. simply to preserve its international trade position and the economic health of its members. As we have seen demonstrated in Japan and Switzerland, a currency's value will be sacrificed to protect the trade position of a nation, or group of nations. This was one of the main attractions to Germany in becoming a member of the E.U. When they did this, they found they could enjoy a 'fixed' exchange rate against their European trade partners in the E.U. If they should lose this, then it would be back to the days of a floating, constant revaluation of the euro, even against the U.S. dollar. The U.S. would benefit from this tremendously as it cut into Europe's exports.
The European banking system would suffer a series of body blows which could bring many of them down and set off a 'domino' effect on U.S. banks due to the interconnectedness of their finances. This may prove a far greater cost than to the individual nations involved. The only way out of that financial explosion would be to inflate out of it through a degree of money creation far beyond our imagined levels. To allow deflation to take hold would savage the economies of the strong members as well as the weak members. So, deflation would not be one of the options available.