The European Union (EU), European Central Bank (ECB), and International Monetary Fund (IMF) spent the first half of 2015 struggling over whether to allow Greece to default and possibly exit the Euro, or to impose another round of austerity in return for more debt assistance. The austerity measures are severe, and if implemented as now planned, will almost certainly extract a high price from the Greek economy, making it much less able to service debt in the future. We look for a much more difficult Greek crisis in 2017 or 2018, assuming a new round of funding goes through. Also, the interest rate implications for the ECB are that it will want to stay on hold for a long time to come, meaning virtually no volatility in short-term Euro Ibor and presenting a mixed picture for the Euro.
Among the EU, IMF, and Greece, there is plenty of blame to go around for excesses of the past. Looking to the future, though, the Greek economy is in the midst of a depression that is already worse than the one experienced in the US in the 1930s. The cash flow of Greece is in no way able to service its mountain of debt to the EU, ECB, or IMF. Greece faces debt default or massive debt restructuring at some point down the road, just not now. (Figure 1 shows fluctuations in the Euro).
So far, the EU has prevailed on Greece to adopt significantly more fiscal austerity in return for another massive increase in new debt. If Greece implements the new fiscal austerity then the economy will suffer a further drop in real economic activity and be even less able to pay off the debt it already has, not to mention the additional debt that it will be provided. This means the EU deal will postpone the crisis until 2017 or 2018 when it will be much worse than the current episode.
In terms of economic impact, the Greek economy has already been isolated from the rest of Europe, and makes up less than 2% of the eurozone GDP anyway. The damage to European equity markets came mostly from the uncertainty of how the crisis would be resolved. The political side of the story is much more interesting. The challenge for European politicians, from German Chancellor Angela Merkel to French President Francois Hollande to the bureaucrats in Brussels and central bankers at the ECB, is how to handle the political fallout from taking huge losses on their loans to Greece. Since the shrunken Greek economy cannot generate enough cash flow for current debts, let alone more debt, the eventual question for EU governments and politicians is whether the debts will be written down, taxes will need to rise in Germany and France due to the losses, or how Germany and France’s credit rating might be impacted – all not very attractive political outcomes. Hence, there has been a strong desire by European politicians to kick the can down the road, force more austerity on Greece, and postpone the next crisis until a new round of leadership in Europe takes over.
We look for a much more difficult Greek crisis in 2017 or 2018, assuming a new round of funding goes through.We note that debt default does not necessarily mean that Greece has to leave the single currency (Grexit), even though the issues are tightly linked. Eventually, there is likely to be a blame game to be played here, as to which institution would be the one to force a Greek exit from the euro. Currently, the IMF is the only institution advising for a more realistic approach and recognizing that the Greek economy cannot sustain its current debt load, let alone a larger one. This stance from the IMF has not been welcomed by the EU, which prefers a rosy scenario and postponement of any crisis. This puts the ECB in an awkward position. The Greek banks are dependent, now and in the future, on the ECB’s provisions of liquidity to survive. If the ECB were to pull the plug, then a Grexit would be forced. The ECB, however, is likely to take its cues from the EU and Germany, rather than choose to be the institution that causes Greece to exit the Euro. The sequel in 2017-2018 may be quite spectacular, and outdo the 2015 version.
For the ECB, the resolution of the current Greek crisis does not change the monetary policy outlook. Growth for the eurozone depends on encouraging more credit to be supplied, and that suggests no change in ECB short-term rate policy for a long time to come – meaning little to no volatility in Euro Ibor even if European government bonds remain subject to sharp swings due in part to a lack of liquidity.
Interestingly, the Euro was stronger during the crisis than afterwards. The main reason was that the way the Greek crisis was resolved suggested that the ECB would be on the hook for even more money to Greek banks and needed to maintain its QE program for a long time into the future. This put market attention back on the Federal Reserve’s likelihood of raising rates before the end of 2015, and resulted in a weaker Euro against the US dollar when the current crisis was resolved. Down the line, whether the Euro rises or falls against the US dollar probably depends as much on whether European economic growth starts to rise, as we think it will, or not. Stronger than expected (by the market) real GDP performance might well be enough to counter a 0.25% rise in US federal funds rates that has been exceptionally well telegraphed.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
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