Greek Election Creates Unease in Europe

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 26, 2015 1:52:00 PM

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greek electionEurope just got quite a bit more uncertain. The election in Greece over the weekend brought to power the Syriza party, which has vowed to challenge the existing Greek financial bailout, an implicit threat to the current economic consensus throughout Europe.

Some background

For years, Greece has been subsidized by other European countries. In exchange for the money, it has been cutting spending, restructuring its economy, and, in general, becoming more like Germany. This model has been known as “austerity,” although you could just as easily describe it as “living within your means.”

Before the euro era, Greece (and other countries) typically spent more than it brought in, borrowed to make up the difference, and periodically defaulted on that debt, either directly or by devaluing its currency. When it entered the eurozone, despite promises, Greece continued the same behavior—apparently without fully realizing that the devaluation option was no longer available. When times got tough, its options were reduced to one: default on the government debt.

The fear that Greece (and others) would default on its debt is what led to the last Greek crisis, in 2010–2011. This was an unacceptable option for the major countries in the eurozone, who stepped in to prevent default and “save” the Greek economy, at the price of enforcing a behavior change.

This is where we’ve been for the past couple of years. But, although the treatment has worked, the patient has not recovered. Greek unemployment remains at tragic levels. The debt problem has not gone away; in fact, it’s gotten worse. The economy is not growing. Most seriously, Greeks have tired of the seemingly endless economic stress for no benefit to the general public.

Enter Syriza

The leftist, largely Marxist, party has promised to end austerity, raise wages, and essentially return Greece to its pre-euro policies—all while staying in the euro and getting the benefits (and subsidies) of eurozone membership. After winning the election this weekend, Syriza can now attempt to make good on its promises by negotiating, primarily with Germany. Its bargaining position? If the rest of Europe doesn’t agree to allow it to start spending again, and forgive much of its debt, the country might leave the eurozone, to everyone’s cost and regret.

This is what drove the initial European support of Greece: the fear that the eurozone would collapse if Greece left and the panic extended to Spain and Italy, among others. At that time, supporting Greece was definitely the lesser evil. Now, however, that may not be the case.

Will Europe continue to support Greece?

Today, the European financial system is much less stressed. Italy and Spain are much less exposed. Europe as a whole has spent the past several years developing systems and procedures to manage risk, which it didn’t have in the last crisis.

Significantly, Greece is now a known problem and not a rapidly developing crisis. Markets can see this one coming and deal with it calmly. Should Greece leave now, the thinking goes, it would be a manageable risk, of more concern to the Greeks than anyone else. It seems possible that Syriza will not have the bargaining power it thinks it does, and that Europe may be much more willing to say goodbye.

The potential consequences of cutting Greece loose

If that happens, expect considerable turbulence in the markets. A massive default of a developed nation’s debt is something we haven’t seen for some time; combined with the effective start of the eurozone's unraveling, it would shake the financial world. Europe would have to deal directly with the consequences, financial and humanitarian, and Greece would find that its present situation can, indeed, get worse.

Given the severe potential consequences, Greece and the eurozone will probably find some way to agree. The problem is that every crack makes the system weaker, and the political forces that brought Syriza to power are operating in every country, including Germany. A weaker system and stronger political winds suggest that risks are rising in areas well beyond Greece.

                                     

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