I solve my problems and I see the light. We got a lovin’ thing, we gotta feed it right. There ain’t no danger we can go too far, we start believing now that we can be who we are. Grease is the word. Change the spelling in the last sentence in this 1978 Barry Gibb song and you could be speaking about Europe today.
Over the past week I have seen analysts say that the US stock market is moving up due to the situation in Greece, or that it is moving down because of Greece. I have seen articles warning about “contagion” and others stating that there will be little impact from Greece leaving the Euro. The best line that I have heard was from Robert Horrocks from Matthews Asia who said, “If Greece defaults, the direct impact on the Chinese economy would be roughly equivalent of the entire Chinese workforce taking a long lunch-break.”
I think that says a lot, for Greece is a tiny economy that is really only linked to international markets as a tourist destination and debtor. In fact, the largest sector of the country’s GDP is government (over 40%) followed by tourism at about 15%. Shipping accounts for about 4.5% of the economy and international aid contributes over 3%. In other words, what happens in Greece really does not impact what happens in most of the rest of the world. So why all of the hubbub?
Actually, unless you are an investor holding Greek debt, or have loaned a company in Greece money you probably should not care very much. In fact, the Greek government already defaulted on most privately held sovereign debt so really its only European governments, international institutions and some European banks that were forced by their governments to purchase Greek debt that should be concerned. A complete default on all of this sovereign debt will put a strain on European credit markets but would really not be much different than Iceland’s default a couple of years ago. It will for the most part pass unnoticed.
So in order to build some excitement around the pending Greek default, commentators have brought up the idea of “contagion.” This concept suggests that there will be a domino effect of defaults across Europe since nearly all of the “peripheral” countries are ridiculously deep in debt. Some of these countries – particularly Italy are large economies that do have significant ties to the outside world. But will a Greek default lead to contagion and will contagion even matter?
If there were to be a massive default on government debt throughout the Eurozone there would be serious repercussions across global economies as credit markets would again become unhinged. But these would be short term issues that would unwind quickly. I think this is very unlikely. Unlike Greece, the other countries in question, Spain, Ireland, Italy and potentially France, actually have working economies. They may not work well, and they may be unaffordable, but they are not bankrupt. A complete default on sovereign debt is unlikely in these countries and they can adjust their welfare states if push came to shove. Greece on the other hand, has a completely dysfunctional government, a fairly high level of corruption, literally no productivity and not much in the way of productive industry.
While the sovereign debt crisis (outside of Greece) will likely work itself out over the medium term, in the long run it is highly unlikely that 17 sovereign states with differing fiscal policies, different levels of productivity and different wage rates can survive in a monetary union. It is nice to be able to travel to Europe and not change currency at every border, and the Euro has reduced trade and transaction costs, but it is impossible for a state with an inflationary fiscal policy (like France or Spain) to be monetarily joined to a productive country (like Germany or the Netherlands) without massive transfers of wealth. The United States serves as a historic example. The country was first formed much like the EU, with 13 sovereign states each and a central government with limited powers. While the Confederation Congress could make decisions, implementation required unanimous approval of all thirteen state legislatures. This is the same system that the EU maintains today.
Like the EU, Congress did not have the power to tax and could only request resources from the various states, which were often quite stingy. But unlike the EU, which is held in check by Germany, the Congress printed large amounts of fiat money which was used to pay the Army (remember that the war with England was still on-going). This led to a massive inflationary period that did not end until Alexander Hamilton was able to restructure the country’s debt in 1790. The opposite problem is occurring in Europe, as some of the sovereign states are running highly inflationary fiscal policies while their currency is not allowed to depreciate. This is what led to the high levels of public debt in the first place as governments were forced to borrow (rather than print money) to pay for their expensive welfare programs. As Nixon’s economic advisor Herb Stein said, If something cannot go on forever, it will stop. This is a good adage to keep in mind when thinking about the Euro and the European debt crisis, for even if the debt problem is solved, the inconsistencies between economies will not go away. Greece may be the word of the day, but it is only the canary in the coal mine.