Grexit and all that

I thought I would say a few words about the likely outcome of the ongoing Greek efforts to renegotiate its bailout agreement with the European Union. How likely is an exit by Greece ("Grexit") from the Euro currency? What would be the implications of a Grexit for the EU economy and asset prices? For the Greek economy and asset prices?

The bottom chart shows the Stoxx 600 index of European stocks. You can see that this index recently made new highs for the bull market which began in 2009. And it has moved sharply higher since the Greek election in late January. This tells me that European stock market investors do not fear the Grexit, either because they think it is unlikely or because they think any negative consequences for the EU will be very modest.

This response to the Greek elections is not as implausible as the Grexit media frenzy of fear and gloom might lead you to believe. The best way to think about the economic consequences of the Grexit for the EU is by analogy with the Y2K computer system transition on January 1, 2000.

The Y2K problem was widely recognized and understood. Computer disaster was predicted for January 1, 2000 when the third millennium of the Christian calendar was to begin because the yearly calendar used by most computer systems recognized only the last two digits of the year to save storage space. Faced with a specifically scheduled disaster computer system managers thought about little else for the several years prior to the transition date.

But January 1, 2000 came and went without anything untoward happening. Computer systems did not crash, utilities did not shut down, aircraft did not fall from the sky, there was no banking panic - yet all of these events were widely predicted by Y2K doom and gloomers right up through December 31, 1999.  Why this gigantic predictive misfire?

The answer is obvious. Faced with the possibility of a disaster with serious financial consequences computer programmers and managers put their heads together to fix the problem before January 1, 2000. And they were successful. January 1, 2000 was uneventful.

In the economic arena a similar phenomenon occurs. If an economic or banking panic is widely anticipated to occur for some specific reason, it probably won't. Panics are always surprises. The reason is similar to that which explains the the Y2K non-disaster. Central bankers, bank mangers, investors and all other economic decision makers will take all necessary steps to see that their portfolios and businesses avoid harm from a widely predicted, dangerous economic event. (Note the interesting corollary of this way of thinking - had economists been able to predict the 2008-09 financial crisis that crisis would not have occurred!!!)

In the case of the Grexit the biggest potential problem faced by the EU is the exposure of its banking system to a Greek government debt default, a default which could bankrupt big banks if they hold too many Greek assets. This was a very big problem for EU banks three years ago when the possibility of a Grexit was first taken seriously. But since then the EU banking system has systematically cut its exposure to Greek debt to levels which render a Greek default unpleasant for EU banks but not life-threatening.

Moreover, I think any Grexit would only strengthen and probably lengthen the European Central Bank's commitment to its quantitative easing program. A Grexit would remove the single biggest German objection to QE.

I think these two considerations explain the bullish Stoxx 600 response to the Greek elections. This response should be contrasted with the frenzy of fear these elections triggered in the popular media because the winning party ran on an anti-EU, anti-austerity platform.

But will there be a Grexit? I don't think so and I think the market for Greek debt agrees with me. The middle chart shows the yield on the Greek 10 year bond during the past four years. You can see that Grexit fears in 2012 sent the yield well over 40%. But now the yield is only just north of 10%. Clearly the bond market thinks a Grexit is much less likely now than it was three years ago despite the recent political changes in Greece.

A Grexit would also throw Greece into a much worse recession than the one it from which it is currently emerging. The value of domestic Greek assets would plunge as euros are exchanged for a new Greek drachma and the drachma falls perhaps 50% against the Euro. Unemployment and inflation would surge. I think these economic problems would be relatively short lived but they would be very painful and would probably lead to another change in political leadership. Thus Greece's recently elected leaders have every reason to fear and thus to avoid a Grexit.

If I am reading the tea leaves correctly I think there is a good chance that we have seen the bottom in the Greek stock market (top chart) near the 708 level. If I am wrong then I think a drop to 600 would be in the cards. But note that even the 600 level is above the 500 low reached at the height of the last Grexit crisis in 2012.