At the G-8 meeting at Camp David last weekend, lip service waspaid to keeping Greece in the euro zone. But economists who arewatching the continuing financial crisis in Europe are increasinglycoming to two conclusions: Greece is likely to abandon the commoneuro currency now used by 17 European countries. And when it does,perhaps within a matter of months, there will be a damaging dominoeffect throughout much of Europe. Not all domino effects arecreated equal, however. And there are two possible consequences ifGreece leaves the euro zone that few observers seem to haveconsidered. |
The scenario everyone recognizes is based on Greece'sreviving its traditional currency, the drachma. In this case,salaries and prices within Greece would be converted from euros todrachmas, and the drachma would be allowed to depreciate to makethe Greek economy more competitive. The problem comes with debtsthat are denominated in euros, especially if the lenders areoutside of Greece. These lenders would naturally resist beingrepaid with less valuable drachmas. However, if Greek borrowershave to repay the loans with euros, the debt would become moreexpensive for them to pay off after the drachma is devalued.
( PHOTOS: Protests in Athens ) The most likely domino effect, therefore and the one most widely expected is that debts to non-Greek creditors would be compromisedafter Greece switches to the drachma. There would be lawsuits overwhich currency to use, or borrowers would default on the loans, orlenders would be forced to accept reductions in the amount of theloans that have to be repaid, in order to avoid outright defaults.Whichever outcome occurs, the lenders lose money. Just as in theU.S. mortgage-lending crisis, once some banks lose enough money tobecome troubled, the contamination spreads to other banks, becausethey all lend to one another. That s not a pleasant prospect, but at least it s fairly clearhow to manage it.
Greece leaves the euro zone, and its economysuffers for a couple of years but then stabilizes. With Greecegone, the rest of the euro zone could be propped up more easily.Many major banks take big losses on Greek debt. Some fail, some aretaken over by stronger banks. Governments have to bail out thebiggest losers.
And the banking system is made sound again,although at considerable expense to taxpayers in many countries. ( MORE: Why Portugal May Be the Next Greece ) But what if Greece s exit from the euro zone causes other kinds ofdomino effects that don t have obvious precedents? The falloutcould be a lot harder to control. As I see it, there are twoscenarios that aren't getting the attention they should. Derivatives could set off a global chain reaction.
Most people have heard of the complex, "synthetic"financial securities known as derivatives, which Warren Buffettfamously referred to as "financial weapons of massdestruction." In the case of bonds, these are known ascredit derivatives. They include all sorts of loans secured bybonds as well as incredibly complicated vehicles that amount toinsurance policies if the bonds default. No one really knows howmuch of this stuff is sloshing around the internationalfinancial system, but the total value for all types of bonds wasestimated at more than $50 trillion in 2008 and has continued to grow rapidly since then. Trouble is, if thebonds underlying these derivatives become questionable, all thederivatives become uncertain too, even if they add up to far morethan the value of the bonds themselves. Moreover, some of thesynthetic investments based on Greek bonds could be governed byGreek law, some by British law (if anything originated in London)and some by U.S.
law (if Wall Street was involved). ( MORE: Is a Greek Exit from the Euro Inevitable? ) What if one legal system accepts the conversion of euro loans intodrachmas and another doesn t? Everything could be thrown into thecourts for months. Even worse, if synthetic investments secured byGreek bonds become untrustworthy, why would anyone trust similarlycomplex investments involving Spanish bonds or Italian bonds? The result of a meltdown in the world of derivative investmentscould cause far more chaos than simple bond defaults, not leastbecause it would be almost impossible to figure out who owed howmuch to whom. Greece recovers quickly, and all the other troubled countries wantout of the euro zone too.
At the opposite end of the spectrum is the possibility that Greeceabandons the euro and bounces back surprisingly fast.Paradoxically, that could cause another sort of disaster. Both Argentina and Iceland suffered currency collapses, but after a horrible year or two,they each rebounded and were better off than if they had fought tosave a failing currency. Analysts point out that both countrieswere big exporters of grain, meat or fish and that sales boomedafter currencies were devalued. But Greece, in its own way, couldprofit from a similar recovery a rebound in tourism.
A 30% drop in the exchange rate might make a vacation in Greecethe best deal in years. ( MORE: The Future of Oil: The Environmental and Economic Costs of NewExploration ) So why would that be bad? Think of what it would mean for the othercountries in the euro zone. How could the Italian governmentconvince its people of the need for higher taxes or the Spanishgovernment explain soaring unemployment if Greece were obviouslybetter off outside the euro zone? Result: the entire European Unionmight unravel, with financial consequences many times greater thanthose resulting from Greece alone. I m not predicting an extreme, doomsday scenario as the mostlikely outcome of a Greek exit.
But it is important to realize justhow unpredictable this situation is. In my own stock portfolio, Ieliminated all the banks a long time ago and have largely stuckwith financially strong companies that deal in essential goods,such as oil and gas, consumer staples and pharmaceuticals. Theeuro created a financial entity comparable in scale to the U.S.,and if it gets into serious trouble, the financial effects could beworld shaking. PHOTOS: Greece Lights Olympic Torch.
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