Greece, the problem child of the European Union (“EU”), is living up to its reputation. The EU continues to falter economically, with the peripheral members in various states of recession and with the central and northern nations stagnating or experiencing only minor growth. Overall, as of the beginning of 2015, Europe has not experienced anything like the – dare I say robust? – recovery that has occurred in the U.S.
Greece, with a debt crisis ongoing since 2009 and rampant political instability, has contributed greatly to the perception that the EU is only as strong as its weakest link. The current debacle relates to a growing concern that the January 25, 2015 Greek elections will lead to a new coalition government whose primary goals will be to: (i) end austerity, risking default on the nation’s debts; and (ii) exit the Euro, leading to a “contagion effect” among other poorly performing EU member who may also be tempted to return to their own monies.
Greece and Monetary Policy
The EU is a political union, encompassing the majority of European countries and providing streamlined interstate commerce, policy, and migration. The European Monetary Union (“EMU”), is the mechanism which facilitates the use of a single currency – and thus a single monetary policy – amongst its members, who represent a smaller subset of the EU membership. Monetary policy is one of the primary ways governments influence their economies. Put simply, a government can decide to either print more money, print less money, or take money out of circulation. This is in contrast to fiscal policy which encompasses taxation and government spending. There are a few more theoretical nuances to monetary policy, mainly in regard to what is meant by “money” and “put into circulation”, but for the purposes of this discussion money can be thought of in the figurative sense as being purely cash currency, which is quote-un-quote “printed”. Thus, if there is only one currency being used, that is printed by a central agency (in the EU issued by the E.C.B. and in the US determined by the Fed and issued by the Treasury), then there can only be one monetary policy. Just as Florida can’t print $100 bills on a whim, Greece cannot print €100 bills to cover its debts.
Monetary policy is primarily used to control inflation. Most economists agree that a little bit of inflation is good, generally in the range of 2 %. More is bad for obvious reasons, however many would say less is even worse. The reverse of inflation, deflation (the increasing value of money, i.e. falling prices of goods) is a major concern of central banks for a number of reasons: (i) it inhibits exportation of goods produced in-country (as they become ‘more expensive’ to importing countries), (ii) it curtails consumer spending (why spend today when your money may have more purchasing power tomorrow?), and (iii) it causes havoc on the relationship between borrowers and lenders (existing loan payments become more costly to borrowers in terms of purchasing power); amongst other downsides. These forces are controlled by adjusting the money supply. Currently, many Southern European countries are experiencing deflation, even as the Euro depreciates against the value of other currencies – namely against the rising value of the US Dollar. So what is a country like Greece to do when the EU says it has had enough, and will not bail it out of its debt messes again, nor inject more currency into its economy?
What An Exit Might Look Like
Greece could seek a return to its own currency as a way of stopping deflation, ending austerity, and returning to the heavy state funding of social programs. Sounds like a win-win? Maybe yes, more likely no. By regaining the ability to print its own money Greece will again be able exert its own monetary policy, most likely to its own detriment. Greece does not possess the internal political will (nor unity), the technical aptitude, nor the fiscal responsibility that the guiding nation(s) of the ECB (i.e. Germany) wield. In issuing new money to fund such programs as food, energy, and transportation subsidies Greece will in turn raise inflation significantly, and perhaps uncontrollably.
In the short-term the resurrected Greek Drachma will most likely plunge. What happens to the Greek economy is debatable, and for the purposes of the global macro-economy not that important. What is important is the instability this will cause. Capital markets will grow scared and become more volatile, as investors and corporations despise uncertainty, especially when it grows out of political instability which to corporate managers and investors is the worst kind of instability. The primary fear is that other struggling Southern European countries on the Euro, such as Spain and Italy, will be spurred to exit the EMU as well; this worst case scenario has been dubbed the “contagion effect”. Such an outcome would yield compounding instability amongst investors.
Furthermore, such an outcome would in the short and medium-term lead to real losses for corporations that sell goods and services in the affected countries, as currency risks and ‘menu costs’ shave down profit margins, in addition to a decline in consumer spending as the effected economies react to the new volatility by cutting jobs and lowering real (inflation-adjusted) wages.
Now in the long-run a much brighter picture has the potential to emerge. If the contagion effect does not occur, with Greece (and Greece alone) exiting the Euro, what may happen? After the commotion in the markets dies down, Greece will likely continue to flirt with default, semi-hyperinflation, and general economic recession until it gets its act together and learns to balance fiscal spending and monetary policy. However, overtime the EU and EMU will become for-the-most-part absolved of Greece’s problems. Concerns over Greek bond defaults, or Greek political instability will become far less impactful. Other “contagious” countries may be deterred from following suit after seeing the heavy consequences that Greeks experienced during their transition. And while the loss of part, or even most, of the Greek market will impact European corporations, the impact is not likely to be catastrophic.
Overall, the Euro and the EU may emerge from Greece’s exit stronger than before, free of its weakest link.