Will Grexit Kill the Global Recovery?
Uncertainty over the fate of the euro currency is already dampening US economic growth and any significant worsening of the crisis would deal a blow to a recovery that is gradually gathering steam.
Economists estimate that volatile markets and business uncertainty over the fate of Greece and the policy course in Europe is already shaving anywhere from one tenth to one half a percentage point from US 2012 gross domestic product growth.
In a Reuters poll last week, US GDP was forecast on average at 2.3 percent for 2012 and 2.4 percent for 2013.
The direct hit to growth comes through trade. US exports to the European Union account for 19 percent of total exports, and those to the euro zone represent 13 percent of the total. But when calculated in terms of GDP, the share is tiny - only 1.3 percent of total output.
The indirect effects are another matter. Europe in 2010 accounted for 25 percent of world trade, according to Deutsche Bank. Europe also is the biggest trading partner for China and the United States. Loss of this market would ripple worldwide and slow global growth.
The other indirect impact is through the financial sector.
If Greece were to leave the euro zone, it would raise questions about the survival of monetary union and trigger turmoil in markets. Business investment would stall, banks would pull back on credit, and lost wealth as equity prices fall would cause consumers to slow their spending. Commodity prices would plunge, helping importers but hurting growth in export economies.
The extent of the damage would depend upon how quickly global policymakers could stop the rout and stabilize markets.
Following is a look at three scenarios for the euro zone and the likely impact on the US economy.
EURO ZONE STUMBLES ALONG
SCENARIO: Greece elects a government on June 17 that continues implementing the EU/IMF bailout program, possibly with some softened conditions. Greece stays in the monetary union for now. Spain recapitalizes its banks, possibly with some EU help. ECB liquidity injections and EU-wide guarantees help stabilize the big French and German banks to insulate them and the broader financial markets from further damage. Bouts of market uncertainty continue in the months and years ahead, but gradually EU integration advances.
IMPACT: Ongoing volatility in financial markets and slow-to-mildly negative euro zone growth would continue acting like a low-grade fever weakening US growth. This already is the baseline scenario for most analysts' forecasts. TD Economics said it has marked down its 2012 outlook for 2.0 percent growth by about a quarter to half a percentage point because of Europe. IHS Global Insight has trimmed about one tenth of a point from its 2.2 percent forecast for this year.
GREECE LEAVES EURO ZONE
SCENARIO: An anti-austerity government takes power in Greece and rejects the bailout terms. The EU and IMF stop lending Greece money. Athens runs out of cash, defaults on its debt and starts printing its own currency to pay bills. Its banking system collapses. The European Union has had time to draw up contingency plans and succeeds in preventing the currency exit and debt default by Greece from pulling down Spain, Italy and Portugal and manages to stabilize its banking sector quickly. The Federal Reserve may help provide market liquidity through new FX swaps with Europe and quantitative easing.
IMPACT: Greece accounts for only 2 percent of euro zone GDP and US exports to Greece are negligible. So too is US credit exposure. US money market funds have largely moved away from investing in Europe. Greece owes the private sector $70 billion, but mostly that is to German and French banks, according to the Institute of International Finance. The bulk of its $460 billion in external debt is held by the European Central Bank, the European Union and the International Monetary Fund.
Hence the direct impact of a default and euro exit by Greece on the US economy would be quite small, as long it were contained - but that is a big «if.» Once one country leaves, market focus would switch to other deeply indebted countries - Spain, Portugal, Ireland and even Italy. European policymakers would need to sling a safety net under these countries and big EU banks to prevent the contagion from spreading and imperiling the euro zone.
The immediate shock of a Greek exit probably would shave half a percentage point from US GDP in the quarter when it happened and soften growth in the subsequent quarter, said Craig Alexander, chief economist at TD Economics. But if managed smoothly, a Greek exit could cause a burst of optimism that the euro zone woes are over and strengthen US output subsequently, he said.
Nariman Behravesh, chief economist at IHS Global Insight, said his firm is about to change its baseline forecast to a managed Greece exit, probably early next year. He expects to cut its US GDP forecast for 2013 of 2.4 percent by two to three tenths of a percentage point.
MESSY GREEK EXIT, DAMAGE SPREADS
SCENARIO: Greece crashes out of the euro. Yields skyrocket for Spanish and Italian bonds locking them out of the government debt markets. Spanish and Italian depositors withdraw cash in panic over the possibility of their countries leaving the euro zone, too. Global equity markets sink. Investors pile into US markets as a safe haven. The US dollar soars as the euro plunges. European banks face funding shortages as investors shun the euro zone and the banking system seizes up. Global markets become chaotic.
IMPACT: This is the nightmare scenario. The economic impact in the United States would be felt through trade, financial linkages and business and consumer confidence. The size depends upon how quickly policymakers could stabilize the situation and whether any big financial institution whipsawed by a rapid repricing of assets is in danger of collapsing.
At the very least, shockwaves through financial markets would cause a downward jolt to the US economy, immediately erasing at least half a percentage point from growth in that quarter.
If Europe's banking system shuts down, violent shudders through global financial markets would equal or surpass those seen when Lehman Brothers collapsed in 2008. Banks are better capitalized today than four years ago and therefore better able to weather the storm. But with interest rates near zero and governments fiscally stretched, advanced economies this time around would have fewer tools to offset the hit to growth.
At the very least, the US and global economy would fall back into recession, and some economists warn it would be far deeper and more dangerous than the one of 2007-2009. The US Fed would be almost certain to embark on a fresh round of bond buying, known as quantitative easing, to keep financial markets highly liquid and hold interest rates low.
I fall in the camp that a Greek exit will be extremely messy and dangerous for the global financial system and economy. Why? Because any 'initial optimism' will be short-lived as people in Spain, Italy and Portugal realize that this union is a farce and pretty much revolves around what Germany dictates, which right now is status quo on austerity measures.
Importantly, citizens suffering from the ravages of devastating austerity measures in other peripheral economies will also want out and place immense political pressure on their leaders to break away as they realize that their fate could be the same as Greece.
I'm the first to admit that structural reforms in Greece are desperately needed, especially in the public sector, but Germany is basically dictating all the terms now, steadfastly refusing to create a common eurobond market and proceed with meaningful growth initiatives.
Should US policymakers be concerned? Damn straight! And they are placing immense pressure on eurozone leaders to address this crisis in a holistic and forceful manner, but at the end of the day, it's Germany who is calling the shots and if a crisis develops, it's German leaders who will have to accept full responsibility. And Germany must realize that they got a bailout too.
The greatest economist in history, John Maynard Keynes, once famously quipped: "When the facts change, I change my mind. What do you do, Sir?". Actually, the attribution of this quote is a matter of controversy, but the point is simple, if current policies are worsening the situation, how long before European policymakers wake up and adopt a different stance? Will they wait until unemployment soars even higher, creating a dangerous political dynamic, threatening the continent?
Already the ECB has to step in to avoid a full fledged banking crisis. This can't continue indefinitely without spreading fear throughout the global banking system. At one point, Ms. Merkel and other eurozone leaders have to heed Mr. Hollande's and Mr. Monti's calls to create a eurobond market and focus on "growth, growth, growth." If they don't, they will send Europe into a depression and kill the global recovery.
Below, Bloomberg reports a majority of European Union leaders at a Brussels summit this week backed joint euro-area bonds, and Italy can help persuade Germany to support Europe’s “common good” as well, Italian Prime Minister Mario Monti said. It seems Germany may be persuaded on a euro debt-sharing compromise.
If so, this is positive. I believe investors need to look beyond Grexit and start loading up on risk assets. Over the weekend, will go over the portfolios of top hedge funds, mutual funds, endowment funds, pension funds and sovereign wealth funds to show you where they are placing their bets. This will be a great weekend comment, stay tuned!