Greek Butterflies

Is it possible for the Greek debt crisis to unravel the Euro?

That’s what it looks like may happen. A country whose GDP is about 2.5% of the Eurozone has gotten into fiscal trouble, and now hedgies are running a bear raid on Italy, a core European country whose $2.1 trillion economy is larger than California’s. If Italy goes down, the Euro is at risk.

How did we get here? It’s not as if the Greek debt problems are breaking news. Their bloated debt and chronic deficits are the stuff of legend. The EU’s dithering, and especially the European Central Bank’s tightening credit in the teeth of a balance sheet crisis in Greece, Portugal, and Ireland have convinced many that the Euro may not have the support many thought it did.

Accordingly, some aggressive traders are trying to drive Italian and Spanish interest rates to unsustainable levels. This will be harder than it appears at first. Italy’s government is running a primary (ex-debt service) budget surplus, and they have significant public assets they can sell. Even so, this crisis can end in only one of three ways:

First, the European nations can arrange a bail-out. This is hard in the case of Italy, which has $2.2 trillion in debt. Nevertheless a Hamiltonian debt assumption and re-issuance under a central authority is possible. Europe is still a powerful economic engine. Second, default is possible. That would likely lead to multiple banking crises across the continent, and if the sovereign has defaulted, the sovereign can’t shore up its banks. But some kind of controlled, limited restructuring is possible. The third possibility is monetization. The ECB could buy the troubled debt and expand its balance sheet. We know where that leads: inflation. There is no free lunch.

There may be another way for Europe to muddle through, though I can’t see it. One thing is certain—there is more pressure for integration than most people realize. That’s why I continue to expect a resolution.

Douglas R. Tengdin, CFA
Chief Investment Officer
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