On Greece’s eventual exit from the eurozone

I don’t think it’s a big secret that I believe Greece will eventually leave the eurozone. I have said this repeatedly. But I have also written that I do not believe that Greece would attempt to do so while Europe’s economic crisis is ongoing. Instead I believe that Greece will exit once things have stabilized but it becomes clear that it faces an interminable jobless recovery.

My view here is very much related to the post I wrote yesterday on Germany’s response to Euroland’s problems. I do not believe that Germany is the driving force of austerity and depression within the eurozone. Instead, I believe the institutional structure of the eurozone is such a straitjacket that it’s hard to find a solution to the euro zone’s economic problems within the existing framework without years of pain. Europe would need to make huge constitutional and operating changes and create even more significant dodges to existing law to prevent another decade of malaise.

This is a particular problem for Greece given the magnitude of the downturn in Greece and the level of joblessness there. Here are a few figures and background details:

• Greece’s economy is still falling, with GDP down 5.3% year-on-year through Q1 2013. 
• Through March, Greek new industrial orders were down 12.7% year-on-year, suggesting that the near-term economic outlook is also bleak.
• Greece’s unemployment rate is now 27% with youth unemployment at 64%.
• Yet, because of EU rules, government is sacking yet more workers, 15,000 more in the last cut in order to receive Troika aid.
• Out-migration is increasing rapidly due to the lack of jobs. Stories about Greek migration to Germany are manifold.
• This is having a huge psychological impact. For the latest year of statistics available, suicide was up 26.5% in 2011 from 2010, with women hardest hit. 
• The electorate has become radicalized. Right wing extremism is increasing with an increasing number of attacks on foreigners (including refugees) and Golden Dawn polling third in national polls. Syriza, the left-wing alternative is not associated with street violence and is polling second. Independent Greeks polls fourth and the former ruling PASOK party is fifth with only 4.8% of the votes.
• Nationalism has increased tremendously. Some of this was evident in mainstream parties before. However, Golden Dawn has taken all these positions into a single nationalistic pot. For example, Golden Dawn is calling for re-instituting the death penalty for violent migrants – something forbidden under EU law. There is also a move to push for World War II reparations from Germany. Eight in ten Greeks want this.

The human toll is extraordinary. In short, the social fabric of Greece has completely disintegrated. And by no means should we believe that Greece’s economy is on its way up. Greece isn’t turning a corner. The economy is still headed down, with growth probably resuming in 2014 at the earliest. So that’s the macro picture here. It is bleak.

Yet, when one looks at the bond market and the equity markets, another picture emerges. For example, the Greek yield curve has disinverted for the first time in three years, with 30-year bond yields now higher than 10-year yields. 10-year yields have dropped from over 30% to below 10%. The Greek stock market index has more than doubled in the last year.  S&P upgraded Greece in December, Fitch this past month. Fitch has upgraded Greek banks. This is why I am bullish on Greece right now.

However, there is a stark difference between the real economy and stock markets as there seems to be nearly everywhere including in the US. But the difference in Greece is tremendous. In this difference lies the seeds of Grexit in my view. What is happening is that Greece’s economy is bottomING. The economy has not bottomED and will not bottom until 2014. However, the rate of decline has decelerated. And so markets are anticipating a better future in Greece. The Armageddon scenario has been removed from the table.

Tail risk is diminished so much that punters are moving in everywhere into Greek asset markets and this creates positive fiscal momentum. Despite the enormous government debt to GDP overhang, Greece will have a smaller deficit in 2013. The debt load decreased in 2012 to 156% of GDP. And the EU sees the country hitting all its fiscal targets for 2013 and 2014. In fact, Greece achieved a primary surplus last quarter. That’s a big difference from just two years ago when Greece was missing all of its targets. And the prospect of a privatization round in which investors have now returned in droves means a lot more revenue from asset sales in my view.

So I would describe Greece as in a deep depression with massive joblessness and a radicalized electorate. But while we are not yet at bottom, the economy is bottoming, the fiscal picture is improving and the bond and stock markets are rallying in anticipation of more to come.

The problem is that internal devaluation means the struggle will be long and arduous. Look at this graphic from the Wall Street Journal.

It shows the economic path from the onset of crisis in Argentina in 1998 and in Spain, Italy and Greece in 2007. Notice that Argentina was tracking Greece until its devaluation. Then it surged to near peak 1998 output in short order. Argentine GDP continued to collapse immediately following the devaluation and then zoomed upward. That’s not what Greece’s economic path will look like.

The euro means external devaluation is out and internal devaluation is in – no massive kinks up in Euroland. And given the radicalized electorate, that creates redenomination risk in my view.

It was one year ago that the financial community was abuzz with talk of Grexit – Greece’s expulsion or departure fro the euro zone. Things have changed dramatically in the debt markets since then. And people have short memories. But let’s revisit that theme because what I said then is still what I am saying now.

Now I wrote on May11th last year that I believed the eurozone was preparing itself for a Greek exit from the eurozone. But I said an imminent Greek exit would have been catastrophic given the turmoil in Spain, Italy and elsewhere. Instead the Europeans were building a new framework based on four planks: fiscal rules along the stability and growth pact guidelines, a new growth compact to reduce the pro-cyclical nature of those rules, penalties for not adhering to the rules and a mechanism for eurozone expulsion. All of these features have been validated as in the works including the mechanism for expulsion. Both the Austrian and German Foreign Ministers back explicit euro expulsion mechanisms but this is not a plank that can be executed without treaty changes after the crisis has died down. And that’s when Greece can avail itself of this mechanism.

On May 14th of last year, I asked “Will the Greek exit be voluntary or involuntary?“. My answer:

“I believe Europe can ‘handle’ a Greek departure from the euro zone. It will be painful but the politics of such an exit increasingly favour it. My view for some time has been that it is a question of when and how not if i.e. now or after bailouts and crisis have slowed to simmer and by the Greeks or by mutual consent. My view in February was that the exit would be by mutual consent after crisis had died to a simmer, because voters do not want the euro zone to be broken up.”

I continued the thinking with more on the political economy of the coming Grexit:

“These steps can only be taken at the end of a long and miserable economic and political downward spiral when all other options have failed. So, while I do think Greece will eventually exit the euro zone, I still do not think it can happen immediately unless the economic and political situation deteriorate much further.

“What does this mean in the interim? For me, it means that we will see more bailouts and credit writedowns of Greek debt. Likely we will see a Greek re-default that prompts or is presaged by a euro zone bank recapitalisation. But, we also will likely see more austerity that means greater unemployment and lower GDP in Greece until the political situation prompts a re-evaluation or until the primary deficit is closed.”

And the primary deficit has now been closed! But I still believe re-default and Grexit are on the table given the high debt to GDP and the lack of growth, meaning that a re-evaluation will eventually come.

A long and arduous path lies ahead. Greece will be in a permanent funk due to its membership in the euro zone and the restrictions this places on the economy. As the all Street Journal suggested on Sunday, we need to be “thinking the unthinkable: quitting a currency“.

In late 2001, Argentina’s economy minister called the country’s dollar peg “a permanent institution,” whose unthinkable collapse would cause “the dissolution of the basic institutions of the economy and society.” A month later it was gone.

Those who say the risk of countries leaving the euro has gone away should consider other times when people viewed a currency regime as sacred, right up until the time they swept it away.

The only chance Greece has of remaining within the eurozone is if it can pull of a huge economic resurgence that beats back the populist political wave which will almost surely spell exit as long as joblessness remains so high. I don’t see this happening without significant reform to eurozone institutions.