Saturday 22 October 2016

Don't underestimate the damage of a 'small' failure like Greece

Published 01/07/2015 | 02:30

Tourists visit the ancient Acropolis hill in Athens as Greek voters prepare to decide in a referendum on Sunday on whether their government should accept an economic reform package. Photo: Milos Bicanski/Getty Images
Tourists visit the ancient Acropolis hill in Athens as Greek voters prepare to decide in a referendum on Sunday on whether their government should accept an economic reform package. Photo: Milos Bicanski/Getty Images

Havana is a strange place from which to write about Greece. Cuba has been cut off for years, access to information is limited, people can't travel and the Party is so paranoid that the Internet is barely available. However, what happens next in Greece and in Europe is less a matter of news and more a matter of analysis about what happens when people feel the world and their assumptions have changed forever.

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Perhaps the fact of being in Cuba, so far away from everything, offers a degree of clarity. (Interestingly, today Greece is about to join Cuba as one of only four countries to have defaulted on the IMF.)

One relevant way to look at what is happening in Greece is through the kaleidoscope of symbolism. Symbols are important. Many commentators and politicians are discounting the Greek crisis as being specific to Greece. They argue that Greece is only 2pc of European GDP, but the plug is also only 2pc of the bath and we know what happens when you pull the plug.

Even taking the "Greece is too small to matter" angle, this is a real problem for the EU's politicians because if they admit they can't find a political solution for such a small problem, what's to happen when they encounter a big one?

What happens if contagion from Greece spreads not because there are identikit problems in other countries, but because by allowing the Greek situation to become so acute, the EU has shown itself to be extremely fragile?

Fragility is the key here. Greece is a symbol of the EU's fragility. If an institution is fragile and untested it can implode under the most innocuous of circumstances. This is what happened with the Soviet Union. It was so brittle that the smallest challenges exposed it as a chimera. Consider even the difference between Italian and British political institutions. For years, the British have laughed at Italian politics with its interminable coalitions, crises and North versus South squabbles. Yet which country now is on the verge of dissolution? Not Italy, but Britain. Why is this? It is because years of doing deals, finding last-minute compromises and pulling back from the brink has made Italian institutions surprisingly robust in the face of challenges. Whereas British institutions, which are used to "all or nothing", "first past the post" solutions are the ones facing "yes or no" referendums.

Now consider the EU. Is it robust or fragile? Is it practical or dogmatic? Could the stitching which ties this multi-national quilt together unravel?

In the case of Greece, the issue for most Irish people is whether our preconceptions about the EU are wrong and need to be reassessed. In short, we know that Greece is broken but is the EU broken and, more importantly, is EU or eurozone membership conditional?

If Greece does leave, and that exit causes minimal disruption (outside Greece), the pro-EU argument will be one of:"See, we told you Greece was not that important."

But the path paved by Greece implies that such an exit path exists where before it did not. And if it exits, it can be prepared again for some troublesome country. What happens the next time other countries get into trouble, such as Spain and Portugal? Or what about debt-laden Ireland, in the future, when interest rates go up?

And then, if exit is possible, what about countries that may want to leave the EU, such as the UK? And what happens in Ireland if (1) the UK leaves and (2) interest rates rise at the same time?

This would mean that political pressure on Ireland because of our close trading links to the UK and financial pressure because of our membership of the euro arrive simultaneously. By the way, this is a highly likely scenario because (1) rates will rise in Europe and (2) Britain will have a vote.

If such a path is being prepared following Greece, the only question is, who's next?

Into this toxic political mix we must add the instability of global financial markets. Far from making the world a more stable place, the free movement of capital makes the world highly unstable. This is because in "good times" too much capital comes into a country and asks no questions.

This is precisely what happened to Greece when it could borrow what it wanted and was lent whatever it asked for. Once uncertainty arrived, capital high-tailed out of the country leaving it stricken. Since 2008, the world has become more, not less, unstable.

We have seen a huge build-up of debts all around the world. Central banks cut interest rates in response to the financial crisis and this encouraged companies and corporations - particularly in emerging markets like Brazil, Turkey and large parts of Asia - to borrow heavily. Money borrowed at very low rates from the central banks has gushed into every nook and cranny of the global economy.

All these debts are yet to be paid. If interest rates rise and growth slows, the Greek crisis has the potential to be a second 'Lehmans' moment for international markets.

For example, think about what has happened in Ireland, Spain, Portugal and Italy since 2011. Our Government has made great play out of telling everyone that the interest rate at which the Irish Government can borrow has fallen to the lowest ever.

Have you ever stopped to think about what that actually means? It means that someone has been prepared to lend to Ireland at very low rates. They have lent us money in return for Irish IOUs.

Those people who have been lending to Ireland are hedge funds and investment funds with pretty short term horizons. They have been encouraged to lend to Ireland because the European Central Bank has promised to lend to Ireland. The ECB was credible.

What happens to ECB credibility if Greece goes?

Obviously, the ECB's failure to keep the Greeks in the euro will make its promises look less binding, more equivocal and more conditional.

In this case, the hedge funds would try to get out of Irish, Spanish and Portuguese IOUs not only because they are worried about the risk in the peripheral countries but also because the politically unstable euro will be falling against the politically coherent dollar.

Most of the funds are American.

Now consider what would be happening to the balance sheets of these funds.

They start losing money on their Irish IOUs because the value of these IOUs is falling as people reassess the risk after a Greek exit. As the euro falls against the dollar, these losses amplify.

Their balance sheets start to register huge losses. The funds panic and all run for the door; but there is no liquidity as no one is willing to buy from them. They then have to sell "good" assets to make up for the losses on their "bad" assets because their balance sheets have to balance every day.

The investors in these funds panic and they take money out of the funds, exacerbating their losses.

Financial contagion takes hold and it is a strange and frightening thing that has the potential to amplify shocks like Greece far beyond the shores of the Aegean.

As you can see, a relatively small failure has the potential to change everyone's assumptions about the way the economy works.

This is now the risk. Wouldn't it be weird if a supposedly permanent and powerful euro currency frayed quicker than the isolated and fractured communist Cuba!

Irish Independent

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