"We are basically trying to change the course of the Titanic. People think we are in a terrible mess and we are."
Greece Finance Minister, George Papaconstantinou
Greece and a few other highly leveraged European economies have risen to the top of our worry list as the potentially most disruptive influence in an otherwise increasingly attractive overall global economic recovery. How can this be the case when Greece’s total annual value of all goods and services produced (GDP) represents approximately 2% of the GDP of all Euro based economies? If we make an analogy in terms of the U.S, Greece’s GDP is approximately equal to the economy of the state of Maryland as it relates to the GDP of the U.S. So why should we, as U.S. investors, be concerned about Greece’s current deficit problems? Two primary reasons come to mind.
First, watching the Greek financial crisis unfold, we have a perfect view of the startling rapidity with which financial contagion spreads like a wild fire through a parched pine forest on a windy day. Greece has been the most profligate spender among the 16 countries comprising the Euro region and is the highest leveraged. Its financial behavior is grossly in violation of European Union (EU) rules regarding acceptable levels of sovereign leverage.
The country suffers from many political and financial ills. Included in this partial list of woes are the following:
S&P’s recent downgrade of Greek debt to junk status was followed by downgrades for Spanish and Portuguese debt as well. Borrowing costs for each of these countries has, as a result, risen sharply and with each downgrade European banks take an additional hit to their net worth. The natural reaction for banks caught in this situation is to hunker down, lend less to worthy borrowers, etc, etc. This crisis is following so closely on the heels of the last recession that people haven’t yet had time to forget how quickly events can spin out of control. The difference between this and the 2008 crisis is that today, the crisis is caused by the regulators and politicians. Nobody regulates the regulators and eventually the citizens have to pay the price of their misfeasance.
One of the promises that countries make when they join the EU is to keep their annual deficits at not more than 3% of their GDP. One year ago, Greece estimated its 2009 deficit at 3.7% of GDP. More recently the figure was revised upward to 12.7%. Then EU officials discovered omissions in Greece’s calculations which when taken into consideration have brought the deficit up to approximately 14% of GDP or perhaps even higher.
The current Greek crisis has illuminated a fundamental flaw of the EU and its common currency which stems from the disparate economic strength of its members and the lack of control by EU officials over their fiscal policies. For example, Greece’s low productivity and bloated public sector normally could be counterbalanced by currency devaluations were it not an EU member. Without the currency devaluation option, the country’s debt burden continues to grow as expenses mount and government revenues languish until bond markets rebel by refusing to lend more money regardless of interest rates offered. Every borrower eventually reaches a limit in borrowing capability. Greece has just discovered theirs. Portugal and Spain and Ireland are not far behind. There is a clear lesson here for the U.S. as well.
Our second reason why we at home here in the U.S. should be greatly interested in this unfolding calamity is because the financial problems of Greece mirror those of many other overleveraged, developed countries – including the U.S. We are simply a few years behind Greece in facing the market consequences of reckless use of leverage. Greece represents a very clear window to what the future holds for us if we don’t stop spending money we don’t have on new and expanded entitlement programs.
Should we encounter unexpected bad economic news, such as spreading contagion from the euro crisis, for example, U.S. tax revenues could plummet once again and we could experience debt to GDP ratios similar to that of Greece in a much shorter period of time.
These are some of the reasons why Greece matters.