Season Investments


The Greek Tragedy (Act III)

Posted on July 28, 2015

"But in so dying I will prove deadly to another's life." - Phaedra, in the Greek tragedy Hippolytus 

2015-07-28_greece.jpgThe Greek crisis will surely be one of the defining macroeconomic stories of this decade. It’s hard to believe, but we are now in the sixth year of this drama. Greece has found its way back onto the front page repeatedly since late 2009, and the past six weeks have ushered in Act III (as measured by the number of bailouts the country has received) of what is truly turning into a Greek Tragedy. 

To start things off let’s review the background of how we got here. The Euro, still a relatively young currency, was first adopted by 19 European nations back in 1999. The currency is administered and managed by the European Central Bank (“ECB”), which controls the money supply and interest rates for those countries (the ECB is to the Eurozone what the Federal Reserve is to the United States). The monetary union formed by the common currency is referred to as the “Eurozone”. It’s important to remember that the Eurozone only refers to those European countries that use the Euro and is not to be confused with the European Union, a band of 28 European countries who collaborate on a broader level for the advancement of Europe as a whole. 

Despite opting into the monetary union, the 19 member states of the Eurozone never established a fiscal union, meaning they each maintain full autonomy in running their own individual finances (taxes, spending, debt, etc). This would be akin to the US having the Federal Reserve but no federal government, leaving all the individual states to set laws, collect taxes and manage their budgets in isolation. 

In the wake of the new monetary union, the debt markets began assigning the same credit risk to all the member states, meaning less austere countries (ie, Greece) gained access to more credit at lower interest rates as a benefit of being perceived to be “in bed” with the stalwarts of the Eurozone (ie, Germany). This occurred right as a credit-fueled consumption boom took hold across the developed world, with the end result being that countries like Greece, Ireland, Spain, Italy and Portugal borrowed far too much money far too quickly in proportion to the underlying fundamentals of their respective economies. 

In 2008 and into 2009 the global financial crisis took its toll on Europe as a whole, but especially on the peripheral countries. Economic growth slowed, capital markets dried up and almost overnight Greece found itself unable to make good on its debt obligations. In October of 2009 Greece’s finance minister announced that the country’s budget deficit was expected to reach 12.5% of GDP, well above the 3% threshold agreed to by Eurozone member states. 

In early 2010 the country’s government began to pass controversial measures, called “austerity packages”, in an attempt to shore up the situation. These austerity packages consisted of various pension reforms, tax increases, spending cuts and public sector layoffs. By April of 2010 the situation had worsened and Greece formally requested international help. It was at this time that the European Union, the European Central Bank and the International Monetary Fund, collectively known as the “Troika” and led predominantly by German officials, banded together to provide the first bailout package in the form of €110 billion in loans over three years. The thought behind this intervention was that if given enough time the Greek economy could institute the needed reforms and return to a growth path, thus bridging the country to a more sustainable financial future. 

But nothing improved. By the end of 2011 Greece had passed three more austerity packages leading to strikes, riots, vandalism and even the violent death of innocent people on the streets of Athens. Greek debt was partially restructured via the application of a “haircut” to certain debt classes, but this had minimal impact. Amidst heavy turnover in political leadership Greece received its second Troika-funded bailout in February of 2012, bringing the total amount of committed funds to €246 billion. A sixth, seventh and eight austerity package passed through the Greek parliament, but a languishing economy just suffered more under these measures and there was no improvement in the nation’s debt levels or budgetary shortfalls. 

Early this year the populist cries of the Greek people gave birth to the election of Syriza, a radical leftist wing within the Greek political system. Alexis Tsipras, the party’s leader, was sworn in as the country’s Prime Minister in January 2015 amidst promises that Greece would no longer suffer under the ruthless thumb of the German-lead Troika. The harsh austerity of the previous five years had done enough damage, and it was time be free of the shackles and reclaim Greek autonomy. Unfortunately there was no cohesive plan for addressing the nation’s financial and economic problems in conjunction with snubbing the Germans. 

And this brings us to the events of the past six weeks. 

Earlier this summer it became clear that another bailout was needed in order to keep the country out of technical default with creditors. But this time the negotiations were markedly different. Prime Minister Tspiras, along with finance minister Yanis Varoufakis, struck a blatantly defiant tone, insisting that no further austerity measures would be accepted. Their message to the broader European contingent was that they would rather go through the pain of exiting the Euro and returning to the Drachma than tolerate any more bullying by their fiscally strong European counterparts. This, in essence, was a threat. Tspiras knew that other Eurozone countries, and particularly Germany, would lose a lot of money in a Grexit if all of Greece’s debts were re-denominated from Euro to Drachma. 

But Germany refused to budge, and upon reaching a standstill in the negotiations Tsipras shocked the global community by announcing that it would be the Greek people who would decide via a referendum vote whether or not to accept the Troika’s conditions attached to a potential third bailout. Not surprisingly the referendum, held on July 5th, produced a 61% “no” vote thereby rejecting the proposed conditions of the bailout. The Greek people had spoken, and they had had enough. 

greek_euro_poker.jpgThis is where it got really interesting. Tsipras was betting that the threat of a Greek exit from the Eurozone would be so unpalatable to the Germans and that they would be forced step in and provide a third bailout with no strings attached (see opening quote). But what Tsipras saw as a viable threat Angela Merkel saw as an empty bluff, and the Troika refused to re-engage talks with Greece until they agreed to the proposed conditions. 

What happened next was both humbling and humiliating for Tsipras, Syriza and the Greek people. After attempting to play hardball with the Germans, the Greeks found themselves in such a bad state of affairs that within one week of the referendum vote the Greek parliament was overriding the peoples’ voice and agreeing to the Troika’s terms. By July 13th the Greeks and broader Europe had struck a deal…€86 billion in additional bailout funds in return for more austerity. (While there are a few more formal procedures to go through before this deal is executed, it is looking likely that it will go through.) 

At the end of the day this bailout represents yet another “kick the can down the road” move by European leadership. No one in their right mind expects Greece to be able to pay this money back, but by buying more time the Europeans hope to find a way to mitigate (or at least delay) losses as well as continue to work out the extremely complicated details of what a Grexit might actually look like. 

As we’ve expressed previously in our Weekly Insights, economies and financial markets are extremely complex systems with innumerable semi-related moving parts. Chaos theory holds true in this field of study, and prognostications and concrete if/then claims should be taken with large grains of salt. We don’t pretend to know what the best course of action is for the Europeans. Nor do we understand exactly what a Grexit might realistically look like. But one thing that has been fairly clear from the start is that the bailouts have not been doing anything to fix the underlying issues. Back in early 2012 we wrote the following: 

A disorderly unraveling of the crisis in Europe is still the greatest “known” threat to investors of all types. While a number of potential outcomes are possible, we do not believe a worst-case scenario is the most likely. In our view, all European participants are in a slow creep towards a scenario in which fiscally sound countries (ie Germany) will reluctantly backstop losses for creditors of the fiscally rogue countries (ie Greece). In return, the rogue countries will have to cede a certain amount of control over budgetary policy to those footing the bill. This evolution is unfolding at a painstakingly slow pace as policy makers are engaging in political gamesmanship for the sake of appearances, despite realizing that certain eventual outcomes are inevitable. These outcomes will NOT be popular among anyone’s constituency. German taxpayers won’t appreciate being a source of bailout funds, and Greek citizens won’t appreciate being put under the strict thumb of a German-led governance authority. 

Later in 2012 we explained why any hopes of spurring economic growth in Greece were unfounded in our Insight entitled The Troika Has No Clothes: 

The real issue that no major decision maker in Europe (or anywhere else for that matter) is willing to address is the fact that the recent recession and recovery isn’t of the normal, garden variety business cycle type. The current recession and recovery is the aftermath of a multi-decade credit expansion that peaked in 2008 and will take years if not decades to unwind. In a business cycle recession credit temporarily contracts as growth slows, but it quickly picks up again after interest rates are lowered in response to the slowdown in growth. In a credit cycle the response mechanism to lower interest rates is broken because the end user (e.g. businesses and consumers) is not willing to take on more debt because their focus has shifted to paying it down. 

The easiest way to think about the difference is that the focus of the credit end user shifts from their income statement (how do I maximize profits?) to their balance sheet (how do I stay solvent?). This is the definition of Keynes’ phrase “pushing on a string” when it comes to monetary policy’s effect on the real economy. 

Even we could see the writing on the wall three and a half years ago, and it’s still there for anyone to read today. We still believe the most likely outcome from all of this is a Greek exit from the Eurozone, or at least something other than the bailouts fixing the underlying debt problem with yet higher amounts of debt. 

Act III of this Greek Tragedy brought the audience more of the same in terms of political posturing and gamesmanship, but a much higher level of tension between the actors in the play. As John Mauldin describes it, “Greece was once again forced to agree to a deal that will let it to borrow more money that it can’t pay in return for hobbling its economy even further.” There are no good options here, and we empathize with certain aspects of both sides of the debate. The Greek economy is teetering on the edge of needing humanitarian aid, and many of its people are truly suffering. Its leadership sees no way forward but to accept policies they don’t believe in. Meanwhile, its creditors are attempting to find the balance between preserving European “unity”, holding a member state accountable for its past mistakes and protecting their own long-term financial interests. This truly is a Greek Tragedy, and unfortunately we have yet to see the final act.

david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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