Four Dangerous Paths: War-Gaming The Greek Crisis From A Global Investment Perspective

February 12, 2015

Sharp-edged Risk with a capital "R" has returned to the financial world as a result of Greek voters in overwhelming numbers electing the far left Syriza party and installing Alexis Tsipras as the new prime minister.

The investment world had in some ways grown placid since 2012, the days when the financial woes of the heavily indebted and economically troubled PIIGS (Portugal, Italy, Ireland, Greece & Spain) dominated global financial headlines, and when a possible Greek default last threatened to bring down the financial world.

And now, comfortably numbed by the central banking opiate of trillions of dollars of quantitative easing around the world, and lulled by the record high markets and record low yields created with all this cheap and easy money – the investment world has once again reached a consensus of sorts whereby the insiders agree that for now, the underlying fundamentals can be ignored, and that Risk has been banished.

This sort of consensus has been reached before – indeed, many times in different nations and centuries – and the end results have never been pretty.

The Greek election results are a real time reminder that the toxic fundamentals vexing Europe never were solved; indeed they have grown worse than ever in the last three years.  The Southern European nations in particular remain heavily indebted, and their aging populations now being three years older are that much closer to their promised pensions.  Meanwhile, due to the lack of economic growth their youth remain unemployed in massive numbers, and many are incapable of supporting themselves, let alone supporting their collective parents in retirement.

Greece also reminds us that change happens on its own schedule. The financial world is in play again, and this time the deadline for resolution is February 28th, 2015, when the current bailout terms expire.  Now this doesn't mean that there won't be extensions of a sort, including Greece perhaps drawing down its final reserves to defer default, but the time interval currently appears to be weeks and months, and not years.

If the current negotiations fail to produce an agreed-upon solution there is indeed the potential for global financial meltdown, and it could come quickly in 2015, possibly even in the next few months.

That said, such a collapse scenario is far from inevitable. Unfortunately, however, the methods that are used to avoid a global financial meltdown may necessarily be acutely painful for investors around the globe. Assuming the Greeks do not give up their demands, then as we will explore, there are at least four paths when it comes to investment returns in Europe and the United States, as well as nations like Canada and Australia – and none of them are pleasant. 

For reality is what it is, and a consensus to ignore reality does not remove its unpleasantness, even though it may change the form through which it is expressed.

Attempted Blackmail

First, semantics aside, what the Greeks have effectively voted for, and what their government is attempting to do, is quite simply blackmail. And many in the Eurozone leadership have openly acknowledged this in one form or another, and have firmly said that they're not going to give in.

What the Greeks are saying is that they are not going to pay their debts under the current terms of their debts. Their rationale is that because they elected a new government, they are no longer bound by the agreements of previous governments. They therefore have the right to set aside all such agreements, including the austerity programs upon which their current bailouts are based.

They will not let the "troika" of the European Commission, European Central Bank and the International Monetary Fund boss them around anymore – for the Greeks are a free people. They may not pay their short-term debts coming up at the end of February, but instead expect to negotiate a "bridge" deal with the European Union whereby those payments will be made for them by other nations, even as it buys them time to work on a more permanent solution.

With the more permanent solution involving, in one form or another, a restructuring of the Greek debt where they don't have to pay much or most of it back.

Greece's "leverage" in attempting this blackmail is effectively to be standing on the edge of a cliff and threatening to jump.  There is no subtlety here – for as the new Greek finance minister recently stated in an interview, the euro zone could "collapse like a house of cards" if Greece is forced out.

In unmistakable language, the new Greek government has let it be known that either Greece is given the financial treatment it demands, or he is willing to go down a path that could inflict damage on the entire world, and if that means the entire global financial system goes down in flames, then apparently, so be it.

To be clear then, whether you live in the United States, Canada, Australia or elsewhere, so long as you have savings and investments, or even need a job – this blackmail is directed at you as well.

Now that doesn't mean that Mr. Tsipras actually has the power to do this, or that a Greek default would necessarily lead to any such outcome. But make no mistake that he is quite publicly willing to set in motion a process that could potentially lead there, and in some ways, it is the teeth to his bargaining power in seeking special treatment for Greece.

Setting A Precedent

Now if it were just Greece by itself then the chances are that, all posturing aside, they would get what they want. For while an approximately $270 billion national debt may be a massive burden for the Greeks, it is trivial compared to the total global economy, or even the debts of the major nations.  That amount isn't worth the danger involved for the euro and the Eurozone in the event of a default and exit, so a way would be found to effectively write off $100 billion or $150 billion of that debt. This is what Greece is counting on – and it could still happen.

However, the problem goes back to what we've seen before in 2012 and the PIIGS. Which is that Greece is not and never has been the problem. Indeed the Greeks are minor in comparison to the much larger problems for Europe – and the global financial order – that are individually posed by Italy and Spain, as well as in combination along with Ireland and Portugal.

The Irish have already said that if Greece gets special treatment – they want similar concessions.  Now we haven't been hearing much about the Irish these days, because they've been dutifully sticking to the terms of their own deal, being the "good boy" instead of the Greek "bad boy". Nonetheless, whether forgotten by the world or not, the Irish people are paying an economic price everyday for this compliance, and if they see that it is bad behavior that improves the standard of living for the average Greek – the lesson will be duly noted.

As it will be duly noted in Italy and Spain, which are also heavily indebted with weak economies and exceptionally high unemployment – particularly among the young.

Now, the EU's immediate response to Ireland was to brush it aside, and make clear that Greece has nothing to do with Ireland. That is obviously what the EU wants, and indeed needs badly, is some form of separation.

Yet, if voters in Ireland (or Spain, or Italy) see Greece actually pull this off, with merely electing a new government leading to higher minimum wages, higher pension payments, and an end to austerity – and with all of this being paid for by the rest of the EU – then what's to keep those nations from doing the same?

Let me suggest that the stakes are high, and the dilemma is acute. 

As previously mentioned, there are four potential paths that the Greek vote could set Europe and the rest of the world down. And while they are quite different – indeed almost opposites in some ways – what they all have in common is the potential pain for savers and investors on a global basis.

1) "Dirty Grexit" & Collapse In 2015

We continue to have a fragile global financial system that's dominated by "too-big-to-fail" financial institutions and heavily indebted governments, along with the ongoing threats of contagion risk, counterparty risk and liquidity risk bringing down the global financial system, as openly stated by the International Monetary Fund and as explained here.

It could be that one major financial institution has an exposure to Greece that was greater than anticipated, and panic selling sets in, with the psychological contagion then spreading around the world in a matter of minutes and hours, dropping the prices of at-risk assets into freefall.

Or, there could be a market surprise at the peak of the crisis, with fears about Greek debt then jumping to fears about Italian or Spanish debt, and prices could then plunge on both that debt and the institutions which hold the debt.

In this world of hundreds of trillions of dollars of interlocking contracts – including derivatives – the imminent failure of one major bank could threaten to also bring down its counterparties around the globe.

Banks are highly leveraged, and much of their funding is short term.  In an environment of contagion and counterparty risk, then, many of the institutions which fund the banks may refuse to roll over their funding and instead demand their money back.  All of it.  Right Now.  Thereby creating a liquidity crunch that becomes a bank run of epic proportions.

None of this is mere theory or paranoid speculation – given that we've seen this in practice in the real world, and relatively recently.  Contagion intertwines with counterparty risk, which intertwines with liquidity risk – just as we saw in September and October of 2008.  The global financial system did actually come within days or weeks of potential collapse, as the liquidity crisis that was the result of contagion and counterparty risk meant that investment banks and other banks did not have the cash to pay off their lenders, which threatened imminent bankruptcy, along with a quick jump from one bank to another.

To get the cash to dodge bankruptcy, they would have had to take major losses through selling assets that had plunged in value as a result of global contagion, which would have wiped out their equity, and which would have led to almost instant insolvency anyway.

The way out and what did stop this collapse in process was the first round of "unconventional monetary policy", that being the first quantitative easing by the Federal Reserve. The money to stop the crisis didn't exist, so hundreds of billions of dollars were created out of the nothingness, and this newly created money was then loaned to the too-big-to-fail banks of the United States and Europe, giving them the money they needed to pay off their creditors without selling their assets at depressed prices. 

Now the danger is that if we have a "Dirty Grexit" as it is known, or a Greek exit from the European Union that happens not by way of a negotiated solution on Greek payments but as a result of a collapse in negotiations and a subsequent default, then it could be straight back to a crisis like we saw in 2008, with intertwined contagion, counterparty and liquidity risk bringing down the global financial system like dominoes.

Another issue in this tightly interlinked economic world of ours is that besides the danger of economic contagion, whereby a recession or a depression in Europe sets off similar negative economic consequences in other nations – we're in an extremely volatile world when it comes to currency values because of competitive quantitative easing by central banks around the world.

And any time we have a fragile and complex interlinked system, and there is sharp volatility in one major component of that system – such as the value of the euro for instance – there's always a chance we could see a quick plunge to the downside.

To be clear – I do not think that a Greek default and exit are likely to set off such a financial doomsday scenario in the near term, given that there are numerous defense layers in place that were not there in 2008.  Europe has stabilization mechanisms, the ECB has vastly enhanced powers, the Federal Reserve has shown its willingness to create as much money as is needed, and there are now derivatives clearinghouses to lessen the counterparty risk.

So, if there is a bank run on Wall Street, the Fed will just create however many trillions of dollars it takes to stop the liquidity crunch.  If there is a run on Spanish government bonds, the ECB may create as many euros as needed to buy every single bond in the market – at par. If trillions of dollars of cascading derivatives losses wipe out the clearinghouses, then the central banks use their effectively infinite monetary creation abilities to bail out the clearinghouses.

That's the theory, anyway.

And being that it's a theory that's yet to be proven, I just don't know for sure whether these defense mechanisms will be enough to avert a new major crisis – and neither does anyone else.  And this is the essence of the attempted blackmail.

The central bankers and other financial officials in Europe and around the world don't know for sure that they can keep the lid on, and Tsipras knows that they don't know it.

For in the midst of crisis – stuff happens.  Unexpected stuff.  That is what fills history books is the unexpected stuff happening in the midst of crises.  People under acute stress and needing to make quick decisions end up making what historians with access to much more information afterwards will agree was a spectacularly bad decision.

Let me suggest that a global financial order in which 1) the underlying economies are still weak and stressed; 2) financial risk is concentrated in relatively few institutions, each of whom are highly leveraged; 3) stock and bond market levels are at record-highs; and 4) extraordinary types and amounts of central banking interventions are needed to hold the whole system together; is 5) inherently unstable on a fundamental level.

At the same time, because of these pervasive governmental interventions the whole system can look remarkably stable, indeed even more stable and safe than what would be seen with healthy economies and robust free markets.  Right up until the moment when it isn't stable anymore.

On the most fundamental level, what Greece is effectively doing is saying, "Give us the comparatively little bit that we want, or we will set in motion a crisis that will feed and strengthen that inherent instability, and thereby test whether the defensive mechanisms of the global financial system are truly up to task."

And if the defensive mechanisms prove to be not up to the task – then everything may change for all of us.

2) Grexit & Containment Via Unconventional Monetary Policies

Our second path could happen with either a "dirty" or "clean" Greek exit from the European Union as a result of Greece defaulting upon its debts. If that occurs, we already know that this is the path the world is most likely to take – because we've been traveling it since 2008.

To contain the damage, central banks around the world are likely to up what they're already doing, which is their level of quantitative easing.  That is, continue to create vast sums of money out of the nothingness, maintaining stability by using this effectively infinite supply of money to prop up prices and provide liquidity, and thereby avoid what could otherwise be an imminent financial meltdown.

Now while this may sound better than a meltdown, the long-term effects are questionable, and indeed could be problematic. To the extent that we might possibly be better off in the long run with sharp meltdown and then true recovery.

Because in this environment, there are several acute issues for investors as we have already been seeing, and they could potentially get much worse even as they persist for a longer period of time.

One of them is that investors are being denied yield, and as a matter of global economic policy (as further explained here), interest rates are being quite deliberately kept negative on an inflation-adjusted basis.

This means that for the people who are already retired or that have high-quality interest-bearing investments, there's virtually no yield available, so they're just losing the real value of their investments to inflation on a steady basis year after year.

The other issue is that the reason behind many prominent economists agreeing on the need for "negative real interest rates" is that the purpose of inflicting these losses upon savers is to fight an environment of what is known as "secular stagnation".

What "secular stagnation" means is a long term (10 years or more) environment of little or no economic growth and persistently high unemployment levels.

And if a Grexit of some form inflicts additional financial pain on Europe – on top of the pain that's already being felt by European companies from the sanctions on Russia due to its actions in the Ukraine – then we have double damage, which increases the "stagnation", which makes it longer term, and which thus extends the process of steady and ongoing investor losses.

All around the world, investments are already underperforming due to very low yields.  Retiree standards of living are lower than planned, and retirement is being deferred. 

These negative investor returns in inflation-adjusted terms are the entirely deliberate result of governmental policy, and they could be called the price of avoiding our previous scenario of financial meltdown.  Reductions in investor income and retirement lifestyle are the side effects of the deployment of the "defensive mechanisms".

All of us have felt these effects first hand, whether or not we understand their cause. Even after the worst of the financial crisis of 2008 had subsided, for year after year since then negative real interest rates (in inflation-adjusted terms) have been inflicted on investors, because prominent economists in the United States, Europe and Japan are all in agreement that this is the best way to reboot economic growth.

So if there is a Greek debt default and EU exit, and if this creates a crisis, and if the crisis is successfully contained via the currently expected defensive mechanisms – with this scenario being substantially more likely than the previous disaster scenario – what needs to be understood with clarity is that this defense is not "free".

Millions of savers and investors will likely "take a bullet for society", albeit in an unknowing and involuntary manner. 

And what this will involve is lower yields, and for a longer period of time.  Meaning further delays in retirement, and lower standards of living for those who depend upon income from investments in order to pay expenses. This could be the case not only in Europe, but also in other nations, as a result of our deep economic and financial linkages.

Moreover, even if a default and exit does not create a global financial crisis, it would likely still cause deep financial turmoil inside of Greece, which in combination with the potential loss of EU subsidies would reduce the average standard of living over the next several years – not increase it – with the end results of trying to force the renegotiation of debts being a lose-lose scenario for everyone involved.

3) Grexit, Then Containment, Then Eventual Collapse Anyway

The 2nd half of this article explores:

1) The worst outcome for investors, which is potentially years of low and negative yields followed by a major crisis, which may itself be triggered as a side-effect of the defensive mechanisms;

2) The implications if the EU capitulates and gives Greece what it wants; and

3) The dilemma for investors that is created by these four paths.


Contact Information:

Daniel R. Amerman, CFA



This article contains the ideas and opinions of the author.  It is a conceptual exploration of financial and general economic principles.  As with any financial discussion of the future, there cannot be any absolute certainty.  What this article does not contain is specific investment, legal, tax or any other form of professional advice.  If specific advice is needed, it should be sought from an appropriate professional.  Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.

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