It seems like every day I come to the office and look at the news there is a story about Greece and how it is affecting our markets. With an economy only 1.4% the size of the United States, how does Greece obtain so much interest? Today I want to illustrate three reasons why tiny Greece has become so important in market news lately.
The first reason why Greece’s financial woes are affecting world markets (including U.S. markets) is because of fractional reserve banking. Most of the world’s financial systems operate using fractional reserve banking. This is a complex system where central banks actually create money out of thin air. For example, If you were to deposit $100,000 into your local bank, through fractional reserve banking, potentially $900,000 of new money could be lent out to borrowers. If the bankers were to loan this new $900,000 out to borrowers who don’t pay back the loans, the prudent depositor would be justifiably concerned about his $100,000 deposit. Similarly, this is what has happened throughout the European banking community. Millions of European citizens have made deposits into European banks, and the banks lent some of those funds created through fractional reserve banking to Greece. If Greece doesn’t pay back their loans, it can have a catastrophic cascading effect on the safety of millions of European deposits.
While Greece isn’t alone in having a national debt problem, their situation appears to be worse than most other western countries. With an annual economic output of approximately $238 billion, the Greek government owes over $360 billion to various lenders, such as the International Monetary Fund (IMF), The European Central Bank (ECB), the European Financial Stability Facility (EFSF), and various other European financial institutions. Since the global financial crisis of 2008, Greece has been pressured by its many lenders to adopt austerity programs, which is a fancy term for: “Stop spending more than you collect in taxes!” The lenders want to get paid, so they are demanding Greece reduce its public spending and raise taxes on their citizens. The Greek government is arguing that prolonged austerity will lead to a reduction in their economic output making tax collection more difficult. The citizens of Greece have been less than enthusiastic about reductions to their government pension checks or liberal social entitlements, and being a social democracy, they are voting accordingly. As a result, Greece has threatened to default on its loans. If they do, it will have a catastrophic cascading effect on the integrity of the European banking system.
The second reason why Greece is so important is there is little consensus on how Greece should be treated if they default on their loans. If they are treated with kid gloves, other countries (such as Italy, Spain, and Portugal) operating under similar lender imposed austerity programs, may choose to default as well. While the European banking system might be able to absorb Greece’s default, it might not be able to absorb multiple defaults by nations whose citizens have grown weary of living under austerity. The final concern of a Greek default is the strengthening of the U.S. dollar relative to the euro. As investors and governments continue to lose faith in the Euro out of fear of a Greek default, they have been flocking to buy U.S. dollars. When the demand for U.S. dollars increases, so does its price in currency exchanges. While a strong dollar is good for tourists vacationing in Europe, it is horrible for any American company that wants to sell their goods and services there. All other things being equal, American companies will find their prices less competitive in Europe if the dollar continues to get stronger relative to the euro. If American companies see a decline in their exports to Europe they will experience lower profits and declining stock prices.
Investment markets hate uncertainty, and the actual impact of a Greek default is difficult to predict. Whenever markets experience uncertainty they tend to react with pessimism. In the short-term, Greece’s financial problems could have a negative effect on U.S. stock prices; however, history has shown that individuals and nations rarely focus their attentions on fixing small problems until they become big ones, and it isn’t usually until big problems become crises that we actually demonstrate the resolve necessary to implement distasteful solutions. Therefore, a Greek default might actually be the catalyst for long-term positive change in central banking protocols.