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June 21, 2012

Our View: Greece is symptom of larger problem

The Free Press

— Worldwide media focused attention on the Greek election this past weekend, and many Americans likely wondered what all the fuss was about.

For starters, it was about the billions of dollars Americans hold in U.S. stocks and how political and economic upheaval in a small country with an economy 2 percent the size of the U.S. can impact $15 trillion in U.S. gross domestic product.

The Greek crisis highlights the fact that the world is much more connected economically than it is politically.

In other words, calamity in a relatively small economy like Greece tied to world markets through a common currency — the euro — can have surprisingly wide-ranging effects on large economies around the world.

An in-depth report by Associated Press reporter Matthew Craft clearly detailed the connections. The first connection comes from major world banks and investors, who Craft reported “think the path of full-blown crisis would start in Greece, quickly move to the rest of Europe and then hit the U.S. Stocks and oil would plunge, the euro would sink against the U.S. dollar, and big banks would suffer losses in complex trades.”

The expert scenario lays out like this:

n Greece drops the euro as currency, goes back to the drachma, but currency markets quickly devalue it and Greek face 35 percent inflation. Prices would rise for everything from oil to food in the country that imports much of what its citizens need for the basics of life.

n Greek debt held by other European countries would decline or be worthless. The European Central Bank and others would incur losses on the $65 billion in Greek debt they hold.

n The bond market investors might get nervous as Greek spins downward and hedge their bets by selling other risky bonds from Italy, Spain and Portugal, further pushing prices down and interest rates up. That would cause added stress to European banks who bought a lot of those bonds.

n The financial “contagion” might spread to those countries who see what happened to Greeks in the loss of value of their business and their investments. Bank runs could begin to occur in various countries.

n European banks would have difficulty raising money from bondholders to stave off bank runs.

n Finally, the financial stress in Europe would spread to U.S. markets, experts say, through the complex web of contracts, loans and other financial instruments like credit default swaps.

n The swaps are basically insurance against a certain amount of losses on bonds and other investments. The thinking is that the losses would be so great, the financial companies that sold the credit default swaps would be on the hook to pay for more in “insurance payments” than planned.

n The companies needing to come up with the insurance payment would be forced to sell U.S. bonds and securities they hold, thereby creating more downward pressure on the markets.

At that point we could say hello to major losses in the 401Ks of the average American worker.

So what can be done?

It appears the Greek election was won by a coalition of parties willing to take European bank austerity measures in order to get bailed out.

That may be a temporary solution.

Ultimately, U.S. financial companies that do business worldwide and our elected leaders have to be more aware of these risks that expose the U.S. economy to relatively small mishaps in other places. Maybe the world financial system needs to be a little less interdependent and a little more independent.

We have to examine if we’ve set up incentives to create these risks or incentives to protect against them.

If not, U.S. markets will continually be driven and disrupted by small events in small countries over which we have no control.

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