Economic News & Analysis—May 29, 2012
Eurozone: Breaking up is hard to do
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist

Brian Jacobsen photo

Summary:

  • Recently, several pundits seem to be saying that Greece would be better off leaving the eurozone, ceteris paribus (all other things being equal).
  • Giving up the euro is a much more drastic move than just leaving the eurozone.
  • Because of severe switching costs I think the Greek people will vote on June 17 to stay in the eurozone and to retain the euro.
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Many people probably remember the Latin phrase ceteris paribus from their introductory economics course. It is translated as “all other things being equal.” Recently, several pundits seem to be saying that Greece would be better off leaving the eurozone, ceteris paribus.  Perhaps, but in the real world, ceteris is never paribus. In other words, other things are never left equal. The knock-on effects of a eurozone exit would be so disruptive that it wouldn’t be prudent for Greece to leave at this point.

It is almost comical when someone assigns a probability to the event of Greece leaving the eurozone. I think the actual probability is fundamentally unknowable. It’s not like rolling a die, where you have a 50% probability of rolling an even number. If someone says that the probability of Greece leaving the eurozone is 50%, they’re saying you might as well flip a coin. In other words, they have no idea. So while I cannot assign a probability to Greece leaving the eurozone, I do know that the effects would be so socially that it just wouldn’t make sense.

There is some confusion as to what it would mean for Greece to leave the eurozone. Some people conflate the idea of Greece leaving with Greece abandoning the euro. Those are actually two different things: leaving the eurozone doesn’t necessarily mean giving up the euro as the legal tender of the country. Monaco uses the euro as its legal tender, but it is not part of the eurozone. Being part of the eurozone means having access to the resources of the European Central Bank (ECB). Leaving the eurozone would mean Greek banks couldn’t access emergency funding from the ECB, which would create a strain on the banking sector—though  it’s not as though they’ve had an easy go at it recently.

Giving up the euro is a much more drastic move than leaving the eurozone. It’s likely that the Greek government would be unable to sell many drachma-denominated bonds, so it would have to balance its budget immediately. That would be devastatingly difficult, especially in a country where the public sector makes up around 40% of the economy. If the Greeks think the austerity they have now is bad, it would be magnified immensely and immediately if they gave up the euro.

Some argue that Greece would benefit from abandoning the euro, since a Greek currency would depreciate rapidly, making Greek exports more competitive in the global market. I believe that’s not likely. Greece’s biggest export industry is tourism. While it would get cheaper to vacation in Greece, I don’t know of many people who like to vacation in an area of riots and lawlessness. A depreciated currency would drive up the costs of imports (especially oil and manufactured goods), significantly deteriorating the standard of living in Greece. Coupled with the dramatic shake-up in government finances, it would probably be like a vacation in a warzone. I doubt that would be good for tourism.

Abandoning the euro would be extremely damaging to trade for Greece, which has persistently run a trade deficit. The counterpart to a trade deficit is a flow of money back into the country, in the form of foreign investors buying government debt, real estate, or private sector financial obligations, such as debt and equity. It might not be easy to sell those financial assets to finance the trade deficit, so trade could possibly collapse. That would be a further blow to the economy and the people of Greece.

Exiting a currency union is not simply the reverse of entering a currency union. There are such severe switching costs that I think the Greek people will vote on June 17 to stay in the eurozone and to retain the euro. Even if, theoretically, it would be good for Greece in the long-run to leave the euro, the country might not survive the short-term. I think the Greek people are aware of this and will vote accordingly.

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