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Why a potential Greek default matters to US investors

Greek default | Why a potential Greek default matters to US investors Morningstar

A few weeks back, I argued that Standard & Poor's lower outlook on U.S. sovereign debt was nothing more than distraction from the real problems in Europe. We saw further proof of an escalating euro debt crisis this week from another S&P downgrade of Greece's debt and a warning that further cuts were possible.

The downgrade was not all that surprising. Greece's debts are bigger than its ability to pay them back. Although the country is trying to push through severe austerity measures, there is significant pushback from citizens, making it hard for the most extreme reforms to happen. And given how anemic growth has been, hoping for greatly increased tax receipts to make up the difference seems like a pipe dream. The only plausible way for the crisis to end is through some sort of debt reorganization, which is a nice way to say "default."

But debt reorganization will be far from easy. The hope is that richer eurozone members (namely Germany) will bail out Greece by making up the gap between what Greece can afford to pay and what creditors are owed. But the political will to throw money at this problem is likely waning. Voters are sick of bailouts after being subjected to years of watching tax dollars go to prop up failing financial institutions. And politicians aren't going to gain a lot of favor by helping bail out a foreign country, even if they do share the same currency.

This lack of political will is more than just a short-term problem; it is a structural fact of the eurozone. When the monetary union was created, the hope was that it would be the beginning of a stronger political union that could create a reasonably unified fiscal policy to complement the common monetary policy. This didn't quite pan out. National governments did give up chunks of sovereignty to Brussels (the de facto capital of the European Union), but the creation of a United States of Europe remained a distant dream. So now there are a lot of hard decisions to be made, but there isn't a real organization that is able to make them. In many ways, the fate of the Greek economy rests with the generosity of the German people. But what happens if they decide enough is enough and they stop the intervention?

Suffice it to say, it won't be pretty. There is a very real chance that Greece would choose to leave the eurozone. In fact, if credible rumors begin to circulate that the government is seriously considering leaving the common currency, it will be hard for the country to not follow through. The whole point of leaving the euro would be to massively devalue Greek currency to make the debts more manageable. A consequence is that instead of letting their accounts devalue, holders of euro-denominated bank accounts in Greece might seek safety in a more stable country, such as France. The resulting bank runs that the rumor could spark might force Greece to stop capital outflows from the country and eliminate the country's eurozone membership if the residents and politicians like it or not.

Short of an exit from the eurozone, there is also the possibility of a negotiated default that would pay back current debtholders a small fraction of their debt's face value. This isn't a great outcome, and a default is still a default. I think there would be a number of knock-on effects from this event that could have a real impact on U.S. investors. Here are a few:

Contagion

Greece is not a large economic power nor a large market for most U.S. firms, so its failure would not in and of itself make a big splash. The biggest threat is the pressure it will put on other struggling European economies. Ireland and Portugal have already received assistance, and a Greek default would shine a bright spotlight on those countries. The market would wonder if they were also on the verge of default, and the spiral of rumors that forced Greece to capitulate could overcome these two countries, as well. If the pressure reached Spain or even Italy, the consequences would be even worse. These are much larger economies, and their default would send shockwaves across the entire financial world.

Bad for Banks

European banks would be some of the hardest-hit institutions by a default. They hold a fair amount of government debt, and many are still trying to recover from the financial crisis. And as we learned in the financial crisis, the banking system is extremely interconnected. Failures of banks in Europe will affect the global banking system and put even more stress on a sector that has seen its fair share during the last few years. Mass defaults of European sovereign debt will be a big test to see if the improved capital levels are enough to stabilize the banking system or if more bailouts will be needed. I imagine that one of the major factors that might force Europe to attempt to work out an agreement with Greece is to try staving off a bank bailout later.

Even Slower Growth in Europe

It is hard to imagine how a Greek default or exit from the eurozone would be good for European growth rates. The recovery in Europe has already been sluggish compared with Asia and the Americas, and the added uncertainty of a major shock isn't going to do anything to attract investment and get consumers spending again. A default would also likely force even the more sound countries to accelerate their austerity plans. That contractional fiscal policy will be a drag on growth. Finally, if the banks do get in trouble, the drying up of credit will also have a negative impact.

Europe as a whole is an important market for U.S. firms. And for the global economy to really get back on track and expand, Europe needs to come along for the ride.

Flight to the Dollar

A crisis in the eurozone would further cement the U.S. dollar as the global reserve currency. Large investors looking to keep cash safe will move from euro-denominated deposits to dollars, strengthening the dollar versus the euro. A stronger dollar will have myriad effects on the U.S. economy. On the downside, manufacturers and other firms trying to sell goods abroad will suddenly find that their products are more expensive on the global market. Creating headwinds on exports and manufacturing will hurt what has been a key driver of the recovery. On the upside, U.S. consumers' purchasing power will increase. Furthermore, if the crisis reaffirms the dollar's role as the reserve currency, it will make it easier for the U.S. government to continue to finance its deficit.

Eastern European Effects

This might be a longer-term impact, but an extended European crisis will reduce the potential of emerging Eastern European economies. One of the biggest successes of the EU has been enticing former Eastern Bloc countries to liberalize their economic and political processes in order to gain access to the EU and the euro. However, if there's only a small chance that these countries could ever join the common economic area, it might reduce their incentives to modernize their economies.

What do you think? Is Greece headed for default? Will it leave the eurozone? Will the problems stop there, or will they spread across the continent? How will this affect U.S. investors?

By Bearemy Glaser

Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser.

This guest blog was first published on Morningstar.

Tags: EU , eurozone , Greece , Greek bailout , investments , US
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