Live Big® Digest – Beware of Greeks Bearing Gilts* edition

I’m sure it doesn’t surprise you that I’m writing again to chat about the chaotic world in which we live, but before I get to that, I wanted to remind you that recorded version of our webinar “Economic Vomitility and Financial Planning as Dramamine” is now available for viewing.

Now back to our regularly scheduled broadcast . . .

It has not gone unnoticed by many that stock markets everywhere have had a bad couple of months, giving up most of what they’d gained since last September in a very short period of time.  While we think it’s worth noting that, as of today, markets are generally back in the black for the 12 months just ended (albeit barely), we also know that it’s not where we stand in relation to a year ago that has everyone unsettled, it’s the suddeness of the recent adjustment.

The two most apparent sources of the recent turmoil are an ongoing “sovereign debt crisis” (aka “government debt crisis”) in Europe, largely centered around Greek problems, and the slowing pace of economic growth in the US. The fist issue is one that may not seem like an obvious source of trouble, so we thought we’d take a moment to explain why the markets care about what happens in Greece.

Our story begins with the Greek government’s unsustainable spending spree of the past few years, which was financed by selling government bonds. This is not the first time a country has done that, and it undoubtedly will not be the last.  Historically, when such a period of binge spending reaches its limits and the government can neither borrow more from private investors nor repay earlier ones, it solves the problem by “printing money.”  This involves the country’s central bank buying government securities, increasing the money supply in the process and, if pursued with enough vigor, triggering higher inflation.  One consequence of a rising inflation rate is that the value of outstounding debts shrink in “real” (inflation-adjusted) terms. However, everything else in the economy continues to rise, including wages and government tax receipts.  The net result of this process is that the government gets to pay off the outstanding debt with a now inflated currency. While this sounds like a happy ending, there are many economic dislocations caused by high interest and inflation rates, so this is not a path policy-makers will choose if they’re prudent-minded.  The real point is that, for some countries, there is a path through such a crisis that doesn’t necessarily involve defaulting on outstanding debt.

Everything changed for Greece, however, when it became part of the EU’s monetary union and adopted the Euro as its currency.  The Euro is controlled by the European Central Bank (ECB), which will not do the bidding of a progligate EU member by buying up its debt.  Having ceded control of its monetary policy to the ECB, Greece no longer has the option of inflating its way out of trouble, it must either find a way to pay its debts (with or without restructuring), or go into default.  Why does the world care whether or not the Greek government defaults on some or all of its outstanding debt?  It’s because so much of that debt is held by banks.  These banks are in many cases still on shaky ground after the economic meltdown of 2008 and a Greek default would further shrink already slender reserves.  This in turn would lead to a contraction in lending and holds the potential for creating another credit crunch.

European leaders are not unmindful of the hazards.  While they began with inadequate half measures at the beginning of the crisis, they have recently ramped up both their financial commitments and their rhetoric in order to calm markets.  Jean-Claude Juncker, head of the eurozone finance ministers, said on Monday that “everything will be done to avoid that (Greek default)  and it will be avoided.”  While the final shape of the solution isn’t completely clear, it will probably involve a combination of financial support to Greece and a restructuring of its debt, including mandatory writedowns by European banks. As the outlines become clearer, the market volatility of recent weeks should begin to abate and we can look for something new to worry about.

We’ll end on a brief note related to the pace of economic recovery in the US.  While it’s true that the pace of recovery declined during the first half of this year, slowing to barely one percent, such is not at all unprecedented.  Recoveries from financial crises are typically slow, as households retrench and rebuild balance sheets. And American households are doing just that: spending less, saving more, and paying down debt.  While this is an extremely healthy trend at the level of the individual household, it unfortunately leaves the wider economy with weak consumer demand and an anemic rate of growth.  We think it would be a mistake to extrapolate this trend too aggressively into the future, however, as American consumers have proven their resilience again and again.  Pessimism is not their natural state and any shift toward optimism will have a powerful impact on the pace of economic recovery.

Be well and beware Greeks bearing gilts (*the British term for government bonds)!

The Yeske Buie Team