With the increasing likelihood of Greece defaulting on its debt, investors should plan for the worst and hope for the best.
Like the classic Greek tragedy Oedipus Rex, Greece and its creditors made the very mistakes that have led to this key moment.
For example, Greece did what most countries did when times were good: borrowed lots of cheap money to fund lots of spending programs. But when the Financial Crisis and the resulting Great Recession hit, Greece’s spending went up even higher due to expansive entitlement programs and bloated government while revenues went down. With debt piling up and budget deficits as far as the eye can see, borrowing costs went up because of their higher credit risk.
But each time Greece has edged up to the abyss of default, creditors have forced austerity measures on Greece in exchange for forgiving some debt. But without the necessary free market reforms, Greece’s recession just deepened. That has given rise to an anti-austerity government, which is colliding into increasing aggressive creditors who want their money back and are reluctant to make more new loans. Greece is letting the clock run out, betting that the creditors ultimately do not want to push Greece into default and deal with the consequences.
The worst outcome would be a default and as a result, Greece leaving the EU. That would have enormous ramifications, not least would be jeopardizing the weak global economic recovery.
First, creditors would lose most or all of their investment in Greek bonds. That would be a huge financial hit to the balance sheets of EU countries whose economies are already weak.
Second, the contagion might spread throughout the EU, especially the Greek-like economies of Portugal, Spain, Italy, and maybe Ireland. This would hurt the economically struggling EU and reduce confidence in and value of the Euro.
Third, the contagion may spread worldwide and hurt the United States and China, both top trading partners with Europe. A lower Euro makes imports more expensive, which slows down the middling US economy and ensures a harder landing for the slowing Chinese economy. This could also be the trigger to set off the much talked about U.S. stock market correction.
The best likely outcome of a Greek default is the orderly restructuring of their debt. While that might reduce their debt burden, the problem is that one cannot assume that Greece will still be able to make those payments.
And without changing the structural problems that caused the debt in the first place, Greece’s budget deficits will continue to add to debt. Finally, borrowing money to pay for existing debt and future spending will be excessively high to account for the credit risk after a default.
Institutional investors have already figured this out. To prepare for the worst, they have started dumping lots of Italian, Spanish, and Portuguese bonds, which have further exacerbated the growing liquidity problem in the bond markets.
Many have locked in their equity profits and are sitting on piles of cash. Others have renewed their interest in the other safe haven asset, gold. Gold bullion sales at the United States Mint have begun to tick up.
And while investors hope for the best, most know that hope is not a sound investment strategy.
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