Evaluating the “Grexit” as an Economic trend

grexitAs the European crisis continues to escalate the amount of political uncertainty that is moving today’s markets, it is interesting to notice how issues that were once seemingly resolved tend to return to haunt the market as often as possible. Most recently, the re-emergence of Greek risk has lead to another near-melt-down in the market, as the country’s upcoming election has the ability to determine the country’s strategy for tackling its overwhelming debt.

More importantly, because of the way in which the Greek election sets a precedent for how markets react to an austerity vote, it alone demonstrates a tipping point for determining the ongoing sustainability of the Euro itself. As this issue develops, economists have begun referring to the event itself as the “Grexit” event, and have outlined a potential timeline of events that will occur in the event of Greece removing itself from the Euro.

In stage one of the “Grexit” scenario, the Greek people will determine the kind of action that their country will pursue through their election. If they choose to elect a pro-austerity party, they will remain in the Euro-zone, and endure the coming period of frugality. However, if they should elect an anti-austerity party, or even an anti-euro party, they will likely be forced to remove themselves from the Euro-zone, and re-instate their own currency. Because of the significance of such a vote, the latter outcome results in the “Grexit” scenario.

Upon electing an anti-austerity government into power, the Greek government will likely need to revert to its own currency. This is because of the way in which the ECB has made it very clear that it has no intentions of bailing out a non-austere government. Essentially, the ECB will leave Greece out to dry, and they will be forced to pursue their own means of economic restoration. Given that such an outcome presents a great deal of currency risk to investors, it is predicted that the result to such a decision will be a flight of capital to safe-haven countries, Germany in particular.

However, because of the way Germany will now need to support such a great influx of capital, the ECB now need to begin supporting Euro-denominated banks, so that they can support their new capital levels. More importantly, Germany will need to determine how it wants to support the assets that come with these deposits. Because many of these funds will be coming from countries that are currently supporting the Euro (ie. Spain) they will see that their own currency will start to become unstable from the flight, even though it is within the same currency.

The end result is that Germany will need to decide if it wants to use ECB backing to support the lower quality assets in Spain and Italy using the leverage it has obtained from the new depositors, or pull out from the Euro –zone so that it does not suffer from dramatic Euro-deflation as the crisis continues.

While this is still just a single hypothesis, it comes from Paul Krugman, a noble-winning Economist. Coming from such a reputable source, and given that the contexts of the scenario are plausible, it provides us with a road-map of how to understand how it is that Greece still plays a part in the evolving European crisis.

Update: Interestingly enough, 2 days after writing this article, the Grexit scenario came much closer to a reality as European savers began pulling their funds out of Greek banks en-masse.