If you scour our planet, you would be hard pressed to find an investor not impacted by the sovereign debt crisis. It is still hard to believe the credit and sovereign debt crisis that started some five years ago still has an uncanny ability to move markets in a dramatic way!
From the face of it, the resolution seems quite clear; if cash outflows are consistently higher than income, at some point you will either need to curb your spending habits or increase your income. For Greece and other troubled peripheral countries, there are two roads ahead: default and exit the European Union or be at the mercy of the troika of international creditors.
Following the bailout of Portugal, Ireland and Greece, little did the world realise that standing in the shadows hat in hand, are some of the ‘wealthiest’ regions in Spain. The negative credit rating outlook to Germany, Netherlands and Luxembourg, meeting after meeting by Euro finance ministers and the IMF seemingly on the brink of giving up, a fresh round of turmoil is again brewing.
As I thought about the dilemma facing the Euro zone, I was reminded of John von Neumann‘s work on decision making under uncertainty, involving many different players. Game theory, as it is popularly known, is best described as the study of strategic decision making, using mathematical models to deal with conflict and cooperation between intelligent rational decision makers. Put simply, players must trust each other enough to cooperate or they may see greater gains for themselves through non-cooperation (even though, should they cooperate, the collective outcome would be great for all). Given the limitations to the Maastricht Treaty, the Euro bloc will stand to gain if Italy, Greece and Spain effectively pursue their austerity measures and the European Central Bank lend further financial support through the collective support of its member countries.
Greeks and Spaniards are increasingly rejecting the agreed austerity plans while member countries such as Finland, Germany and Luxembourg are growing more reluctant to undertake additional financial burden. Not so black or white it appears, as players see greater gains on both sides of the fence.
For fiscally prudent EU members, footing the bill of member countries who adopted irresponsible fiscal policies has become political suicide and taboo. A failure to support the common union however could result in lower economic growth for export driven economies, negative balance sheet effects and higher financing/borrowing costs. The expected loss from a Greek exit could essentially wipe out the ECB’s capital forcing a recapitalisation from remaining EU governments that may not have the finances to do so. The size of this potential burden and cost to avoid a complete collapse and contagion may be the cogent force to keeping the union intact.
While an exit from the monetary union could facilitate greater competitiveness and economic growth for troubled peripheral countries like Italy and Ireland, member countries are still significantly exposed to each other’s debt via the ECB and outstanding liability over the Euro zone Target2 payment system. Consequently, an exit by any member state would make access to funding markets for countries with a hint of trouble that much more difficult.
Lest we forget the oil that greases the machine, investors have suffered massively during this sovereign crisis. It is hard enough to share the tax burden for the benefit of other sovereign nations but changing the rules after the game has started is undoubtedly more difficult to swallow. The 2009 Lisbon Treaty now makes it legally possible for countries to leave the EU, 10 years after its inception. In the same way, the forced participation in Greece’s debt restructuring late last fall left many investors billions of dollars short. Now, mere months later, an imminent Greek exit and possibly meltdown of the EU structure would lend itself to significant volatility within financial markets.
Whist the public spat is very much in favour of preserving the union, only time will confirm the outcome. Angela Merkel’s recent praise of Bulgaria as a country quintessential of fiscal virtue coupled with her vice chancellor rhetoric of members’ exit ‘losing its terror’ effect, should give investors some perspective.
History has proven that in times of economic distress, countries have always resorted to doing what is best to preserve their own sovereignty. To this end, John von Neumann may best provide some foresight for those of us struggling for an imminent resolution to this sovereign debt crisis.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information. Statistics and Data Source: Bloomberg LP, www.stanford.edu