Why Greece's election settles nothing
Supporters of the New Democracy conservative party celebrate at an election kiosk at Syntagma square in Athens, Sunday, June 17, 2012. The pro-bailout New Democracy party came in first Sunday in Greece's national election, and its leader has proposed forming a pro-euro coalition government. / AP Photo/Kostas Tsironis
(MoneyWatch) COMMENTARY Investors who expected clarity from the outcome of the Greek elections will be sorely disappointed. To paraphrase Winston Churchill's famous statement: The Greek election didn't result in the end of the eurozone crisis. It's not even the beginning of the end. But it is, perhaps, the end of the beginning.
The only thing we know for certain is that the financial chaos afflicting the region will eventually end, if only because something that can't continue must end. It's only a question of when, how messy the conclusion will be, and how much damage will be done.
Greece's public sector, and the promises it made, are unsustainable. Greek labor costs are also woefully uncompetitive. A recent study found that from 1980 through 2007, Greek unit labor costs rose by a factor of 17! This compares to an increase of just 1.6 for Germany and 1.7 for the Netherlands. Greek labor costs grew much faster than productivity, making Greek companies uncompetitive and undermining the country's exports. No amount of austerity will correct the problem. Only a liberalization of its labor market and a dramatic drop in wages can solve that problem. And for now, neither outcome seems likely.
In pre-euro days, before the currency was launched in 1999, the problem would have been solved by devaluing the Greek drachma. The currency would fall sufficiently to make Greek wages more globally competitive. Inside the monetary bloc, that's not possible. And there doesn't seem to be much will to sufficiently shrink the public sector or alter Greek labor laws to allow domestic companies to become competitive.
When the euro was introduced, Nobel Prize winning economist Milton Friedman predicted that the new currency wouldn't survive its first major crisis. In 2002, he added: "Euroland will collapse in five to 15 years." His reasoning was simple -- you cannot have a monetary union unless you also have a fiscal union.
The eurozone countries entered a monetary union, but couldn't agree to also coordinate on taxes and spending. So while the union is a noble experiment, it seems doomed to be a failed one (unless fiscal union can eventually be achieved). The failure of the countries in the southern rim of Europe to adhere to fiscal discipline eventually led to the crisis we have been facing now for two years. And the proverbial can has continued to be kicked down the road, without ever solving the underlying problems. The bloated Greek bureaucracy, its uncompetitive wages, and constrained labor markets have never been fully addressed.
While financial markets seemed to be relieved that the parties in Greece favoring staying in the eurozone won the election, unless Germany is prepared to "throw good money after bad" the uncertainty about an ultimate resolution seems likely to continue. And investors dislike uncertainty. When uncertainty increases, the tendency is for risk premiums to follow suit, driving prices down.
Readers of this blog know that I don't believe in crystal balls. And certainly the market is well aware of everything we have covered. Certainly, we must acknowledge the possibility of a relatively positive outcome. The Greeks could agree to dramatically shrink the size of their public sector. Germany could agree to provide Greece with the requisite financing, as well as provide the country with more time to achieve the needed fiscal and structural changes to its economy, easing the pain somewhat. Should that occur, the financial markets might just breath a sigh of relief, risk premiums could fall, and stock markets could recover.
On the other hand, Germany could decide that Greece is unlikely ever to make the needed adjustments and that throwing good money after bad is a lousy idea. No one knows how that ends -- and no one wants to find out. That outcome could lead to a financial panic that would make the "Asian Contagion" of 1998 and the 2008 financial crisis look like minor bumps in the road.
Since there are no clear crystal balls, you should be prepared for either environment. What's important to understand is that in "normal" markets, stock prices are determined by the "wisdom of crowds." However, when crises occur, it's the "madness of mobs" that takes over. Volatility soars.
Those who know their financial history know that stock returns aren't normally distributed. (Bernard Mandelbroit pointed this out back in 1963.) Instead, returns exhibit what are called "fat tails." In non-technical terms, the current European crisis is like holding a lottery ticket that you paid $2 for. There's a 50/50 chance that tomorrow it will either halve to $1 or double to $4. If there were no crisis, it would also likely be selling for $4. Thus, $2 is close to a fair price today. One last point to remember is that not only do we have fat tails, but both volatility and large losses tend to cluster -- large changes tend to be followed by large changes.
Legendary investor Warren Buffett once advised: "Success in investing doesn't correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing." Unfortunately, we know that there's an all-too-human tendency to have the stomach take over decision making during crises. Stomachs don't make good decisions. The typical result is panicked selling.
The best way to ensure your stomach doesn't take over as the drama in Europe unfolds is to have a well-developed plan that anticipates that there will be frequent financial crises and accepts with equanimity that such events are unpredictable. A necessary ingredient for success is to be sure that your plan doesn't take more risk than you have the ability, willingness, and need to take.
Finally, your plan should be in writing and signed. It should also include a rebalancing table. We know that signing the plan increases the odds of compliance. Forewarned is forearmed.
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