May 2012 – NORTH AMERICAN & INTERNATIONAL ECONOMIC HIGHLIGHTS

Merkel’s Bluff

by Benjamin Tal

Recent polls from Greece are showing the anti-austerity Syriza party capturing around 22% of popular

support—up by five points from the election tally. And markets are not liking it. The iTraxx Europe Crossover

Index widened to the 740 basis point zone, a level close to that seen in late 2011 when fears about the

Eurozone collapsing under the weight of peripheral countries’ debts were highest. Perhaps as telling, is the fact

that the stock price of the world’s largest commercial currency printer surged by 10% in the past three weeks

to its highest level in more than three years.

If you live in Greece, what do you do after reading the morning paper? You go…no, you run…to your local

bank to withdraw your euro-dominated deposits before they turn into worthless drachma deposits. So the

surprise is not that Greek households and businesses withdrew close to €1.3 billion over the past week. The

surprise is that it was only €1.3 billion.

Maybe part of it is the belief by many in Greece that Syriza can have its cake and eat it too. After all, Syriza’s

dogma of a middle way between austerity and eviction is being encouraged by Europe’s shifting political

mood. In France, Italy, the Netherlands, and to some extent even in Germany, voters and politicians are

increasingly critical of the effects of austerity in a downturn. The party builds on the realization that although

Greece accounts for only 2% of the euro area’s economic output, its exit could disintegrate a system of

monetary union designed to be irreversible.

In many ways, Syriza is trying to call Merkel’s bluff. Their thesis is that the hawkish Chancellor and the

Eurozone as a whole are facing an asymmetrical risk. A Greek exit is a strategy with a degree of risk. No one

has tried breaking up a monetary union before. There is absolutely no way to know in advance whether the

crisis spreading to other countries can be controlled. Such a scenario could trigger a default-inducing surge in

bond yields, capital flight that might spread to other indebted countries and a resultant series of bank runs—

leading to increased capital controls on cash withdrawals and transfers, alongside huge draws on ECB credit to

keep the banks from collapsing.

At the same time, Germany will have to accept significant indirect public claims on Italy and Spain, or simply

admit defeat and kill the euro. Against this gigantic potential cost, the money involved in a “Marshall Plan”

type approach that will buy Greece and the zone some time is a bargain.

And time is key. It is impossible to predict how things will develop after the June 17th election. The betting on

this one comes down to whether one thinks European officials will stick with their principles or act in their own

best interests. While the odds of a Grexit have risen, we are not there yet. Simple math might convince

Germany to close its eyes and buy Greece, Italy and Spain more time—at least until it gets all its ducks in a row

for a more orderly Greek exit. For now, in this game of chicken, Merkel might blink first.