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The Law of Unintended Consequences

Last updated 8/17/2012 4:48 PM EST (GMT -5) 0 Comments - Add your comment

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Neal Gilbert

Technical Analyst, GFT

Follow @FXexaminer

*Not much has happened in the afternoon session of North American trade, plus I spent a little more time at the dentist’s office than I expected (ouch!). Therefore, I am rereleasing a piece that I wrote about 6 months ago related to the possibility of a Grexit. Enjoy!

Isaac Newton was a pretty smart guy. The founder of our modern understanding of physics’ 3 ^rd Law of Motion states:  For every action, there is an equal and opposite reaction . Chances are, he didn’t intend for that Law to be the basis for the Law of Unintended Consequences. It reminds me of the popular DIRECTV commercial that says:

If you have cable and can’t find something good to watch, you get depressed. When you get depressed, you attend seminars. When you attend seminars, you feel like a winner. When you feel like a winner, you go to Vegas. When you go to Vegas, you lose everything. And when you lose everything, you sell your hair to a wig shop. Don’t sell your hair to a wig shop. Get rid of cable and upgrade to DIRECTV.

Similar to the DIRECTV commercials, there could be unintended consequences in the financial markets. According to a recent report, some economists / traders are saying the likelihood of a Greek exit (Grexit) from the European Monetary Union (EMU) is between 50% - 75%. That is an awfully high percentage to be throwing around considering the number of hoops that policymakers and citizens would need to jump through to get to that point. Consider this. There was a report done in December 2009 by the European Central Bank (ECB) that says [emphasis added]:

“a Member State’s exit from EMU, without a parallel withdrawal from the European Union (EU), would be legally inconceivable; and that, while perhaps feasible through indirect means, a Member State’s expulsion from the EU or EMU, would be legally next to impossible. ”

Does that sound like a high probability scenario for a Grexit? Personally, I don’t think so, but let’s operate on the assumption that Greece is expelled from the EMU. What are the potential unintended consequences of that scenario?

Potential Scenario:

*This is all conjecture and based on estimates that may or may not prove true in the event of an actual Greek exit from the EZ.

Over a weekend toward the end of 2012, Greece formulates a plan to exit the Eurozone on its own accord, and issue the New Greek Drachma (NGD). There is a 4-week window where Greek citizens are instructed to exchange their euros for NGDs at their local banking establishment. Unfortunately, before the officials are able to put this doctrine in to effect, information has been leaked to the public, and a bank panic ensues as Greeks take their euros out of Greek banks and put them in the banks of EMU nations. Therefore, they are able to bypass the exchange in to NGDs and keep their euros outside of the country. At the end of the 4 weeks, the NGD is placed on the open market for trade at 340 NGD equal to 1 EUR (the rate when the original Greek Drachma was absorbed in to the euro). The markets go crazy as everyone watches the demand for NGD plummet since no one wants to hold the toxic paper, falling all the way to 600 NGD per euro.  *This figure was based on the devaluation of the Icelandic Krona in 2008.

Meanwhile, all of the debt that Greece had accumulated in euros previous to this issue is transferred to NGD at 340 NGD per euro. Assuming estimates are correct in that Greek debt equals 170% of GDP, then Greece owes approximately 398 Billion euros or 135.32 Trillion NGD. As the exchange rate plummets, it settles at 600 NGD per euro, making that original 398 Billion euros only worth about 225.5 Billion euros. Greece eliminates approximately 57% of their debt, and the European banks that are owed that money take significant losses. Greek citizens also begin taking their euros out of European banks and converting them in to NGDs at 600 NGDs per euro and depositing back in Greek banks. Greek citizens become 57% wealthier creating a wealth boom and a credit surplus among many Greek citizens and banks. Germany and France are forced to bail out their banks much like the US did in 2008, putting their own citizens on the hook via taxes and bond issuance.

Seeing the success of the Grexit for Greece, the rest of the PIIGS nations – Portugal, Italy, Ireland, and Spain – prepare to issue their own currencies and follow Greece’s successful blueprint. French and German banks lose more of the money they loaned to the PIIGS nations and require more bailouts that would then be provided ironically by Greece. Unhappy with their leadership, Germans abandon status quo and vote David Hasselhoff supreme leader of Deutschland. Don’t let David Hasselhoff become a world leader. Keep Greece in the Eurozone.

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About The Author

Neal Gilbert, an avid follower of the markets, began working at GFT in 2006, educating new and experienced traders in an easy-to-understand manner. His focus has been teaching common technical indicators, risk management, and sharing his favourite trading strategies. His Braving the Rapids strategy guide can be found on GFT’s website.

Neal conducts live webinars throughout the day, including his” Long and Short of It,” which is a Fundamental Live Market Analysis webinar centred on key economic releases. He also conducts webinars in Basic and Advanced Technical Indicators, Volatility and Risk Management, Trader’s Edge, and Fibonacci Trading and Theory.