There was no shortage of bad signs in the market last week. The Morningstar U.S. Index dropped about 5% to the lowest level in four months.
Investors seeking safety rushed into Treasury bonds, sending yields to near-record-low levels. And it isn’t concerns over Facebook's ability to monetize mobile users that is sending global investors to safe havens. It's Greece and the worry that a forced exit from the eurozone would have on the rest of Europe.
This fear isn't misplaced. There is a very real chance that Greece will need to leave the eurozone, sending further ripples from Greece and upsetting the global financial pot.
Why now?
Greece's economy hasn't suddenly become weaker during the last few weeks; it's been in a deep recession for years. The key problem is political. In order to keep the aid from the rest of Europe flowing, Greece needs a government that is credibly able to agree to the austerity measures that Germany and the European Central bank are demanding.
But it doesn't seem that a stable government is going to appear anytime soon. Elections from a couple of weeks ago were inconclusive and followed the recent European trend of rejecting incumbents and, more broadly, austerity.
A fresh Greek vote is scheduled for June, and no one knows who (if anyone) will emerge with the power to form a governing coalition in parliament.
The one thing that does seem likely is that the previously mainstream parties that supported the earlier austerity efforts are likely to do poorly, and any new government is likely to be much more skeptical of implementing further reforms.
So the stage is set for another round of tension-filled negotiation between Greece and its lenders in the next few months. Despite some of the hardline rhetoric, the outcome of these talks is hardly a fait accompli.
What's said in the heat of an election campaign is usually more of an opening offer than a final word. Given that Germany and the European Central Bank still have a vested interest in keeping the eurozone together, they might end up being more flexible in their demands.
Add in the wild card of how the new French president Francois Hollande will influence negotiations and the stage is set for an unpredictable discussion.
But even if this next round of negotiations manages to not end in failure, it doesn't mean Greece is suddenly out of the woods. The country still has way more debt than it can ever reasonably handle, the economy is uncompetitive on the world stage, and many of these problems are just poised to get worse.
Greece will need a steady steam of aid for the foreseeable future and will likely need to execute another bond swap to have any hope of staying in the common currency and becoming a functioning economy again.
Given the volatile political situation across the continent, the terms of this aid will likely need to be renegotiated time and time again. What are the chances that all parties are going to agree to terms every time? Any agreement will be at best a temporary Band-Aid.
A self-fulfilling prophecy
The fear that any deal will not be permanent is fueling chatter that Greece is going to leave the eurozone sooner rather than later. These rumors can quickly become a self-fulfilling prophecy and lead to instability in the financial markets.
As ordinary Greeks worry that their savings are going to suddenly be redenominated from euros to much less valuable drachmas, those who can are going to move assets from Greek banks to German banks or other stronger institutions.
In fact, we've seen this happening. Reports this week showed that a huge number of euros are flowing out of Greek banks. This is just making already-weak Greek banks weaker and making Greece even more dependent on aid to keep its financial system above water. If the ECB decided to cut off this aid, the country would essentially be forced out of the eurozone.
A Greek exit from the eurozone would be chaotic (particularly for Greeks who would be subject to capital controls and a major loss of savings), but on its own it would likely not sink the global economy.
As we've discussed before, the real issue is the contagion effect on other peripheral European economies. If what would have been unthinkable just a few years ago happens in Greece, what's to say it can't happen in Portugal, Spain, or even Italy? This could send depositors to the exit in these countries and create a broader, less manageable crisis.
And if we learned anything from the 2008 crisis, it's that the global financial system is incredibly interconnected. The U.S. would see a large impact from a European banking crisis. It's impossible to say if it would derail the recovery, but the prospect of U.S. banks being more reluctant to lend would certainly throw up another hurdle over which the economy would have to jump.
During the next few weeks we will hear a lot about the potential impact of the upcoming Greek election. But no matter who is in charge, Greece's fate might be out of any one politician's hands now.
Anything short of a resounding election mandate to enter into a lasting agreement on a permanent bailout with the country's European partners--coupled with a surge of confidence among regular Greeks not to pull deposits--will be needed to stay in the euro. That's a tall order. It could happen, but the chances of Greece staying in the common currency seem to be shrinking by the day.
The article first appeared on Morningstar.com, our sister US site. Jeremy Glaser is markets editor for Morningstar.com
