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Headlines over the past several weeks have been focused on the financial crisis playing out in Greece; the potential impact to European Union countries, and global investors. Given the amount of media noise, I thought it might be helpful to sort through the headlines and provide some context for investors who may be worried about the potential impact to their own net worth.

First, a little history.

The European Union (EU) has its roots in plans created by Winston Churchill and other leaders after the Second World War, designed to prevent future wars between European countries.  Steps were taken to link countries both politically and economically, to encourage them to become allies, however the EU didn’t officially come into existence until 1992, with the signing of the Treaty on European Union (also known as the Maastricht Treaty).

To create further economic integration among countries, the Treaty laid out plans for the creation of a common currency.  By January 1999, the euro was launched as a virtual currency for cash-less payments, and banknotes and coins were introduced in 2002.  Greece is one of 19 countries in the EU that now share the euro as their common currency, also known as the eurozone.

Why is a common currency important?

The primary benefit of a common currency is the ability to sell goods and services across borders without having to convert to a different currency, improving trading efficiency.  Imagine us, here in Cincinnati, converting our Ohio dollars to Indiana or Kentucky dollars every time we bought or sold something across state lines.

While there are benefits, there are also shortcomings.  Milton Friedman, the Nobel prize winning economist, did an excellent job of spelling out these shortcomings.  Countries with radically different economies, banking policies, languages and cultures have less flexibility to correct financial imbalances than we do here in the US.  European countries are not as cohesive as the various states within the USA, with a Federal government that can extend unemployment benefits or influence banking policies in times of financial crisis.

And as an individual trying to improve their own situation, the ability to pack up and leave Greece, where unemployment is now 26%, for a job in financially stable Germany is far more difficult than moving from West Virginia to Ohio for a job.

A united Europe is positive political goal, but a common currency binding the countries is an economic challenge, and Greece (and Spain, for that matter) are excellent illustrations of those challenges.

How did Greece get into this situation?

Greece was the last country to join the eurozone before the euro was launched in 2002.  In hindsight, it’s clear the Greek government hid its true financial situation to qualify to join the EU, but it wasn’t until a new Prime Minister took office in March 2004 that the country’s budget deficit was discovered to be 5.5 times higher than was reported.   Even then, the incoming government continued to hide the severity of its financial problems to avoid losing the Olympic Games, scheduled for Greece in August 2004.

It wasn’t until 2007, when the financial crisis began in the US and spread to the rest of the world that Greece could no longer hide its problems.  By 2009, no one believed the country would be able to pay it back, the country’s credit rating fell, and people stopped buying Greek bonds.  Other EU counties – represented by the European Commission (EC), the European Central Bank (ECB), and the International Monetary Fund (IMF) had to step in and make loans equal to $122.1 billion US dollars, to keep Greece afloat, in April, 2010.

To pay off the debts, the Greek government was required to reduce spending and increase revenue.  That meant laying off government workers, who no longer paid taxes, or had money to spend.  This had a negative ripple effect throughout the Greek economy. Businesses closed, which increased unemployment and reduced tax revenues even further.  By February 2012, Greece’s debt was 135% of its Gross Domestic Product, total unemployment nearly 30%, and unemployment for young people over 50%.  Needless to say, Greek citizens aren’t happy, which is why we’ve seen protests and turnover in government leadership over the last three years.  Alexis Tsipras, the country’s current Prime Minister, was elected with the promise he would improve the country’s situation.

Why has it reached crisis proportions now?

After receiving the first loan package in April, 2010, Greece negotiated a write-off of 53% of their debt in October 2011, but still needed a second bailout in February 2012.  After three years and the challenges described above, the country is no closer to being able to pay off its debt as its economy continues to shrink.  The country missed a scheduled debt repayment to the IMF last week, and has a larger deadline approaching later this month, when a 3.5 billion euro payment Greece owes the ECB comes due.

Greece asked for additional financial assistance last week, and other European leaders, especially German Chancellor Angela Merkel, insisted that the country implement additional cost-cutting measures to work toward balancing its budget before receiving more help.  Tsipras pulled out of talks with negotiators last Friday, and put the requested financial reforms to a referendum vote on July 5th.  Greek citizens resoundingly rejected the terms.

Meanwhile, Greek banks are closed and withdrawals from ATMs are limited to the equivalent of $66 dollars per day.  Food and other imports into the country are restricted due to the inability to make payments, which only adds to the stress.

What happens next?

The next few days are key, as negotiations resume between Greece and the summit of EU leaders.  Greece has promised to put its economic proposals in writing, and Merkel has repeatedly said there are only a few days left to come to an agreement.  This chart shows the possible outcomes for the country.

If Greece does exit from the EU, they would be forced to convert from euros back to drachmas.  Banks would probably have to close for several days to reprogram their systems and the currency would be allowed to float against the euro after the banks reopen.   The first few weeks would be quite volatile.  When Iceland went through their financial crisis in 2008, their currency fell by 40% before stabilizing.

Inflation would likely soar, imports would probably be scarce, and food and other goods might have to be rationed.  In short, Greek citizens would experience much more hardship before things improved.

Borrowing costs would likely increase for other EU countries that are seen as riskier credits, including Italy, Spain and Portugal, however their situations have improved since the financial crisis in 2008.  The euro would probably fall further, which would make their exports cheaper for other countries to purchase.

How does all this impact me?

You’ve heard this from us before, but it bears repeating.  Over time, financial markets are very efficient at pricing future expectations into current prices.  Greece has been dealing with a debt crisis since 2010, when they received their first bail out.  The country’s economic problems have not been a secret since they came to light in 2009.  The situation in Greece has been more of a slow-motion financial train wreck than a surprise.

Then there is the issue of Greece’s size relative to the global economy.  As of December 31, 2014, Greece’s total equity market capitalization was $28 billion in US dollars, closer to the size of the city of Philadelphia than the state of Pennsylvania.  Greece is considered an emerging market, and is therefore considered a higher risk country to invest in to begin with.  In our own client portfolios, the country represents only 0.4% of the holdings in the DFA Emerging Market Value Fund.

Banks and investment companies have reduced their exposure to Greek bonds and bank stocks over the last five years as well.  The debt Greece owed to French and German banks was essentially repaid with the first IMF bail-out.  Unless you’re in one of the hedge funds that made bets on Greece, you likely have little exposure to investments in the country.

Greece’s economic troubles are difficult for its citizens, and their problems are likely to become worse before they’ll get better, but this is not the global Greek tragedy that you might think.