Greece suffers from unsustainable public-sector debt, low productivity, and an overall uncompetitive economy. In 2009, the government’s fiscal deficit was 13.6 percent of Greece’s gross domestic product (GDP) and its outstanding debt stood at 115 percent of its GDP. Lenders were losing confidence in Greece’s ability to repay them. Before the loan agreement with the International Monetary Fund (IMF) and the EU announced on May 2, they were demanding an almost 10 percentage points premium over lending rates to Germany, which worsened Greece’s deficit. Even with the large corrective measures Greece has agreed to undertake, its debt is projected to increase to 149 percent of GDP in 2012 before beginning to shrink in 2014.
Greece’s government must cut spending and improve tax revenue in order to greatly reduce or eliminate its need to borrow, reduce the cost of its output (via domestic deflation or leaving the Euro and depreciating a new currency) in order to restore the external balance between its imports and exports, and to reduce the impediments to economic efficiency and productivity growth so that its economy can grow more rapidly. How did it get in such a mess? What role was and is played by its use of the Euro? And what are its options?
How Did it Get There?
Americans like to think that we are responsible for our own well-being and turn to others for help only reluctantly and exceptionally. We do not generally think of others—whether through government or private organizations, other than our families—owing us anything but civil treatment and respect for our property. American’s are generally critical of Europeans for their entitlement attitude and the large state welfare systems that result from and/or feed it. Surprisingly, European per-capita income grew a bit more rapidly than it did in the U.S. over the 10 years since 1997 (67 percent vs. 55 percent), however this outcome reflects the unusually rapid growth in those Old European countries that reformed their welfare systems and markets the most (such as Ireland and Sweden), the broadly favorable effect of the Euro on competition and improved productivity, and the fact that population is stagnating in Europe while growing rapidly (via immigration) in the U.S, thus sharing the income growth among fewer people.
But following the retrenchment of entitlement spending resulting from Clinton’s welfare reforms in late 1996, the U.S. has more recently joined Europe in an ever-expanding welfare budget. Two factors were particularly important for the growth in such expenditures: the aging of the population and a global abundance of saving and hence low interest rates. Commitments were made (unfunded social security promises, medicare, etc) in the U.S. and elsewhere that generated future rather than current costs. Thus today’s politicians could gain credit for increased benefits that future generations would have to pay for out of (hopefully) larger incomes. Unfortunately, the future work force will be smaller relative to the retired workers they must support, greatly compounding the burden. In addition, borrowing costs have been unusually low making short term deficit financing particularly tempting. Low interest rates encouraged the shortsighted expansion of government programs financed with money borrowed from present and future generations. The result is a growing debt burden and a slowdown in the growth in output with which to pay it. But the future is now at hand and adjustments MUST be made in the U.S. and in Europe.
Americans tend to think of the Nordic countries and especially Sweden as leading Europe in the third way of a generous welfare state. In fact, over the last decade Sweden has trimmed its welfare programs, privatized much of its education, and liberalized its labor markets. It is in Southern Europe that economic efficiency suffers the most from overly generous work rules and benefits and competition stifling professional syndicates.
The Economists’ Charlemagne observed that: “Deep down, tensions inside the euro-zone involve clashing social contracts and democratic preferences. Post-war German governments have won voters’ consent by offering thrift and monetary stability (a comfort for Germans with a folk memory of life savings lost to hyperinflation), plus an elaborately consensual capitalism. Greek governments have instead spent years buying social peace and votes with public spending, generous pensions, tax breaks, EU money and jobs for life, directed to an array of rent-seeking interest groups. This sort of social contract, lubricated by endemic corruption and lax law enforcement, has evolved to suit a country emerging from a vile civil war and years of dictatorship in which consensus was painfully absent. Unfortunately the Greek model has proved itself unsustainable.”
The Role of the Euro
Greece replaced its currency, the Drachma, with the Euro in January 2002. It entered the Eurozone in part on the basis of lying about the government’s finances. By replacing its own currency, which suffered chronic devaluations to offset chronic inflation, with a currency it could not itself inflate, Greece removed a major source of risk to international (or other European) investors. The risk of devaluation of the Greek currency, at least visa vise other Euro countries, no longer existed. As a result, Greece was able to borrow at lower interest rates than were available before. Unfortunately, this weakened the financial discipline of the Greek government even more and it borrowed with abandon against the prospect of future growth.
The Greek economy suffered in another way that had nothing to do with its use of the Euro but which the Euro helped to hide for a while. The Greek economy actually grew more rapidly over the last ten years than most other European economies, but its per capita income is still half that of Sweden. Its growth was fueled in part by a growing deficit in the government’s primary budget balance and prices in Greece also rose more than in other Eurozone countries, worsening Greece’s terms of trade (its external competitiveness). Thus it needed to borrow abroad to finance the excess of its imports over its exports giving rise to a large private-sector debt alongside the public sector’s debt.
Greece needs to greatly reduce its government’s borrowing and to increase its international competitiveness to reduce its balance of payments deficit. Leaving the Euro and reintroducing its own currency would open the possibility of devaluing the new currency to restore external competitiveness. However, a nominal devaluation would not overcome the real rigidities in the Greek economy, which must be addressed if it is to remain competitive. According to Willem Buiter, Chief Economist of Citigroup and a former member of the Bank of England Monetary Committee: “Unless the balance of economic and political power is changed fundamentally, a depreciation of the nominal exchange rate would soon lead to adjustments of domestic costs and prices that would restore the old uncompetitive real equilibrium.”
The role of the currency in which people, companies or countries borrow and the solvency of the borrower are often confused. Greece is fundamentally insolvent, but this does not necessarily harm the currency it uses. If New York City had defaulted in 1975, as it nearly did, the fact that its debt was in U.S. dollars would not have harmed the dollar (measured by its domestic purchasing power or its exchange rate, or the willingness of investors to lend dollars to more prudent borrowers). Similarly a default on its debt by the Greek government would not in and of itself affect the value and soundness of the Euro. The Euro could suffer indirectly if a Greek default harmed Europe’s real economies (i.e., the production of goods and services) and thus affected Europe’s balance of payments (balance of imports and exports) with the rest of the world. The Euro could also suffer if the European Central Bank (ECB) increased the supply of Euros too much in an effort to prop up Greek bonds causing inflation.
The Euro is currently overvalued relative to the U.S. dollar. It needs to devalue in order to achieve a better balance between Europe’s imports and exports with the rest of the world. Thus the fact that the Euro depreciated some in recent days should not be seen as weakness or a lack of confidence in the Euro, just as the depreciation of the dollar against other currencies a few years ago, which was and is also needed to restore better external balance, should not be seen as a lack of confidence in the dollar. Quite the contrary, a depreciation of the dollar with an improved external balance of payments, would increase confidence in the dollar.
More challenging are the payments imbalances within Europe. In the United States, for example, where prices and labor markets are more flexible, imbalances between the poor South, and the industrial North in the last century, produced lower wages and labor costs in the South that gradually drew more capital to the South. Wages in the North declined while they increased in the South. The process took decades and is still underway, but no one speaks of an economic imbalance between the North and South any longer. If Europe is lucky the Euro and the market liberalization promoted by the EU will over time reduce the economic imbalances among its member states. Unfortunately, the first decade of the Euro saw the less productive southern states increasing rather the reducing labor costs and thus discouraging the reallocation of capital to the South.
Three options for the government of Greece in the face of its debt crisis are considered here: a) fiscal consolidation without assistance, b) default/rescheduling, and c) the program of fiscal consolidation and structural adjustment actually being financially supported by the IMF and EU.
• Fiscal consolidation without assistance: According to the IMF: “The sharp increase of general government debt to 115 percent of GDP in 2009 can be attributed to three factors, which will continue to weight on Greece for some time: (i) a drop in economic growth, (ii) high real interest rates (as the recession has brought down inflation significantly and market confidence weakened), and (iii) a sharp increase in the fiscal deficit to 13.6 percent of GDP.” While economic recovery would significantly improve Greece’s fiscal finances, they would remain unsustainable without large spending cuts and tax revenue increases. Furthermore, without a significant improvement in Greece’s terms of trade (its competitiveness with the rest of the Eurozone and with the rest of the world) its imports would continue to outstrip its exports needed to pay for them, which would necessitate continued borrowing from abroad. As Greece cannot devalue its currency within the Eurozone, its terms of trade can only be improved by domestic deflation, structural reforms to improve productivity, and/or (with regard to the non Eurozone) a depreciation of the Euro itself.
The fiscal correction needed, from a deficit of 13.6 percent to near zero, is extremely large. Even if spread over three or four years the negative impact on aggregate demand will almost certainly depress GDP growth in Greece for a year or two even under very optimistic assumptions. Falling or stagnant output will temporarily worsen tax collections. Vigorous implementation of structural reforms (e.g., labor market liberalization, state enterprise privatization) designed to improve the economy’s productivity and growth will help speed up the reallocation of resources from the public to the private sector and restore growth, but the positive impact will take time to materialize. The success of this strategy depends, in addition to successful implementation of the promised consolidation and structural reforms (requiring at least begrudging acceptance by the Greece public), on its credibility in the eyes of those buying Greece’s debt. It depends on reducing the risk premium demanded by lenders both to finance the additional deficits needed by Greece during the several years of adjustment and to refinance its existing debt (half of which will mature in the next five years). If risk premiums don’t fall sharply from recent levels, deficits will worsen to cover increased interest costs. However, the more sharply the government reduces its deficit the more sharply income and tax revenue will fall in the short term. Greece is between a rock and a hard place.
The IMF’s debt sustainability assessment projects that Greece’s public debt would peak at 149 percent of GDP in 2013 and fall to 120 percent by 2020 if it faithfully implements the policies agreed with the IMF. Slower fiscal adjustment would have a smaller negative effect on the baseline scenario than would slower economic growth. “A smaller adjustment of 1 percent of GDP per year would imply a more gradual decline [of its debt] to about 132 percent of GDP by 2020…. A one percentage point reduction in the GDP growth rate each year would result in debt rising to around 166 percent of GDP by 2020; (on the other hand, faster growth by one percentage point would bring the debt down to 80 percent of GDP by 2020.” With no policy change the IMF projects Greece’s debt at 194 percent of GDP by 2020. The key to success is in improving Greece’s productivity and growth.
• Default: A default would allow the government of Greece to stop payments of interest and repayments of principle on its debt until it reached an agreement with its creditors on rescheduling it under terms it could manage. “The IMF, which has pretty good experience of fiscal crises, privately recommended that Greece restructure its debt (a kind of soft default, renegotiating payment terms). It was refused point-blank by the European authorities.” Greece’s actual deficit in 2009 was €32.3 billion or 13.6 percent of GDP. Of this amount €11.9 billion was interest. A debt service suspension in 2009 would have left the government short by €20.4 billion forcing spending cuts and/or tax revenue increases of that amount. For this year, Greece has already enacted or plans cuts in spending of €4.3 billion and increases in tax revenue of €4.7 billion leaving an unfunded primary deficit of €5.6 billion. A debt service suspension (default) would require additional spending cuts and tax (or privatization) revenue increases of that amount (€5.6 billion). Such large up front fiscal adjustments are bound to reduce actual output further in the short run, thereby complicating the adjustment process.
The contagion risks of default are considerable. Over half of Greece’s gross debt of around €300 billion is held abroad, and French and German banks hold much of that. Greek banks hold a substantial part of the rest. A default could push some of these banks into insolvency. In addition, lenders have already expressed concerns (in the form of higher risk premiums) about the ability of Portugal, and Spain and even Ireland and Italy to repay their debts. A default in Greece could precipitate defaults in one or more of these, producing even more losses to banks and other lenders. To appreciate the magnitude of the problem for Europe, consider that “the sub-prime property market in the US, together with its slightly less toxic relatives, represented a $2 trillion mound of debt. The combined public and private debt of the most troubled European countries – Greece, Portugal, Spain and so on – is closer to $9 trillion…. Should Greek government bonds collapse, the country’s banking system would become insolvent overnight.” While it is possible, though not generally desirable, for a solvent government to bailout insolvent banks, it is not possible for an insolvent government to do so. Finally, the Greek government would be locked out of financial markets foreign and domestic for some years forcing them to adjust even more sharply.
The primary benefit, which would be a very important one for the future health of financial markets, would be the harsh lesson to lenders to pay more attention to the credit worthiness of borrowers in the future.
• Actual IMF/EU supported program: Neither of these options was adopted. Instead, the EU and the IMF have provided financial assistance to the Greek government in order to moderate the severity of the fiscal adjustment Greece will have to make while avoiding the losses to lenders (for the time being) of a default. This financial assistance is contingent on Greece implementing policies that should return it to a sustainable level of debt without external assistance.
“Greece is adopting an ambitious comprehensive multi-year adjustment program to lower the fiscal deficit and the debt ratio, reduce domestic demand in line with capacity, and increase supply and competitiveness so that the economy can step onto a higher growth path led by investments and exports.”
Compared with the first option of adjustment with no financial assistance, Greece’s adjustment will be somewhat more gradual. The expectation is that the more gradual adjustment will produce a smaller drop in output with its negative impact on tax revenue and thus deficits in the short run and should enjoy easier, broader support among Greek citizens, an essential element of any successful adjustment program. Real wage cuts and the relative deflation needed to restore competitiveness with the rest of Europe will be particularly difficult.
If successful, and thus Greece avoids defaulting on its debt, the IMF/EU supported program will reduce the prospects of losses to lenders to Greece and potential bank failures and contagion to Spain, Portugal, Ireland, etc. Greece will still have to pay off its debt but the economy should grow faster than it would have without structural reforms. The moral hazard of international assistance is mitigated by the strong conditionality (spending cuts, privatization of state enterprises, etc) attached to that assistance. However, the market discipline of banks that underpriced the risk of lending to Greece has been undercut.
European Stabilization Mechanism
A resolution of the debt crisis requires government adjustments that will contain and/or reduce their debts and convincing lenders in the interim that the measures being taken will in fact do the job. Following the announcement and subsequent approval by the IMF and EU of Greece’s stabilization program and financial assistance, market confidence in Greek debt improved. The spread between ten-year Greek government bonds and their German counterpart dropped rapidly from almost 10 percent to under 5 percent by mid May. However, markets remained very nervous and risk premiums on Portuguese and Spanish debt remained high (1.9 percent and 1.1 percent respectively). By May 27 the risk premium on Spanish debt had risen to 1.5 percent.
In order to reassure lenders that the EU and IMF are prepared to provide similar assistance to other qualifying European countries, eurozone members established a more formal European Stabilization Mechanism (ESM) with commitments to lend up to one trillion dollars if needed (of which the IMF would provide about one third). According to The Economist: “The pipes of the world’s financial system are gumming up again. One concern is that American money-market funds, which Barclays Capital reckons have lent $300 billion-$500 billion to European banks, are cutting their exposure to Europe, making it hard for banks and companies to borrow. LIBOR, the interest rate that banks charge one another to borrow, has jumped to levels not seen since August. The pressure is growing on EU states to get a €500 billion stabilisation fund, the biggest chunk of the bail-out, up and running.”
Angela Merkel, German Chancellor, and others have correctly noted that international financial assistance to Greece or any other EU members with debt problems only buys time. If their fundamental fiscal and structural problems are not fixed, the financing will have been wasted.
Because actual implementation of the ESM will take some time and because, according to the European Central Bank (ECB) debt markets had choked up, the ECB also announced that it would start buying member government debt as needed to restore the liquidity and smooth functioning of those markets. The dollar swap lines established with the Federal Reserve in 2008 were also reactivated. According to The Economist the situation “leaves the ECB in a quandary. In buying bonds of distressed countries it is, in effect, opening the emergency exits of a crowded theatre. Its hope is that in doing so it will make everyone feel safer and thus less likely to bolt at the first wisp of smoke. Yet the risk it faces is that in making an exit easier, more people will leave. That already appears to be happening in Greece….”
Though the ECB is sterilizing the monetary consequences of its new sovereign debt purchases, these steps by the ECB have been very controversial bring into question its political independence and commitment to inflation between zero to 2 percent. Time will tell.
Implications for the U.S.
Success of the Greek “bailout” will result in more rapid European wide economic recovery. This will carry with it continued growth in European demand for American exports, which are a major source of U.S. recovery. Outside of North America, Europe is America’s biggest export market.
Failure could take several forms, but all of them would hurt U.S. exports and further weaken U.S. banks (to the extent that they hold Greek, Portuguese, Spanish, etc. debt) and thus the U.S. recovery. Greece may well default before the year is out or in 2011. A default might also be tied with the replacement by Greece of the Euro with its own currency giving it again the option of devaluing in the hopes of restoring external competitiveness.
Greece could leave the Euro without further repercussion to the rest of the Eurozone. However, a Greek default raises the prospects of the default of other over indebted European countries unless the time bought by the IMF/EU supported adjustment program in Greece gives Portugal, Spain and others sufficient time to strengthen their own adjustment programs sufficiently to maintain market confidence in their debt. It could undermine the efforts of the U.K.’s new government to rein in its deficit. A default would also further weaken already weak banks; though the loss would fall on the ECB to the extent it had purchased Greek debt. Bailouts of banks hurt by a Greek default would complicate efforts of southern European countries to reduce deficits.
It is possible, but highly unlikely, that all Eurozone countries would reintroduce their own national currencies, though one or more of the weaker members might do so. The EU itself could be threatened but French and German commitment to European unity is too strong to allow the complete dissolution of the EU. However, sharp differences in situations and aspirations could result in the shrinkage of the Union to its northern core with or without the more the dynamic new economies to the East. Alternatively, the current crisis could result in strengthening EU institutions (or among those that remain in it), including some surrender of sovereignty over fiscal policy. One way or the other, the crisis is bad for growth prospects in the near term and will thus slow the recovery of U.S. exports and the economic activity that accompanies them. The optimists can hope that it will accelerate market reforms that will promote more rapid growth in the longer run.
Warren Coats retired from the International Monetary Fund in 2003, where he led technical assistance missions to central banks in more than twenty countries. He is a Senior Monetary Policy Advisor to the Central Banks of Iraq, Afghanistan, and Kenya for the IMF and is a Director of the Cayman Islands Monetary Authority. His most recent book, “One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina,” was published in November 2007. He has a Ph.D. in economics from the University of Chicago and lives in Bethesda, Md.
 “Greece: Request of a Stand-By Arrangement” International Monetary Fund, May 5, 2010, page 35.
 “The baseline scenario assumes that the primary balance [debt less interest payments] will improve from -8.6 percent of GDP in 2009 to 6 percent of GDP by 2014 and beyond. Output is expected to contract in 2010–11, but growth will reach 23/4 percent after 2015, while inflation is moderately below EU average.” Ibid. page 35.
 The conditions attached to IMF lending are specified quarter by quarter and loan disbursements are also made quarterly. A quarterly disbursement cannot be made until the required actions for that quarter have been taken.
 “Greece: Request for a Stand-By Arrangement”, International Monetary Fund, May 5, 2010
 Ibid, Page 76.