After years of profligacy and failing to rein in its spiralling public debt, Greece was on the brink of default in early May. With a public sector deficit approaching 12.7% of gross domestic product (GDP) in 2009—more than four times the stipulated European Union (EU) norm—and its national debt the highest in the EU and projected to rise to over 130% of GDP in 2011, the outlook for Greece remains pretty grim. It will continue to remain grim until not just Greece, but most of the euro zone makes sure that its labour force is more flexible and that the levels of taxation and regulation don’t privilege the public sector at the cost of the private sector.
Illustration: Jayachandran / Mint
But why do investors, politicians and central bankers worry about Greece defaulting on its debt obligation? The reason is that it has the potential to turn into a full-blown and contagious sovereign debt crisis spreading across Europe. According to the Switzerland-based Bank for International Settlements, European and American banks have $1.7 trillion of exposure to Portugal, Ireland, Spain and Greece. Among the banks, the ones in Germany and France are the most exposed.
As Patrick Minford, Eric Nowell and I wrote in Should Britain Leave the EU?: Economic Analysis of a Troubled Relationship (2005), “…Implicit in a single currency is the sharing of monetary risks, including those coming from the public finances. Should a government whose debts are denominated in the euro threaten a default, this would create a dilemma for other member governments. To allow the default would create spillover problems to other members’ economies; confidence in the debts of other governments would inevitably be shaken. Yet to provide bailout funds would be costly in itself. Prevention of the default threat is therefore highly desirable.”
When Greece joined the European monetary union in 2001, the fundamentals of the economy were already weak. The absence of an effective EU-wide mechanism to monitor fiscal policy in member states allowed further deterioration in its public finances. Furthermore, continuous EU budgetary transfers to Greece under what is known as structural funds, amounting to €24 billion between 2000 and 2006, helped postpone the necessary fiscal adjustment.
Until 2008, financial markets believed that should any EU country threaten to default, it would be bailed out, given the high political stakes involved in the euro project. As a result, risk premium on government debt hardly differed among EU member states, in spite of varying outlooks for their public finances. In the wake of the 2008 financial crisis, however, public finances of most other EU states also deteriorated significantly. In late 2008, with worrisome fiscal positions across many EU countries, market participants began to sell bonds of those countries that were most in trouble. As a result, the borrowing cost on the Greek government debt began to rise sharply, as did the potential bailout cost with it.
Greece is not the only country, of course, to find itself in such a dire fiscal position. Many other European states, including the UK (which is not part of the euro area), are also in the same boat: Government deficit as a share of GDP has risen to double digits even there. However, unlike Greece, the UK has not given up its own currency. It retains the flexibility to use monetary and/or exchange rate policy to boost its economy: It can devalue its currency to make its exports cheaper, which would help offset a fall in domestic demand due to necessary fiscal tightening. The devaluation of the currency alone, however, would not solve the underlying problem.
Resolving these problems require labour market reforms across the euro zone, similar to those that took place in the UK under the Thatcher government in the 1980s. Given that these reforms were not forthcoming, we had estimated five years ago that the potential cost to the UK economy of joining the euro would be around 7% of GDP by 2050. As a result, joining the euro monetary union was not a viable policy option for the UK.
These costs arose due to two main reasons. First, as per the EU constitution, there was no effective mechanism to prevent bailouts. Second, overall fiscal positions of EU countries were set to worsen dramatically over time compared with the UK, due to ever rising pension provision shortfall caused by their growing old age population. We had, hence, argued that the UK should retain the pound and ignore calls to join the euro. In the light of the current problems, these costs would have increased dramatically and been felt much earlier than we had anticipated.
As for Greece and the euro zone, even if they manage to successfully tide over the current crisis, stability is not assured, unless the underlying structural problems are tackled head-on. With an estimated one-third of all employed Greeks working for the government, the public sector needs to be significantly downsized. In the short term, salaries and benefits will have to take a hit and taxes will have to go up. With the recent package coordinated between the EU and the International Monetary Fund, Greece has bought some time, but not for long.
Throwing more and more money at troubled economies has been the euro zone’s strategy for a number of years. This strategy has not worked in the past and is unlikely to work in the future, unless accompanied by painful supply-side reforms.
Vidya Mahambare is senior economist, Crisil. The views expressed here are personal
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