Greece’s fiscal problems have had ripple effects across Europe, bringing back memories of the autumn of 2008, when a global financial meltdown seemed imminent. At that time, countries such as Hungary and Latvia were the poster children for profligacy and bad risk management. Greece was hiding its fiscal woes at the time, apparently by using currency swaps sold by Goldman Sachs. Now its budget deficit is revealed to exceed 13%, and financial concerns have spread to Portugal, Spain and Italy.
Unlike the 2008 problem countries of Eastern Europe, the new fiscal bad boys are all members of the euro zone. This raises the stakes enormously, since they do not have independent currencies that can depreciate, and their pain becomes the entire euro zone’s problem. How did this come about, and what can be done?
Countries adopting the euro were supposed to meet criteria of fiscal rectitude that were fudged in practice, and not strictly enforced afterwards. Unlike the states of India, or of the US, each of which is part of the respective nation’s currency area, and is subject to (more or less) hard budget constraints, euro zone member countries were able to retain fiscal sovereignty. According to Peter Boone and Simon Johnson, in a New York Times blog, governments such as that of Greece were able to take advantage of the guarantee of the European Central Bank (ECB) as a lender of last resort. A US state cannot borrow from the Federal Reserve, but euro zone governments can issue sovereign bonds and sell them to commercial banks, which can borrow from ECB using these bonds as collateral.
Normally, lenders will not lend, or will ask for higher interest rates, when they doubt the borrower’s ability to repay. But if someone else is expected to bear the risk of default, then the lender stops caring. This is what seems to have been happening in parts of the euro zone. Arguably, the party bearing the final risk—here, ECB—should have been doing due diligence and seeking more disclosure of Greece’s fiscal situation, but the threat of financial collapse seems to have dominated decision-making at Europe’s monetary centre. Boone and Johnson argue for euro zone bonds controlled by ECB to replace sovereign bonds, as a future structural reform. Meanwhile, they suggest that the current situation can spiral out of control, as expectations of rising yields and asset price deflation become self-fulfilling. They estimate that $1 trillion of backstop funds will be needed, requiring the Group of Twenty (G-20) nations to step in with financial support to the European Union.
Political intrigue comes in when Boone and Johnson examine a possible International Monetary Fund (IMF) role in the potential bailout. They argue that IMF head Dominique Strauss-Kahn has a conflict of interest, since he wants to be the next president of France, and they offer Bank of Canada governor Mark Carney and India’s own Montek Singh Ahluwalia as possible replacements. Using Europe’s mess to break its monopoly on IMF’s top job is an entertaining idea. It’s not clear, however, that G-20 is cohesive enough to organize the rescue while simultaneously beginning to shift the balance of power at IMF. In any case, China will want to have a large say, and is unlikely to want an Indian at the top IMF post.
India also has its own fiscal skeletons to deal with. It has used public sector banks to soak up government bonds in the past. It avoided fiscal grief in the last decade by growing fast and generating new tax revenue (something the Europeans are unlikely to manage). And now it has to repeat that trick in the next few years. Clearly, Boone and Johnson mostly want to stir things up, but it is gratifying to see India even being blogged about as a G-20 heavyweight.
Ultimately, current data do not quite support the immediate rise of India. Its sovereign rating is weaker and its bond yields higher than Italy, Spain and Portugal, though obviously it is in better shape than Greece. A few years of strong growth, further tax reform and fiscal consolidation may well change this situation, especially if Europe struggles with its fiscal problems, structural rigidities and sluggish growth. Rather than a sudden shakeup, we are likely to see a slow relative decline of Europe as a political and economic power, irrespective of how the current crisis is resolved.
Greece was the cradle of Western civilization, leading the way in numerous social, political and philosophical innovations that ultimately supported the economic rise of the West and its global dominance. Perhaps Greece’s current problems will mark the beginning of the reverse process economically, as Europe comes full circle. That process will take decades if not centuries. Meanwhile, for countries such as India, G-20 should play second fiddle to their immediate domestic priorities of economic development.
Nirvikar Singh is a professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org