The policy debate surrounding Greece has generated almost as much sound and fury as the protesters on the streets of Athens. But some of the discussion involves a key myth, and almost all of the discussion makes a potentially erroneous assumption.
The myth’s the easy part. Much of the criticism of the bailout package for Greece has centred around the harsh fiscal austerity measures that Greece is required to undertake—the notion that Greek citizens will bear the entire burden of adjustment, while banks holding Greek debt are let off the hook. Implicit in this criticism is the assumption that somehow the alternative options (defaulting on its debt or exiting from the euro) would have absolved Greece from undertaking a sharp fiscal correction. This is a myth.
Photo: John Kolesidis/Reuters
Greece would have needed to endure an even sharper fiscal correction if it had rejected the bailout package. Default would have meant that Greece would have lost complete access to markets and would have had to correct its primary deficit (fiscal deficit before interest payments) of around 9% of gross domestic product (GDP) in one year, instead of a fiscal correction of 11% of GDP in three years under the current deal.
Exiting from the euro and devaluing may well increase competitiveness and spur export growth. But monetary loosening cannot replace fiscal tightening—since external Greek debt is, and would presumably still be, denominated in euros (or other foreign currencies) and, therefore, could not be inflated away through loose monetary policy in a new local currency. Furthermore, proponents of exiting from the euro often underestimate how much currency risk premia (above and beyond the existing default risk premia) could emerge in the local interest rates of a new Greek currency, thereby impeding trade and investment, if Greece were to embrace a new currency and a loose monetary policy.
In sum, a sharp fiscal adjustment is unavoidable. The question, therefore, is what will be its impact and how should it be structured.
Almost all the discussion assumes that a sharp fiscal adjustment will have a significant multiplier effect on the private sector, causing a severe and protracted recession. Some economists have assumed that for each 1% of GDP decline in Greek government spending, total demand will fall by a staggering 2.5% of GDP, and have consequently predicted a double-digit contraction of the Greek economy. If this were to be the case, Greece will be stuck in a vicious cycle of debt and deflation. But does a sharp fiscal adjustment necessarily result in a large contraction of private sector demand?
European history suggests otherwise. Two decades ago, Denmark and Ireland engaged in sharp fiscal consolidations of almost the same magnitude as Greece has committed to do (9.5% and 7.2% of GDP, respectively, over three years). Far from contracting private sector demand, these large consolidations led to a sharp increase in private consumption, resulting in an expansionary fiscal consolidation. And these two cases weren’t anomalous. Subsequently, Belgium, Italy, Portugal and Sweden engaged in substantial consolidations that led to a growth of private sector demand.
So what lessons can Greece derive from these experiences? As I have pointed out earlier on these pages (“Contractionary fiscal expansions”, Mint, 18 August), the key to successful fiscal consolidations is credibility.
A credible and sustained fiscal tightening by Greece will reduce sovereign risk premia, allowing interest rates to fall, which could not just potentially crowd in private investment, but also push up asset prices, thereby boosting consumption through a positive wealth effect. In addition, to the extent that Greek consumers interpret a sustained fiscal consolidation as a fall in their permanent tax liabilities and a consequent increase in permanent income, private consumption could well experience an unexpected bounce—as has been the case in many European economies in the past. In sum, both private consumption and investment could grow and fill the space created by a credible fiscal consolidation.
Credibility, in turn, is earned based on how a country consolidates its finances. Research has found that consolidations achieved primarily through cuts in current expenditure (government wages and employment, transfers, social security) have typically succeeded, whereas those achieved through broad-based tax increases or public investment cuts have failed. The rationale is straightforward: Expenditure cuts focusing on parts of the budget that had the greatest tendency to automatically increase or were the most politically sensitive (wages, entitlement programmes) were thought to be more serious, credible and long-lasting, compared with cuts in public investment (such expenditure could not be postponed indefinitely) or tax increases (which reduced the space for private economic activity). Additionally, cuts in spending typically reduce unit labour costs, generating a real currency depreciation and increasing competitiveness.
European history, therefore, contradicts the near-universal consensus that Greece’s fiscal consolidation is bound to generate a double-digit contraction. The current debate therefore needs to be turned on its head. Let us not pretend that Greece’s fiscal consolidation can somehow be avoided or assume that it will necessarily fail. Instead, the focus needs to turn to how best to structure such a consolidation. If that happens, Greece may not have to endure a tragedy of the scale currently being forecast.
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Sajjid Chinoy is a Mumbai-based economist who has worked at the International Monetary Fund and McKinsey & Co.