What Exactly is Wrong with Greece?

As its erstwhile archenemy Turkey just voted for a third consecutive term of stable majority government amidst rapid growth, Greece seems to be stumbling along from one crisis to the next. Burdened with €328bn (end-2010) of sovereign debt, Greece has consistently failed to put itself on a credible trajectory towards fiscal sustainability. With the IMF now expecting Greek government debt to rise above 150 per cent of GDP by the end of this year, even extreme austerity might not enable Greece to service its existing debts. Reflecting the increasingly untenable situation, Standard & Poors’ this month downgraded Greece from B to CCC, ie junk, in reflection of the high probability of the country’s defaulting on its sovereign obligations. The outlook is negative.

Why this sudden change after the €110bn bail-out package agreed by the EU and the IMF last year? In essence, because last year’s rescue package was merely a short-term political fix, an attempt to delay the inevitable, to buy time in a way that would encourage Greece to reform while protecting the Euro as well as European banks which hold a total of $52bn of Greek government debt. $23bn of the total is in the hands of German banks and $15bn in France. The European Central Bank itself has directly acquired €47bn of Greek bonds. And this looks set to continue as the ECB is effectively the sole source of funds for Greek banks which use government debt as collateral.

The challenge for all concerned is that the Greeks have struggled to keep their end of the bargain. Tax revenues have disappointed and spending cuts have been evaded with the consequence of minimal headway towards restoring fiscal balances. This, along with the growing frustration of the EU and the IMF is what forced the government to adopt a €28bn austerity package, which is effectively a precondition for the next €12bn tranche of EU-IMF assistance. Greece has a €2.4bn sovereign debt repayment in mid-July. The proposed new measures include a €50bn externally managed privatization program and further steps to size down the public sector and reduce pensions. If the package is rejected Prime Minister Georgios Papandreou will have to call a new election.

While the package may yet be passed, the chances of the current strategy bearing fruit are rapidly dwindling as the political and economic costs of austerity mount. In an economy with a heavy, long-standing dependency on public sector largesse, the appetite for years of belt-tightening is minimal. Greece has struggled to find a national consensus to support the austerity drive as demonstrations and strikes have become increasingly commonplace. But this ultimately only reflects the enormity of the challenge. Even with dramatic austerity measures, Greece’s debt burden would not come down below 146 per cent of GDP by 2016. The Greeks can engage in measures entailing enormous political costs and not make a dent in the debt mountain because the fiscal situation is unsustainable. The country already faces 16 per cent unemployment.

What can be done? Greece’s original entry into the Euro-zone was controversial. Even as many opposed extending the currency union beyond a core group of fiscally disciplined central and northern European concerns, others were concerned about the unfair competitive advantages that the ability to devalue would give to the southern European countries. In the end, a combination of political suasion and tidying up the statistics created a seemingly acceptable basis for Greek membership. In principle, the Euro-zone could revisit its original assumptions and agree that the inclusion of some countries was inappropriate.

Problematically, while this argument can be sustained with Greece and Portugal, the case of Ireland is far less obvious. The Irish used to be model Europeans. Their problems emerged after they had joined the Euro-zone, partly because the monetary policy pursued by the Euro-zone was too loose for them and engendered a massive property bubble. But even if a way could be worked out to allow Greece and some other countries to leave, the original fears of the core countries would soon come back to haunt them. Really the only way for the heavily indebted southern Europeans to kick-start economic recovery would be to default and devalue, essentially a beggar-thy-neighbor policy that would, at the very least, be unfair toward the more disciplined members of the Euro-zone who would now see their competitiveness eroded. In spite of their relative strength, these countries may be unwilling to penalise themselves at a time of anemic global growth.

Even as the EU policymakers cannot seem to agree just how the responsibility for Greece’s failure should be apportioned, no one seems willing to seriously contemplate the possibility of a Euro-zone without one of its founding members. Following a deal between German Chancellor Angela Merkel and French President Nicolas Sarkozy, the likelihood of another rescue package must be deemed very high even if little is available by way of concrete details, although it is clear that any realistic package must involve an element of restructuring Greece’s debts. Indeed, Germany helped trigger the most recent bout of market unrest by demanding that bondholders should be made to bear some of the pain. However, a restructuring that is not entirely voluntary might be deemed a default by the rating agencies.

The advantage of a voluntary restructuring would be to limit the losses of bondholders who have already seen the value of their debts eroded by about a third. What is less clear is how complete a solution a voluntary restructuring would provide.

Whatever the nature of the rescue, it will have to involve more austerity as well. For Greece, leaving the Euro-zone might offer a seemingly attractive and less painful way out but it would also continue an age-old pattern of fiscal responsibility and failing to face the consequences of actions. As painful as austerity is, many of Greece’s problems are structural and will have to be tackled now if the crisis is not to keep coming back. Greece is unlikely to tackle the structural causes of its deficits in the absence of compulsion.

Similarly, the EU needs Greek austerity so as to minimise the risk of moral hazard. A bail-out with no strings attached is not a solution. Contagion fears would be dramatically amplified by a country receiving a blank check without having to face the consequences of its irresponsibility. And while a Greek, Portuguese, or Irish bail-out may be feasible, allowing the crisis to spread to Spain and beyond would likely prove fatal for the Euro-zone. Moreover, further downgrades remain a possibility with Moody’s putting Italy on negative credit watch. Also some other European countries are vulnerable in the face of a likely increase in interest rates by the ECB in July. The clock is ticking…

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