MacGee: Why Greece matters?

At first pass, it seems difficult to imagine how a small country like Greece – with an economy roughly two-thirds the size of Ontario – could matter so much for the world economy. How did such a small country come to be the focal point of a European debt crisis? Is there a way for Europe to avoid contagion from a Greek?

To understand how Greece (and Europe) arrived at this point requires some history.

MACGEE

MACGEE

The European Union (EU) project is rooted in a post-war push toward deeper economic and financial integration, with the objective of making another European war too costly to countenance. Thus, the European Coal and Steel community of 1950 evolved into the European Union, and then into a Euro zone with a transnational central bank, the ECB.

This political push for integration is why Greece is in the Euro zone – the 17 countries that adopted the common European currency. The economic theory of a common currency area argues it works best when regions have a similar economic structure, free movement of workers across regions and a fiscal authority to make inter-regional transfers. On all of these grounds, Greece was a poor fit for the Euro zone. In addition, Greece had a long history of poor fiscal management, and with its debt-to-GDP ratio near 100 per cent, it was well above the 60 per cent level required to enter the Euro zone.

However, the political push for a large Euro zone meant the debt limit of 60 per cent was waived for Italy and Belgium – and then for Greece. This decision was compounded by a failure to put effective limits on annual deficits. This was not due to a lack of foresight; during the debate over the creation of the Euro, the ‘moral hazard’ problem of a country running large deficits while expecting to be bailed out by other countries (or the ECB) was recognized. However, political considerations again came into play, and resulted in the Stability and Growth Pact – intended to limit this problem – being made ineffective.

While the acceptance of Greece into the Euro set the stage, the next decade witnessed the serious mismanagement by the Greek (and several other Euro zone) government(s) required to lay the groundwork for the current crisis.

The immediate effect of the Euro was a large fall in interest rates on Greek bonds, as investors became willing to lend at rates barely above those paid by Germany. This was based on two (rather optimistic) beliefs. First, that relatively poor members of the Euro zone (i.e. Greece, Portugal and Spain) would undertake the reforms required for their economies to converge to the same level of income as northern Europe. The resulting economic growth, combined with responsible fiscal policy, would lower the debt-to-GDP ratio, thus making default unlikely. Second, if Greece (or another Euro country) encountered difficulties financing their debt, they would be bailed out by the Euro zone.

Unfortunately, successive Greek governments responded to lower borrowing rates not by reducing debt, but instead ramped up government spending and borrowing while systematically under-reporting their deficits. Moreover, much-needed economic reforms did not take place. While recent media coverage has focused on things such as the right of hairdressers to retire at age 52 due to the ‘hazardous’ nature of their work, other policies are arguably more damaging.

First, the taxation system remains unreformed, with some workers facing high official tax rates while workers in other industries avoid taxes by underreporting their income. Second, large sectors of the economy – ranging from pharmacists to lawyers – benefit from legislated barriers to competition, which help protect current workers at the cost of low productivity. Finally, the public service remains too large and poorly administered.

By the time the world economy entered a recession in 2008, Greece was a fiscal powder keg waiting for a spark to light the fuse. What lit the fuse was the aftermath of the election in October 2009. The new (and still current) government came to office and announced the deficit was much larger than previously thought. Despite ongoing protestation by the government that a resolution was near, events have continued to snowball for nearly two years.

With large deficits and a shrinking economy pushing the debt-to-GDP ratio toward 160 percent, the window for Greece to avoid default is rapidly narrowing. The only hope is a combination of fiscal austerity and the drastic domestic economic reform required to set the stage for rapid long-run growth, while borrowing at artificially low interest rates from the Euro zone and the International Monetary Fund (IMF).

Unfortunately, there is little sign the Greek government possesses the required political will or needed popular support. The policy of the past 18 months has been to promise reform in return for each package of loans – but not to implement reform. Commitments to reform the civil service accounting system, to open up protected occupations and to limit government hiring have either not been implemented or ignored. This has led to doubts about whether the EU and the IMF will approve the payout of the next installment of loans.

Regardless of whether or not the next tranche of Greek aid is approved, a consensus seems to be emerging that Greece will default. This explains why markets are waiting intently to hear the details of the EU and the IMF plan on how to deal with the inevitable fallout of a Greek default.

It is essential to recognize that the direct effects of a Greek default are not the main problem facing Europe.

Yes, a Greek default will force European banks to own up to losses on Greek bonds they own, and will hit banks that have made loans to Greek banks, business and consumers as defaults on these loans will continue to rise. However, it is unlikely these losses will bring down a major European bank – and even if they did, they would not be so large that other European countries could not recapitalize them. Admittedly, the Greek financial system will be crippled by a default. Therefore, Greek banks will need to be recapitalized by further loans from the EU if there is to be any hope for a soft-landing of the Greek economy.

The true dangers arise from three interrelated issues.

First, a Greek default will lead investors to ask whether Greece is ‘unique,’ or whether other European countries are on a similar path. Second, can the European banking system survive if a large European country were to default? Third, what is the process for an orderly exit of a country were to decide to leave the Euro?

For much of the past 30 years, investors have downplayed the risk of default by a developed country. Although numerous developing countries have defaulted, most observers believed that developed nations had the foresight to avoid the calamitous results of running unsustainable fiscal policy.

Unfortunately, a Greek default will (and already has) put this belief to rest.

Once Greece defaults, investors will ask which European country with high debt, a rapidly aging population and slow economic growth is next. The problem here is not Ireland and Portugal (which like Greece are small), but that a country that is too large for the rest of Euro zone to bail out (i.e. Italy or Spain or France) will find itself cut-off from borrowing in world markets and default.

This highlights the second danger – that a default by a large country like Italy would trigger a rash of bank failures due to the resulting losses on bonds held by banks.

Here the interrelated nature of sovereign debt and banks comes into play. As sovereign debt problems mount, banks need to be recapitalized – which, in turn, puts further pressure on government borrowing, and leaves governments less able to bail out insolvent banks. Indeed, this dynamic is already at work, as the recent ‘rescue’ of Dexia (a large European bank) by Belgium and France has already raised concerns about possible downgrades to their credit ratings.

Finally, a key question is whether Greece (or other countries) will try to exit the Euro after a default.

On the one hand, exiting will seem to offer countries an opportunity to lower the price of their exports while raising the cost of imports, thus making exporting firms more competitive. While this may seem attractive to a country facing a steep recession, it also raises a host of practical issues about how to unravel a wide range of contracts. Currently, contracts within the Euro zone – loans, wage contracts with employers, rental agreements – are denominated in Euros. If a country exits the Euro, at what exchange rate will these contracts be converted into new domestic currency? Which banks will be forced to bear what losses on loans to one another? Will Euro zone governments respond by raising barriers to trade with countries that exit?

This highlights that Greece is important mainly because of the questions it raises about default risks in other countries, the solvency of the European banking system and the future of the Euro zone.

These concerns are already playing out in the marketplace. The jump in interest rates on Italian and Spanish bonds elative to Germany and the recent difficulties faced by some European banks in obtaining market funding reflect real doubts about future default risks of both sovereign nations and banks. While the ECB (working with other central banks) has responded to these market symptoms by providing additional funding to European banks and buying Italian government bonds, these actions can – at best — provide government leaders with a few months to put together a compelling and credible plan.

The lack of a credible plan from European leaders (two years into the crisis) is a key factor in the recent volatility facing financial markets.

To be fair, any credible plan to manage events after a Greek default requires leaders to come clean about a number of unpleasant facts.

First, some countries will need to make difficult changes to the path of fiscal policy, and domestic reforms to encourage economic growth, in order to convince the world they are serious about not following Greece into default. Second, a credible plan to recapitalize European banks should defaults occur need to be drawn up. This will require countries with relatively strong fiscal positions (such as Germany) take on a large share of the risk. Finally, an ordered and credible plan on how countries can exit the Euro needs to be agreed upon.

There are clear reasons to doubt European leaders will be willing to take these tough decisions before it is too late – especially given that the crisis is the result of an unwillingness of leaders to make tough choices. This raises a real danger that Europe will try to muddle through postponing both a Greek default and economic reforms as long as possible.

Unfortunately, a fiscal problem postponed is also a fiscal problem worsened.

 

Jim MacGee is a Western Department of Economics professor.