A Greek tragedy

AT the time of writing, the yield required by private financial markets on Greek government bonds had just crossed an unbelievable high of 13.5 per cent, more than 10 per cent more than the rates on German government debt.

This spread on government bonds is more than is currently faced by any other developed economy and is even higher than the rates faced by several balance-of-payments-constrained developing countries. It suggests a level of debt servicing that is simply impossible to meet in a feasible manner, which means that the entire process is now clearly unsustainable and heading for a clear collapse.

Therefore, Greece is now on a par with several crisis-ridden emerging markets, embroiled in a crisis of investor confidence that seems to be impervious to the (admittedly half-hearted) attempts by the European Union (E.U.) and the International Monetary Fund (IMF) to offer some sort of liquidity.

How did things come to such a pass? On the face of it, this is simply the fruit of past fiscal profligacy, made worse by the creative accounting (which is the favoured current euphemism for fudging the books) practised by the previous government in Greece and encouraged by private banks like Goldman Sachs. But this is a relatively superficial explanation. In fact, Greece (just like other economies in the eurozone that are now in trouble) is also a victim of its geography and history.

Geography because, like its southern neighbours Spain and Italy, its more equable climate and other favourable features encouraged a flood of investment during the past boom, especially directed to its real estate and construction industries. History because while labour productivity in Greece has been increasing faster than real wages, this gap has still been lower than the gap in Germany, which has seen tremendous strides in competitiveness because wages have been stagnant even as technological change has led to very rapid increases in labour productivity.

This has meant that prices increased faster in Greece than in Germany and similar areas, and so the production of goods and services in Greece has become progressively less competitive relative to Germany.

Unlike the United Kingdom, which had very similar tendencies, Greece is part of the eurozone and, therefore, could not devalue its way out of the mess. But while it is part of a common currency, it is still a sovereign debtor, and that has led to the massive hammering that Greek government debt has received in international bond markets. As a result, a liquidity crisis clearly looms for the country. In a dose of the monetarist medicine familiar to many developing countries, Greece is now being asked by the E.U. to make wrenching cuts in public spending, which are not only difficult to implement for the new Socialist government but unlikely to be accepted by the restive public.

The IMF even seems like a temporary saviour because the adjustment measures it has asked for are still somewhat less than the stringent (and politically unacceptable) conditions specified by countries such as Germany. The new Socialist government that was elected only a few months ago finds itself in the unenviable position of having to push through adjustment measures implying massive cuts in public sector wages, essential spending in social services, infrastructure and the like, and requiring deflationary policies that will not only cause more unemployment immediately but also keep economic activity down for several years to come.

For obvious reasons, there is huge domestic political opposition to such cuts, and, indeed, it is hard not to sympathise with the Greek people, who are being forced to suffer for sins they had little part in. But the problem posed by the sovereign debt issues of Greece is deeper and potentially more significant since it calls into question the stability and viability of the eurozone itself. Without currency union, devaluation of the currency would have been one of the most obvious easy ways to ensure adjustment in Greece and similar economies. With that option closed, adjustment based entirely on domestic economy measures will require such severe cutbacks on public spending and private consumption that they are unlikely to be accepted in a democratic set-up. The only other option is a bailout by Brussels, but the European Charter does not provide any bailout clause, and this depends crucially on the ability and willingness of countries such as Germany and France to set such a precedent.

The euro has always been an unlikely major currency, based as it is on monetary union between countries that do not share political union. Its creation was remarkable, a tribute to idealism and a reflection of the triumph of political will over economic barriers. To outsiders, it is a fascinating experiment, since its apparent stability thus far calls into question a belief that was axiomatically held by many economists: that monetary union is difficult if not impossible without fiscal federalism underpinned by more comprehensive political union. Of course, the eurozone is not the first attempt at monetary union in history, nor is it likely to be the last. But it has been the most successful by far. It is the culmination of the century-long drive in Europe towards greater integration, punctuated by wars, and other conflicts and instabilities, but proceeding regardless of those hurdles.

The driving force of such a union may well have been political, but there are also clear economic benefits. These stem mostly from the reduced transaction costs of all cross-border economic activities, including trade in goods and services. In addition, the stability provided by a single currency serves to reduce risk in a world of very volatile currency movements driven by mobile capital flows, and this is seen to be an additional inducement to invest in productive activities.

But there are also significant costs of such union, which are becoming especially evident now. The most obvious is the loss of two major macroeconomic policy instruments: the exchange rate and monetary policy, which can otherwise be used to prevent an economy from falling into a slump.

For example, Greece could have tried to use a combination of exchange rate devaluation and lower interest rates to stimulate demand, increase income and reduce unemployment, as well as prevent the external deficit from deteriorating. Of course, this is not foolproof, as many countries know, but trying to adjust without such instruments is that much harder.

The other way to resolve this would be for workers in Greece to move to other parts of the eurozone, and so reduce the pressure on the domestic economy. This obviously requires free flow of factors across borders, which is often seen as a basic economic condition for currency union, and this was sought to be created by the Single Market in 1994. But even until date labour does not really move freely across European borders despite the removal of official restrictions.

Finally then, the option would be to have fiscal transfers (implicit bailouts) to Greece from stronger segments of the eurozone economy. This fiscal federalism is important in the United States, which is another large area that is a currency union (in this case backed by political union). For example, some States in the U.S. such as Florida and California (also southern regions with better climate and past recipients of capital inflows), have even worse budgetary problems than Greece, but because their debt is ultimately guaranteed by the U.S. federal government, the matter is not so acute.

But so far such fiscal federalism is much less developed in the E.U. In fact, there is already a backlash in several larger and more powerful countries against ceding more powers to Brussels. In this context, temptations by some members to take a free ride on the strength of others, and equally strong attempts by the stronger members to resist such pressures, can make the currency union unviable.

Thus, the response thus far in Germany suggests that hopes of a viable bailout for Greece are over-optimistic, as the government there has been insistent that Germany should not be called upon to pay for the union, even though it is the largest and strongest economy in the eurozone.

Most estimates suggest that at least 80 billion euros should be pledged over the next few years to tide over the immediate problem, even with stringent austerity measures imposed by Athens. But the amounts discussed so far are much smaller and the actual funds provided have been paltry. This is why bond markets are distrusting the viability of the entire process and pushing up the yields on Greek bonds to ridiculous highs.

Obviously, this cannot last and something must snap. But the problem is not confined only to Greece, because even if Greece is somehow forced to leave the eurozone and go back to some form of drachma or other currency, financial markets will simply turn on other weak links in the euro chain. This is what makes some commentators question the medium-term future of the euro. It is not just the current problem of Greece or any other country, but the larger structural issue of whether the currency union can survive without more explicit fiscal federalism. This requires political commitment to European unification, which goes far beyond anything one has yet seen. Of course, it may still occur, though current indicators are not promising. If it does not, we may be witnessing a 21st century Greek tragedy unfolding on a grander European scale.