Martin Wolf
The Greek government has promised to slash its fiscal deficit from an estimated 12.7 per cent of gross domestic product last year to 3 per cent in 2012. Is it plausible that this will happen? Not very. But Greece is merely the canary in the fiscal coal mine. Other eurozone members are also under pressure to slash fiscal deficits. What might such pressure do to vulnerable members, to the eurozone and to the world economy?
Having falsified its figures for years, violating the trust of its partners, Greece is in the doghouse. Yet, even if it bears much of the blame, the task it is undertaking is huge. In particular, unlike most countries with massive fiscal deficits – the UK, for example – Greece cannot offset the impact of fiscal tightening by loosening monetary policy or depreciating its currency.
Greece is a member of a currency union that has the tightest monetary policy of any large economy (see chart), as Paul de Grauwe of Leuven university pointed out in the FT this week. According to the Organisation for Economic Co-operation and Development, eurozone real final domestic demand will stagnate in 2010. Germany’s is forecast to grow by 0.2 per cent.
The euro has also strengthened by more in real terms since its launch in 1999 than any other leading currency. To add insult to injury, Greece and the other peripheral countries have lost competitiveness within the zone. On one measure, Greek unit labour costs rose by 23 per cent against Germany’s between early 2000 and the second quarter of 2009. This is in line with the experience of other peripheral members (see charts).
Finally, even if fiscal tightening were to lower spreads on Greek bonds over German bunds – a measure of Greece’s default risk – the benefit for the public finances and the economy would not be large. True, early this week, the Greek spread over bunds was as big as 2.74 percentage points. But spreads have only been wide for two years. The impact of lower public sector interest rates on rates paid by the private sector is also likely to be quite small.
Given these tight constraints, a big structural fiscal tightening will generate a deep recession. That is sure to increase the cyclical deficit. Assume, cautiously, that for every percentage point of structural tightening there would be 0.2 points of offsetting fiscal deterioration. Then the structural tightening needed to reduce the actual deficit to 3 per cent of GDP would be close to 12 percentage points. The Greek government would find that, for every step it takes forward, it would slip a bit backwards. So far Greece has not suffered a significant recession. That seems sure to change. The government will soon be facing miserable public and private sectors, with no policy levers.
Having falsified its figures for years, violating the trust of its partners, Greece is in the doghouse. Yet, even if it bears much of the blame, the task it is undertaking is huge. In particular, unlike most countries with massive fiscal deficits – the UK, for example – Greece cannot offset the impact of fiscal tightening by loosening monetary policy or depreciating its currency.
Greece is a member of a currency union that has the tightest monetary policy of any large economy (see chart), as Paul de Grauwe of Leuven university pointed out in the FT this week. According to the Organisation for Economic Co-operation and Development, eurozone real final domestic demand will stagnate in 2010. Germany’s is forecast to grow by 0.2 per cent.
The euro has also strengthened by more in real terms since its launch in 1999 than any other leading currency. To add insult to injury, Greece and the other peripheral countries have lost competitiveness within the zone. On one measure, Greek unit labour costs rose by 23 per cent against Germany’s between early 2000 and the second quarter of 2009. This is in line with the experience of other peripheral members (see charts).
Finally, even if fiscal tightening were to lower spreads on Greek bonds over German bunds – a measure of Greece’s default risk – the benefit for the public finances and the economy would not be large. True, early this week, the Greek spread over bunds was as big as 2.74 percentage points. But spreads have only been wide for two years. The impact of lower public sector interest rates on rates paid by the private sector is also likely to be quite small.
Given these tight constraints, a big structural fiscal tightening will generate a deep recession. That is sure to increase the cyclical deficit. Assume, cautiously, that for every percentage point of structural tightening there would be 0.2 points of offsetting fiscal deterioration. Then the structural tightening needed to reduce the actual deficit to 3 per cent of GDP would be close to 12 percentage points. The Greek government would find that, for every step it takes forward, it would slip a bit backwards. So far Greece has not suffered a significant recession. That seems sure to change. The government will soon be facing miserable public and private sectors, with no policy levers.
The problems of Greece are extreme, because it alone of the vulnerable eurozone member countries has both high fiscal deficits and high debt. Other countries with large fiscal deficits are Ireland (12.2 per cent of GDP in 2009) and Spain (9.6 per cent). But, while net public borrowing was 86 per cent of GDP at the end of 2009 in Greece, according to the OECD, in Ireland and Spain it was only 25 and 33 per cent, respectively. Meanwhile, Italy, with a net debt ratio of 97 per cent, had a deficit of “only” 5.5 per cent. Portugal is in the middle, with net debt of 56 per cent of GDP and a deficit of 6.7 per cent of GDP. Thus, the challenge for Greece is larger and more urgent than for the others.In an article in the FT last week, Desmond Lachman of the American Enterprise Institute concluded that Greece will be forced to leave the eurozone. Simon Tilford of the Centre for European Reform in London argued on these pages that it must be bailed out, instead. There are two other possibilities: Greece toughs it out; or Greece just defaults.
Which is most likely? I do not know. But default cannot be a solution. Greece would then be forced to close its deficit in the midst of a national economic debacle. Leaving the eurozone would be a political catastrophe. Either of these eventualities (let alone both together) would also create lethal contagion for vulnerable members. Suddenly, the unthinkable would be thinkable. The eurozone could then confront a wave of sovereign debt and financial sector crises that would make what happened in 2009 look like a party.
At the same time, a bail-out by the eurozone as a whole would create a monstrous moral hazard for politicians. It would only be possible if the eurozone subsequently exercised a degree of direct control over the fiscal decisions of member states. It would, in short, be the fastest route to the political union that many initially believed was a necessary condition for success.
Given the horrendous difficulty of all alternatives, I am sure the effort will be made to tough it out for as long as possible. That will also be the case elsewhere. All will be forced to accept lengthy recessions. But in the absence of either strong demand elsewhere in the eurozone or a weaker exchange rate, both of which depend on decisions by the European Central Bank, the competitive disinflation route to prosperity seems highly likely to fail. Some countries may find themselves stuck in long-term stagnation.
Meanwhile, the eurozone as a whole, having lost its erstwhile internal demand engines, must now hope for faster growth of net exports. So do countries hit by the financial shock, such as the UK and US. So, too, does recession-hit Japan. So, not least, does China. Either the rest of the world has a spending binge, or these countries – which make up 70 per cent of the world economy – are going to be disappointed.
Some, knowing of my opposition to UK membership of the eurozone, may suppose that I find some pleasure in these looming difficulties. On the contrary, I fear the dangerous consequences. But these are certainly the sorts of difficulties that have worried me. Most of the time having an independent currency is nothing but a nuisance. But every so often and quite unpredictably, countries desperately need a safety valve. As Prof de Grauwe reminds us, the 1930s were a time when such relief was needed. Our own era is posing what look like similar challenges. Stuff does, indeed, happen. Having willed the creation of the euro, its members must overcome the difficulties that arise when, as now, stuff happens.
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