360° Analysis

Can the EMU Project Survive?


March 22, 2011 22:13 EDT

David Vines argues in this article that Greece needs a combination of debt rescheduling and consolidated, coordinated wage cuts – and that it needs both things fast. And he argues that Ireland needs something similar. In addition he argues that, if the European Monetary Union is to survive in the longer term, Europe needs a Germany which behaves in a very different manner.

The huge rescue of Greece last May, by the IMF and the European Commission acting together, means that the Greek government will not need to borrow again from private financial markets for three years. The rescue of Ireland in November has had a similar effect. During this time, bankers and others who lent to Greece, and to Ireland, will get a significant amount of their money back. And Ireland and Greece will have a three-year period to put their houses in order and to consolidate the necessary austerity.

• Sovereign debt and competitiveness in Greece – But this plan may not work in Greece, for two reasons.
First, Greece is saddled with a very large amount of public debt. Severe cuts to public expenditure programmes and large increases in taxes are a central part of the Greek rescue package, in order to get the budget deficit into surplus and to start reducing public debt. Even if this austerity programme proceeds as planned, it will take some years to fully bite. It is projected that the public-debt-to-GDP ratio will go on rising, from 125% of GDP to 150% during the adjustment period, before public debt finally begins to turn around. Such a debt overhang deters domestic investment, since it rightly leads to a fear of future tax increases, whose scale and incidence is uncertain. And the austerity programme that is necessary for the needed adjustment is beginning to be resisted politically. As a result, the Greek economy may end up being crippled by its stock of debt.

Second, what Greece needs is an export-led recovery strategy, like that achieved by Korea and Thailand after the East Asian financial crisis. In East Asia this was brought about by a massive currency depreciation, something which is denied to Greece, since countries within the Eurozone cannot devalue their currencies. Moreover, the outlook for the growth of world trade is weak at present. As a result, the Greek recovery process also risks being crippled by a lack of rapid export growth, in which case the planned cuts will merely lead to unemployment.

• Risk Premia
As a result of these two difficulties, markets do not trust the EU-IMF adjustment programme in Greece. The risk premium on Greek government debt is above 400 basis points, and the price of long dated Greek debt is only around 60-70c per dollar of debt. With such a risk premium, investment will be held back, growth will not recover, and austerity will be further resisted. The fear of failure in financial markets may well become a self-fulfilling fear.

Two imaginative moves are necessary to solve this problem, one in international debt markets, and the other in the Greek labour market.

• Dealing with the Debt in Greece
I believe that the IMF's trajectory for getting public debt back down in Greece will only be achievable if there is some implicit writing down of Greek debt, even if Greek debt is not explicitly written down. Such an action should not involve an actual default by Greece. The banking problems in Greece which would result from that would be too great, as would the resulting problems for the banking system in northern Europe. And the contagion effects on Spain, Portugal, Italy and Belgium might well be massive, too.

One imaginative suggestion, explored by Daniel Gros and Thomas Mayer (see http://www.voxeu.org/index.php?q=node/6093)would exploit the fact that markets do not trust the current strategy. The suggestion is that the European Financial Stability Facility (EFSF) might offer holders of Greek debt, including northern banks, an exchange of EFSF paper for Greek debt at the current discounted market price, which is around 70c in the dollar. Such a debt buy back would give Greece a significant amount of debt relief. It would also cause northern banks to realise a significant loss. And it would lead to balance-sheet risk for the EFSF, a risk which would need to be insured by all European governments.

There will be political obstacles to such a strategy in Northern Europe; in particular Germany might see such a move as creating moral hazard and as setting up a Europe of North-South transfers. But for northern banks to get all their money back after this crisis would involve an even greater form of moral hazard. If such a buy-back creates costs for German and French banks which must be borne by German and French taxpayers and if it leaves these taxpayers exposed to the balance-sheet risk of the EFSF, then that is an issue for the German and French governments. It should not be an issue for Greek citizens. The fundamental point is that a positive action of this kind might draw a line under any worsening of fears about Greek default. That would get the risk premium down – which is good for Greece. And it would also underpin the position of the northern banks who have lent to Greece.

It seems that Greek banks could not participate in such a buy-back to any great extent, since a purchase of much of their Greek government debt at 70c in the dollar would immediately bankrupt them, with catastrophic consequences. But these banks could be offered an exchange of the debt which they hold for new low-interest-rate, long-term debt (of, say, 30 year maturity) at a price of $1.00 per dollar. That would not cause immediate balance sheet problems for Greek banks, since it would spread out their burden of debt reduction over many years.

There is a widespread concern that such a market-based debt reduction scheme might not be enough. According to this line of thought – with which I agree – the official sector (i.e. foreign governments within Europe) might need to provide extra support, over an extended period of time. In particular, these European governments might need to offer an easing of their claims, in a manner similar to that which I have suggested above for private debt. Doing this might be judged politically acceptable, as part of a package involving the other holders of Greek debt.

It has also been suggested that the Greek state might reduce the net cost of such debt purchases to the EFSF by embarking on a programme of $50b of asset sales (e.g. of land and of state-owned enterprises). But just this last week such an idea met with massive political resistance in Greece. (See http://news.yahoo.com/s/nm/20110212/bs_nm/us_greece_economy.)As a result, there may not be much room to move on this front in the short-run. Nevertheless, such asset sales may prove necessary over the longer term, as the Greek recovery gets under way.

• Dealing with Competitiveness in Greece
But debt adjustment will not be enough, since rescheduling debt does not restore competitiveness. There was a very rapid reduction in the competitiveness of Greece, over the period from 2005 – 2008. As a result, Greece now needs the equivalent of substantial currency depreciation, like that which happened in Asia after the crisis there; an improvement in competitiveness of up to 30% may be needed. I do not believe that it will be possible to achieve a large enough reduction in wages, costs, and prices without some sort of central administrative intervention in the process.

How to bring this about? What is needed is a very large overall wage-cut, coordinated across the whole economy. Progress towards this objective has so far been very confused. It is true that there has been some downward movement in public sector wages – although only of the order of 10 – 15 percent – but there has been almost no movement in the private sector. Research shows that private sector wages in Greece have never been responsive to the output gap; there is a clear risk now that internal devaluation could happen so slowly that recovery is repressed – for a matter of years. This would sabotage the dynamics of the adjustment of debt that I have discussed above.

So far negotiations between the Greek government, the IMF and the EU have not focussed on this central problem. They have instead spread their attention over a very wide range of structural issues. What has happened reminds me of what happened in Indonesia at the time of the Asian crisis. At that time the IMF proposed far-reaching, unfocused reforms which had very little to do with the short-run adjustment needs of a macro-economy in crisis. In Greece, energy is being diffused over many battles with the liberal professions, and in other areas, in a way which is politically exhausting. A few key issues such as wages, major state enterprises, business start-ups, and obstacles to the expansion of tourism deserve to be prioritised. And the necessary reforms to wage negotiation procedures are of central importance. The social disruption surrounding this issue could be sizable: it requires a frontal attack on an “insider” dominated wage system, and all parties know that this needs to cause a fundamental change in the way that Greece works.

Moves of this kind will become more politically possible if they are accompanied by the kind of moves, described above, towards an adjustment of Greece’s international debt burden. That way it will be possible to present the wage reductions to the Greek population as part of a burden-sharing approach.

Of course, a general wage cut would need to be accompanied by some legal surveillance that ensures that prices fall in an appropriate manner. It is difficult – nay, impossible – to impose price controls as a continuing system. But some oversight of a one-off cut in prices might be possible.

It is essential that all this happen fast. A slow and gradual reduction of wages would be the worst of all possible worlds. With slowly falling costs and prices, very few people will be persuaded to invest, since there will be a prospect of falling revenues. But investment and growth, particularly in the export sector, is what Greece needs. An environment of slow and gradual deflation is not an environment in which to bring this about.

Dealing with the Crisis in Ireland
There are also very significant – and very similar – issues ahead for Ireland.
Wage adjustment seems more possible in Ireland than in Greece.
It is crucial to note that the crisis in Ireland was not caused by fiscal irresponsibility, but by an over-expansion of bank lending. This has, nevertheless, led to an overhang of debt which is worse in Ireland than in Greece, in per-capita terms, although the debt is bank debt, rather than public debt. To solve this problem will almost certainly require two things. First the Irish state will need to nationalize Irish banks in some way, thereby taking onto the public balance sheet the foreign obligations of these banks – a lot of which are obligations to French and German banks. Then, second, a solution will also almost certainly require that this debt of the Irish state is, in turn, taken over by the EFSF, at a discount, in the same way as was discussed above for Greece.

• Learning the lessons for the Eurozone
What has happened in the last few months in both Greece and Ireland poses deep political challenges for Europe as a whole, not just for these two countries. Many commentators now believe that the European Monetary Union will break up unless there is much greater degree of integration of economic policy-making within Europe. The resulting policy system will need to prevent the kind of fiscal laxity that drove Greece to the edge of a financial precipice. It will also need to prevent the kind of banking laxity that has done the same thing in Ireland, and also in Spain.

There are large challenges ahead for those who design this new policy system. The misguided Stability and Growth Pact must be augmented by a new approach to fiscal policy, and to financial regulation. That new approach must be comprehensive enough to guard against difficulties like those in Ireland and Spain, where fiscal irresponsibility was not the cause of crisis, and where fiscal discipline alone will not be a remedy. The new European policy system which has recently been proposed by the European Commission does not seem adequate for this task. (See: http://www.europarl.europa.eu/en/pressroom/content/20110124IPR12356/html/Economic-governance-not-just-repairs-but-a-thorough-overhaul)

Furthermore, the crisis has revealed an even deeper difficulty, one which has been slow to reveal itself. For all of the ten years since the euro was formed, Germany has determinedly cut its cost and wage levels. The result has been a super-competitive Germany that is now taking demand away from other countries within the Eurozone – not just from Greece and Ireland, but also from Portugal, Spain, and Italy – at a time when these countries are in need of economic recovery.

German policymakers have, at the same time, insisted that German domestic demand be held down to make room for this foreign demand. This unilateral policy has led to a growing German surplus within Europe, and to a reduction in the growth of overall demand in Europe. As a result of this policy, Europe faces a slow-growth future. It is now essential that Germany implement policies to foster rapid growth in domestic demand. Germany will need to choose whether to bring about this growth through greater fiscal laxity – which will be resisted politically – or through more rapid market reforms – which will also be politically difficult. Despite these political difficulties, it is essential that one of these policy responses be implemented. This choice is something which Germany must not evade, however great the domestic political costs that it faces.  

German insistence on the right of Germany to make policies in its own interest, whilst disregarding the interests of other countries within EMU, is creating a situation in which the EMU may become unworkable.  This difficulty has culminated in a constitutional provision, enacted last year that will, within a few years, prevent Germany from running any significant budget deficits at all. Such a constitutional enactment appears to be entirely improper. It should not be possible for one member of a monetary union to change the rules of that union, unilaterally, and it should especially not be possible for this to be done by constitutional means. The effect of this provision will be that, if German private sector expenditure remains cautious, the problem which I describe above will become a permanent problem, written in stone.If Germany is to remain the hegemonic leader within the Eurozone, it must find a way of stepping up to the responsibilities that are required of it. Germany must overturn this constraint on its domestic demand.

• The Need for Quick Action
Naturally policymakers will find it difficult to think about the two-fold radical moves that I have proposed: first debt reduction and consolidated, coordinated wage cuts, in Greece and Ireland; and, second, greater expansion in Germany. However, if my analysis is right, such moves are needed, and needed fast.


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