The New York Times, May 12, 2010
International Herald Tribune, May 12, 2010
Perhaps the wild swings in financial and stock markets over the last week will make people give closer scrutiny to what is going on in Europe, which would be a good thing for the world. According to most news reporting, markets are worried about a potential default by Greece on its sovereign debt, and the possibility of this spreading to other countries, including Portugal, Spain, Ireland and Italy.
The agreement by the European Union and International Monetary Fund to provide up to $960 billion of support to the weaker economies, as well as to financial markets, has appeared to calm investors worldwide for now.
But this does not resolve the underlying problem, even in the short run. The problem is one of irrational economic policy. The Greek government has reached an agreement with EU authorities (which include the European Commission and the European Central Bank), and the IMF that will make its economic problems worse.
This is known to economists, including the ones at the EU and IMF who negotiated the agreement. The projections show that if their program “works,” the country’s debt will rise from 115 percent of GDP today to 149 percent in 2013. This means that in less than three years, and most likely sooner, Greece will be facing the same crisis that it faces today.
Furthermore, the Greek finance ministry now projects a decline of four percent of GDP this year, down from less than one percent last year. However these projections are likely to prove overly optimistic. In other words, the Greek people will go through a lot of suffering, their economy will shrink and the debt burden will grow, and then they will very likely face the same choice of debt rescheduling, restructuring or default – and/or leaving the Euro.
There are lessons to be learned from this debacle. First, no government should sign an agreement that guarantees an open-ended recession, and leaves it to the world economy to eventually pull them out of it. This process of “internal devaluation” – whereby unemployment is deliberately driven to high levels in order to drive down wages and prices while keeping the nominal exchange rate fixed – is not only unjust, it is unviable. This is even more true for Greece, given its initial debt burden. The tens of thousands of Greeks in the streets have it right, and the EU economists have it wrong. You cannot shrink your way out of recession; you have to grow your way out, as the United States is doing (albeit too slowly).
If the EU/IMF will not offer a growth option to Greece, it would be better off leaving the Euro and renegotiating its debt. Argentina tried the “internal devaluation” strategy from mid-1998 to the end of 2001, suffering through a depression that pushed half the country into poverty. It then dropped its peg to the dollar and defaulted on its debt. The economy shrank for just one more quarter and then had a robust recovery, growing 63 percent over the next six years. (By contrast, the “internal devaluation” process promises not only indefinite recession but a long, very slow recovery if it “works” – as we can see from the IMF’s projections for Latvia and Estonia. These countries are projected to take 8 or 9 years to reach their pre-recession levels of output.)
The EU authorities sent markets crashing last Thursday by saying that they had not discussed using “quantitative easing” – i.e. the creation of money, as the U.S. Federal Reserve has done to the tune of $1.5 trillion in the last couple of years – to help resolve the situation. They also made statements that more deficit reduction is needed by countries that are still in recession or barely recovering. The new agreement reached over the weekend partially reverses these statements, but not enough.
The pundits are quick to blame Greece and the other weaker European economies (Portugal, Italy, Ireland, Spain) for their problems. Although they did – like most of the world – have excesses such as asset bubbles during the boom years, they didn’t cause the world recession that sent their deficits skyrocketing. Most importantly, the real problem now is that the EU/IMF is still offering them the medieval medicine of bleeding the patient. Until that changes, expect a lot more trouble ahead.