July 30, 2012
The Guardian Unlimited, July 30, 2012
It has been a bit over four months since the latest bailout of Greece was negotiated. This bailout featured a write-down of most privately held debt in exchange for further austerity measures.
It is already clear that Greece will not meet its deficit targets from this bailout, the main reason being that cuts to the budget have led to a much steeper recession than official forecasters had predicted. The Greek government now expects the economy to shrink 7.0 percent over the course of the year. That compares with the decline of 4.7 percent that the IMF projected for Greece back in April.
This was hardly the first-time that the IMF and other official forecasters had badly under-estimated the severity of Greece’s downturn. In April of 2011, the IMF had predicted that Greece’s economy would grow 1.1 percent in 2012, after shrinking just 3.0 percent in 2011. In fact, Greece’s economy shrank by almost 7.0 percent in 2011. And, in April of 2010 the IMF was projecting that Greece’s economy would be on a slow and steady growth path in 2012 after shrinking by just 1.1 percent the prior year.
Clearly things are not panning out as the IMF and the rest of the troika — the European Central Bank and the European Union — had planned. Budget cuts and tax increases in the middle of a downturn are having exactly the effect predicted by the old economics textbooks: they are reducing demand, slowing growth, and raising unemployment. Furthermore, since lower output means less tax revenue and higher unemployment means more payouts for unemployment benefits and other transfers, the austerity imposed on Greece is doing little to even bring down its deficits.
This is why Greece will almost certainly miss its deficit targets for this year. In principle, this is supposed to trigger a cutoff of funds from the European Union. That would lead to a default by Greece and force Greece to leave the euro and bring back the drachma.
That sounds very scary for Greece. This situation implies a full-fledged financial crisis. Banks will have no money to give their depositors, at least until the government can get the new currency printed up and distributed around the country.
Even in the best of circumstances this would probably take more than a week and quite likely take much longer. Running a modern economy on ad hoc credit and barter for even a week would not be pretty. If the transition to the new currency drags on for 3-4 weeks, the hit on the economy would be far worse. And even after the transition, there will be endless disputes to sort out concerning the rate at which debts and other obligations are transferred from euros to drachmas.
However as bad as this situation sounds for Greece, the troika, propelled by its leading actor Germany, fears this outcome even more. The issue for Germany is that Greece may provide a good example for other heavily indebted countries, most importantly Spain and Italy.
The period of transition will cause enormous economic disruption and pain, but once the new currency is in place, Greece’s economy can return to a healthy growth path. In the case of Argentina, another country that defaulted and broke the supposedly unbreakable tie of its currency with the dollar, the transition period was less than six months. It defaulted in December of 2001 and was on a robust growth path by the summer of 2002. It had regained all the ground lost due to the financial crisis by the summer of 2003 and continued to have solid growth until the worldwide economic crisis in 2008.
There are reasons why Greece’s economy can be expected to perform either better or worse than Argentina did a decade ago. We will only know for sure if it actually does go the default route, but even if it took a year to get back on a healthy growth path, Greece is still likely to look quite good to Spain and Italy. Both countries could easily face a decade of recession or stagnation on the troika’s path.
As long as no country takes the euro exit route, politicians can get away with telling their constituents that there is no alternative. They must accept the austerity prescribed by the troika no matter how painful it is. Once Greece leaves the euro, this is no longer a plausible claim. And, if the Greek economy turns around and grows at a healthy pace then the troika’s path is likely to prove unacceptable to the people of Spain and Italy.
This is the situation that Germany must fear. However many times Greece misses its targets, the troika is likely to come back and lower the goal post further. They don’t want anyone in the euro zone to recognize that there is an alternative to permanent austerity and they will make whatever concessions are necessary to ensure that neither Greece or anyone else ever discovers the truth.