The Greek Tragedy Unfolds

Greece is currently waiting to hear whether a rescue package will be forthcoming from the European Union or whether it needs to go cap in hand to the IMF. Many people living outside Europe will probably think “so what?”. Indeed there are lots of cases of countries in trouble with high levels of debt, where they have gone to the IMF for help so what’s different here? I would say that Greece is different because it is also a member of the euro area and the European Union, so a default potentially threatens other highly indebted euro area member states, notably Spain and Portugal, with a much more direct link than is usually the case.  The link being the fact that they all use the same money, the euro. As Paul Krugman has pointed out (see his blog at http://krugman.blogs.nytimes.com/2010/02/09/anatomy-of-a-euromess/), Greece is a relatively small country so it’s debt is small but Spain is not so small and would be next on the list if contagion occurs. It’s now got so serious that the ECB is meeting tonight (2/10)by teleconference to discuss what to do ( see http://www.bloomberg.com/apps/news?pid=newsarchive&sid=adO.ysWPeJyQ).

What is interesting to me though is how we got into this mess ( - some people are mentioning the Olympics [see the photo above] as one obvious culprit), as well as what could and what should be done about it.

First, the European side of things. Back in 1997, Germany was getting nervous about which countries might qualify to get into Economic and Monetary Union (EMU) which was due to adopt the euro in 1999. Who would get into this “elite” club was to be decided by economic criteria that were set up as part of the Maastricht Treaty. The Maastricht Treaty (Article 103, Section 1) of 1991 clearly states that:

The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

But Germany was afraid that the Maastricht criteria for joining the EMU was only applicable at a single point in time, and the so-called “no bailout” clause was too weak in the face of some kind of emergency in the financial markets that threatened fiscally profligate member states. So the Germans negotiated the so-called “Stability and Growth pact” (SGP) which was not incorporated into the Treaty in any subsequent revision, but was passed as a “directive” which could be revoked without having complete unanimity. In simple terms the SGP said that government budget deficits had to be below 3% of GDP unless there was a recession going on, in which case this level could be overrun on a temporary basis. If there was no recession, a long process kicks into action whereby the member state is given time to correct the situation after which non-refundable fines are levied and the proceeds shared out between the other member states. When France and Germany overran this 3% level back in 2004, a decision was made not to kick start the process, which looking back at what is now happening was a mistake, as it made the SGP completely toothless. For more on all this see my research on the SGP at http://faculty.tamucc.edu/pcrowley/Research/workingpapers.htm and go down to the SGP heading)

So, what’s happened with Greece? Well Greece has run up large debts, mostly through not having good tax collection systems in place and also through not having properly functioning public accounting mechanisms that accurately report the deficit, so that new administrations always seem to dramatically revise debt levels upwards. Only recently another €40 billion of debt was “discovered”, and to try and shrink the debt and deficit levels Greek GDP was revised upwards by including “black market” transactions into the GDP calculations. Of course the SGP doesn’t swing into action on deficit levels retroactively, only on prospective budget deficits, so Greece didn’t worry too much about sanctions under the SGP. But as my research points out, it’s a little crazy to put sanctions on a member state that has public finance problems as you’ll make things worse, not better!!

Second, what is interesting about the Greek case, is that Greece (and other highly indebted “olive” member states) have been benefitting from the low interest rates in the euro area as the area is still dominated by the big players who have lower levels of debt together with low inflation. Even with these low interest rates Greece has clearly not been able to get a grip on its public finances, so when the possibility of a creditworthiness downgrade was raised by the rating agencies, the markets sat up and took notice!

So what could be done? I would say there are 3 options:

i) Nothing. Greek debt is not that high (120% of GDP) compared to say Japanese (over 200% of GDP) and is comparable with Italian debt levels (at around 115% of GDP), so as long as Greece doesn’t default on it’s payments, who cares?

ii) Deny an EU bailout and point Greece towards the IMF. As the Maastricht Treaty states, Greek debt is Greek debt, so the Greeks need to sort out their own house.

iii) Allow an EU bailout, but with stipulations. This is the option currently under discussion, and is probably the most interesting of the options, but most problematic in my view.

The danger in i) is that if the credit rating on Greek debt is lowered, this could create contagion with other member states being next in line. That might tarnish the appeal of the euro area significantly, eventually leading to some departures from the euro area. I doubt it would lead to a collapse of the euro area as some have predicted. The danger as well with i) is that nothing happens in Greece and they have no incentive to put their public finances in order.

The second option is perhaps the most attractive from a strict interpretation of the European rulebook. The “no-bailout” clause is there for a reason, and although Greece has largely escaped scrutiny under the SGP rules, it is basically Greece’s decision about what to do. The good thing about this option is that the “conditionality” that comes with IMF loans would make it essential that Greece clears up it’s public finance mess. The danger for the euro area is the same as under i) – contagion, and nasty effects on member states that may have transparent public finances and lower levels of debt than Greece. But in the financial markets, perception is everything, so contagion cannot be ruled out, but it can't be ruled out under any of these options.

The third option is the least attractive in my judgement. There is talk of arranging some kind of bailout under Article 100, section 2 of the Treaty on European Union:

Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, acting by a qualified majority on a proposal from the Commission, may grant, under certain conditions, Community financial assistance to the Member State concerned. The President of the Council shall inform the European Parliament of the decision taken.

But this would be a “generous interpretation” of the rule, as I don’t see any natural disasters or exceptional circumstances beyond the control of the Greek government. It would also set the stage for bailouts for other member states if and when there is any contagion. The “conditionality” just isn’t there either, so would not give the Greek government any incentive to clean up it’s public finances. So in my view the worst of all possible worlds, not just because it leads to so-called "moral hazard" in the future ( - who needs to worry about public finances when the SGP is toothless and you get bailed out in any case!!), but also because it obviously poses questions about the legitimacy of the European Treaty of Union if noone abides by the letter of the law.

Now there are those who are much closer to the action such as the authoritative Tony Barber of the FT (see http://blogs.ft.com/brusselsblog/2010/02/at-long-last-a-crisis-driven-big-leap-to-european-integration/) who think that this crisis will lead to the "leap forward" that European integration clearly requires if the monetary union is to be firmly entrenched within an integrated Europe, both from a fiscal point of view and a political union point of view. I doubt this. Unless the crisis becomes more widespread, and of course it might, I don't think the Greek crisis will prompt a re-think by the euro area members to press ahead with more integration in a "two-speed" set up and cede more powers to Brussels.

So in summary we got into this mess because we didn't set up a good SGP in the first place, and then secondly we didn't do the appropriate reforms to it and incorporate it into the Maastricht Treaty to give it some teeth.  What should be done now?  Tell Greece to go to the IMF and abide by the European Treaties otherwise what might be at risk is the entire euro area construct.