Today an excellent article appeared in the FT by Gideon Rachman, arguing that further European economic integration in the form of a fiscal union with a European Treasury would not solve the Greek problem, and although I am in favor of moving towards fiscal union, I buy Rachman's argument that Greece is not a compelling reason to do so. Politically speaking though, anti-EU sentiment will continue to rise though unless a "Greek solution" is found - and this must be a lasting solution, not a patchwork solution as has been done so far. Patchwork solutions risk escalating the crisis into a full blown disaster, with the potential for a breakup of the euro, which would be in none of the participants' interest.
Would any student of economics be surprised that we've reached this impasse regarding Greece's situation in the euro? No, as the optimal currency area theory suggests that countries whose economies move together are better suited to a single currency, and any academic paper that I've seen since the mid-1990s which tries to operationalize this shows that Greece and several other periphery countries don't have economies that move with the core member states of the euro area.
So according to the academic research, Greece should not be in the euro, but we also know that as the Greek public finances were not complete when they were assessed for membership of the euro back in the early 2000s, they really shouldn't have been allowed to join the euro in the first place. And that is the conundrum here - it is clear to me that the Greek problem is not one that should lead to contagion - it just needs to be solved once and for all - but on the other hand in a monetary union it is not possible to treat Greece as an exception as what you do for one member state you have to do for them all - hence the EFSF.
To end this continuing crisis, I think Greece should be given a choice before it shakes political confidence in the EU and starts to destabilize the entire euro area as an entity ( - and here I'm not talking about contagion but rather that of credibility). So I would propose that Greece be given a choice - one of their choices should be to leave the euro and return to the Greek drachma so that they can effectively devalue their currency to stabilize their economy (after obviously having to default first), and all those Northern Europeans can then plan their (cheap) vacation in Greece for next summer! The other choice would be to insist that the Greek parliament change their Constitution so that a 2% of GDP primary budget surplus becomes enshrined into law - thus leaving the decision about how the fiscal policy restraint is going to be implemented up to the Greek parliament. In return for doing this the Greeks would have to submit to scrutiny of their public finances by the European Commission but all negotiations regarding debt issuance and rollovers would be taken from the Greek finance ministry and given to the EFSF to negotiate. In this way no new debt could be issued (by law) and all the markets would be concerned about would be the rollover of the existing debt and whether payments would be made on the debt. The EFSF would then also be in charge of making interest payments on the debt, with a maximum of 5% of GDP allowed under normal circumstances ( - which would imply a budget deficit of 3% of GDP, just inside the Stability and Growth pact limits). The interest payments would be billed to Greece.
What are the advantages of the first "Greek solution"? For Greece, obviously getting out of this mess - but that might be the best option if their politicians do not want to tie their hands. The real losers will undoubtedly be the bond holders, as they will have to take a big haircut given that many of the bonds that have been issued or rolled over are denominated in euros, or face almost certain default. The other big downside would be for the euro area which would have been seen to fail in its attempt to keep a wayward member in the fold. It's credibility would be mud for a few years, but the financial markets are myopic and that would soon pass.
What are the advantages of the second "Greek solution" I propose above? In my view it clearly leaves the decision about what to do up to the Greeks, but it also makes very clear that Greece has to pass some "retroactive" tests in order to stay in the euro area, tests that are not being imposed on other member states as they did not misrepresent their public accounts in the first place. Secondly, the financial role of the EFSF is enhanced, and presumably rolling over/issuing the debt will be easier as it is a European institution with much better credit than the Greek finance ministry that is doing the rolling over. Third, it also starts us on the road to further economic integration, in the sense of tying the hands of politicians at the member state level, and then allowing the EFSF to manage debt issuance. It is not fiscal sovereignty at the EU level, but it is a move towards financing public spending at a supranational level.