Monday, May 10, 2010

Ross Buckley on the Greek financial crisis

The whole world could come acropolis
An edited version of this opinion piece by Australia 21 Fellow Ross Buckley appeared in the Sydney Morning Herald, 10 May 2010

The global media has focussed on how Greek profligacy and deception have caused the current financial market troubles. Greece has been spending with abandon, and the Greeks have admitted they manipulated their deficit to gain entry to the Eurozone in 2001, and have since disguised their debt levels using the creative ‘financial engineering’ of Goldman Sachs.

But this is only half the story. 

The seeds of Greece’s, Portugal’s and Spain’s problems were all planted along with the birth of the Euro. Furthermore, their problems have been exacerbated by the access to abundant, cheap credit afforded by the Euro.

From the outset, everyone knew a common currency for economies as disparate as those in Europe was going to be a huge challenge. So all Euro nations made binding commitments to keep their budget deficits below 3% of GDP, and their total debt below 60% of GDP. The idea was that fiscal prudence would carry the day.

The first problem arose in implementing these commitments. Today 14  of the 16 Eurozone countries have debt levels above 60% of their GDP and from 2002 to 2004 even France and Germany breached the deficit rules, a dangerous precedent.

But the bigger problem is the one nobody mentions – the relative competitiveness of economies. Greece introduced the modern drachma in 1954 with a value of 30 to the US dollar. Slowly but steadily the drachma’s value fell, so that by the late 1990s it took 400 drachma to buy a US dollar. This long slow devaluation allowed Greece to remain competitive.

Adopting the Euro ended the long-term trend of southern European currencies slowly devaluing against northern currencies, primarily because the Southern economies were less competitive.   

A report of the European Commission this January estimated the real effective exchange rates for Greece, Spain and Portugal were overvalued by well over 10%. Given devaluation is not an option, wages and prices have to fall by well over 10% for these economies to regain their competitiveness – and that will be an extremely painful process.

In short, if Greece, Portugal and Spain had their own currencies, market forces would mean they were worth much less than the Euro. And the converse applies: if Germany had its own currency, it would be worth much more than the Euro. Germany runs massive trade wurpluses partly because its undervalued currency makes its exports highly competitive. The US rages against China for undervaluing the Renminbi. Yet the Euro is undervalued for Germany, which profits from this precisely as does China. 

So there is some real justice in Germany having to fund the largest share of the Greek bailout. Furthermore, the Euro 110 billion ($157 billion) bailout is essentially of Europe’s banks. It will replace loans currently owed to European banks with loans owed to the IMF and European countries. Germany’s banks are the largest creditors to Greece so Germany will really just be rescuing its banks with its taxpayer funds. None of this helps Greece.
And the really bad news is that the bailout is highly unlikely to work, for it is the wrong medicine.

A bailout is medicine for a liquidity crisis. Yet careful study of the figures suggests Greece’s crisis goes deeper than liquidity, to solvency. The severe austerity measures that accompany the bailout will shrink the economy, reduce the tax base and make servicing Greece’s debt much more difficult. As Greece is highly unlikely to be able to service its debt ongoingly; the bailout is only postponing, and worsening, the inevitable. Credit markets are now anticipating this outcome, as yields of over 18% on two-year Greek government bonds indicate.

What Greece needs is a major devaluation and a debt restructuring involving the cancellation of a sizable proportion of its debt. A devaluation is not possible without breaking apart the Eurozone. A restructuring and partial debt cancellation would require political courage and decisiveness Europe never displays. The only other likely option is default, and the question merely when it occurs.  

Unless Spain and Portugal act with rare alacrity to reduce their wage rates and other costs in absolute terms (which is generally a political and social impossibility) Greece’s problems will probably flow on to Spain and Portugal, and the disaster that currently afflicts a nation which produces only 3% of the Eurozone’s GDP will spread to two countries which together produce 20% of its GDP.

As this contagion spreads, expect global capital markets to seize up, as they did post-Lehman’s collapse. European and American banks are only in business today because governments acted decisively in late 2008 to bail them out with taxpayer funds. But how are sovereign balance sheets to be stretched to fund more bailouts, especially if EU nations now bailout Greece?

Unpalatable as it is, the IMF and Europe now need to attach generous restructuring terms to the bailout, so that creditors write off perhaps one-half of their loans and Greece will be able to service its debts. This will be bitter medicine. However, any other course of action will likely turn Greece’s problems into a global crisis worse than the last one.  

Ross Buckley
Professor of International Finance Law
University of New South Wales

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