Greece – Looking at alternatives to the euro

euro-debtInteresting paper from 2012 on the extreme difficulties of staying within the euro currency – especially now that it is clear that Germany and its band of desperate governments are locked into a hard austerity framework. The paper has relevance today.


See full paper

Executive summary below

This week the Greek government reached agreement with the European authorities and the IMF for 130 billion euros in lending, as part of a new adjustment package to replace the current IMF program that began in May of 2010. Although the agreement should allow the government to avoid default in March, there are grave doubts as to whether the agreed upon program will lead the country to a point where it returns to growth, has a sustainable debt burden, and can borrow from private markets.

The most important problem with the commitments that Greece has made in the past two years is that its fiscal policy is pro-cyclical – that is, the government has been, and is committed to, tightening its budget while the economy is in recession. In 2010-11, the Greek government adopted measures to cut spending by 8.7 percent of GDP.

But the economy continues shrinking and this makes it even more difficult to make revenue targets. The IMF has consistently underestimated the loss of GDP for Greece, lowering its projections by a huge 6.9 percent since its First Review of the Stand-By Arrangement in September 2010. Twothirds of this drop came in the five months between its Fourth and Fifth Review (December 2011).

Although most of the planned adjustment for 2012 is in the form of revenue increases, the IMF’s Fifth Review states that there must be a shift toward spending cuts in 2013-2014. This will increase the risk of further prolonged recession. The IMF program also assumes very large revenues from privatization – about 15 percent of GDP over the next two years, and 22 percent of GDP by 2017. But very little in the way of revenues has been forthcoming from privatization in the past two years, and the Fifth Review notes that lower revenues from privatization could by themselves put the 2020 debt/GDP ratio at 138 percent, instead of the target 120 percent.

The program could also easily be derailed by lower growth. Given the current shrinking of the eurozone economy, this seems quite possible.

On Monday, there were press reports based on a leaked document prepared for the European finance ministers, which contained a much more pessimistic scenario for the Greek economy. In this scenario the debt was explosive and Greece would need “about €245bn in bail-out aid, far more than the €170bn under the “baseline” projections eurozone ministers were using.” Debt would be 160 percent of GDP in 2020. Given the underestimation of GDP losses by the IMF so far, and the failure of the European authorities to recognize the negative impact of fiscal contraction, the more pessimistic scenario may turn out to be more realistic.

The economic costs of Greece’s adjustment have already been quite high; using the IMF’s projections and updating them with the most recent data, if the economy begins its recovery later this year it will have lost 15.8 percent of GDP from its pre-recession peak. This would put Greece among the worst losses of output from financial crises in the 21st and 20th centuries.

Greece also now has the highest interest burden on its public debt of any EU country, at 6.8 percent of GDP; only two other countries are even in the 4 percent range (Italy and Portugal). There are CEPR More Pain, No Gain for Greece z 2 very few countries in the world with a higher interest burden than Greece, and it is unlikely that it will be brought below 6 percent even with the planned debt restructuring.

The social and human costs of Greece’s recession have also taken a large toll. By the Greek national measure, unemployment hit a record high in November at 20.9 percent of the labor force. The IMF’s last projections show Greek unemployment still at 17 percent in 2016, and this is likely to be raised. The IMF’s projections for unemployment in 2013 have increased between the first and fifth review, by more than a third, from 14.5 percent to 19.5 percent. Employment as a percentage of the working age population is now less that it was in 1994. There have been large increases in suicides and violent crime, and access to health care has declined.

The Greek government has agreed to reduce government employment by 150,000 workers by 2015, to cut the minimum wage by 20 percent (and by 32 percent for those under the age of 25); and to weaken collective bargaining. All of this will have the effect of reducing living standards for workers and redistributing income upward.

The economic theory behind these changes is that of “internal devaluation,” in which wage costs, lowered by the recession and high unemployment, are pushed down far enough so that the economy becomes more competitive internationally and can recover through exports. But after four years of recession and reaching record-high unemployment, Greece’s Real Effective Exchange Rate is still higher than it was in 2006. In other words, there has still been no internal devaluation.

The paper also briefly looks at the alternative of a planned default and exit from the euro, considering that such an outcome might happen in any case due to recurrent crises and continued recession. The case of Argentina’s successful default and devaluation is one relevant comparison. Argentina unsuccessfully tried an internal devaluation during three and a half years of recession beginning in mid-1998. After default in December 2001 and devaluation a few weeks later, the economy shrank for just one quarter (a 4.9 percent loss of GDP), but then recovered and grew by more than 63 percent over the next six years. It took three years for Argentina to reach prerecession GDP; Greece is currently projected to take more than a decade. Contrary to popular assertions, the Argentine recovery was not a “commodities boom,” nor even an export-led growth experience. Rather, it was led by domestic consumption and investment, which was only possible after Argentina was able to abandon the “internal devaluation,” pro-cyclical policies that the government – like that of Greece today – had been committed to. It’s also worth noting that Greece’s exports of goods and services are currently about twice the level of Argentina’s before its default/devaluation, relative to GDP.

The authors conclude that the default/exit option should be taken seriously for Greece as an alternative to the current projected scenarios.

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