Greek Debt and the European Dilemma Jayati Ghosh

It is now clear that the problems of the Greek economy – and the eurozone – have not been and cannot be solved by the large infusion of emergency finance from the ECB and the IMF. The Greek government is being asked to implement austerity measures that will cause a major decline in incomes and employment not just now but in the foreseeable future, and which will not correct the existing imbalances but actually worsen them.

The heavily-indebted poor countries (HIPCs) of Africa could tell the Greeks a thing or two about this process. They could tell them how the deflationary measures that are imposed on governments cause economic activity to go into a downward spiral that destroys existing capacities and prospects for future growth, and pushes large sections of the population into a fragile and insecure material existence. They could tell them about how it is fundamentally unsustainable, because the downslide in GDP makes it ever harder to service the debt, which in turn keep not only piling up but even expanding because of the unpaid interest that keeps getting added to the principal and then compounded, so that the country’s debt just keeps rising even with no fresh inflows. They could tell them how ultimately there will be no alternative to restructuring the debt, because the problem will only grow in magnitude even with (and partly because of) the most stringently applied austerity measures. They could tell them about their own experience of several lost decades of economic retrogression, which could have been avoided had the debt restructuring taken place much earlier and a different set of policies for economic recovery been pursued.

Austerity programmes that involve cuts in public spending will have a depressing impact on the economy and make it much harder to “grow” out of the crisis. In the Greek case, in the pre-crisis period the public sector contributed around 40 per cent of GDP, so cutbacks here are likely to have very large negative multiplier effects, lowering economic activity and therefore tax revenues, and perversely making it harder to reduce the budget deficit. In the case of the US in the middle of the crisis in 2008 and 2009, everyone (including the IMF) agreed that it was necessary for the US government to spend more in order to help the economy recover and keep incomes from collapsing. That economic logic does not disappear in the case of other countries.

This experience should point to the obvious lesson: that there is no alternative to a major restructuring of the Greek debt, involving a loss taken by the international lenders who did not exercise due diligence in the act of lending in the first place. If it does not happen now, it will in any case have to happen at some time in the future, after creating a great deal of material distress in Greece.

Part of the problem is that when a country is seen to be in payments difficulties, markets force a major increase in the costs of servicing such debt. This is the sense in which what is happening in Greece today is similar to what has already happened in a number of other countries, mostly developing ones, because interest payments rise as the debt is seen to be more risky. In a sense, a lot of restructuring is already occurring in secondary markets where the price of Greek bonds has tumbled. Such losses are occurring for banks all the time in the private sector, and they are usually able to handle it. The point is to give that advantage to the Greek government, rather than to elements outside the economy, so that the government has more fiscal room for maneouvre and can try to generate an economic recovery rather than add to the slump.

The recent case of Argentina shows that such a restructuring can occur without really damaging a country’s international position (or fundamentally harming the banks involved or reducing their ability to lend) and can in fact contribute to growth prospects. (Of course Argentina had the advantage of currency depreciation, having abandoned the currency board arrangement that tied the peso to the US dollar in the midst of its financial crisis in 2001.)

Why is such an obvious conclusion not even being talked about? One likely reason is that a restructuring of the Greek debt would involve quite a large haircut for the German and French banks who lent extensively during the boom, and helped to create the imbalances that have made the Greek economy less competitive than that of Germany, for example. This cannot be allowed to happen because of the greater lobbying power of finance, so the burden of adjustment is being placed entirely on the Greek people, for several generations, in what will clearly be an unsustainable process.

It gets worse. Other countries that are seen to have potential problems like Greece are already moving towards austerity measures and contractionary macroeconomic policies that are bound to threaten the frail economic recovery and engender or intensify the next recession. Spain has just announced not only tightening of monetary policies, but fiscal contraction involving cuts in public sector pay and pensions and much else. This is particularly remarkable because until two years ago Spain ran a fiscal surplus (the deficit was because of the private sector) and its recent deficits are entirely a result of the crisis.

Ireland is already undergoing the most extreme deflationary package involving significant decline in GDP and slashing of public expenditure in all sorts of areas from physical infrastructure to education. The Baltic countries, not only Latvia which has an IMF programme but Estonia where the pain is self-inflicted, are experiencing dramatic declines in incomes, employment and wages because of their severe austerity packages. In Romania there was the recent remarkable spectacle of policemen taking to the streets to protest against their wage decreases. In Britain the new government is already talking about measures to cut the deficit by slashing spending and raising indirect taxes.

All these countries are hoping that they can export their way out of this mess, but that is simply not feasible as he numbers do not add up. It is close to ridiculous to expect Greece to be able to export its way out of trouble. It is not only that Greece is a member of the eurozone and therefore will require really sharp declines in price to appear competitive relative to trading partners. It is also that most of Greece’s trade is with other countries in the eurozone. This means that even tourism (a major foreign exchange earner) will not generate more volume without significant price falls. But in general, obviously every country cannot hope to export its way out of growth, because of the fallacy of composition, and the suppression of domestic demand will only make it harder for other countries to use exports to grow. In fact the European Union as a whole will head for a major recession if all its members try to rely on export-led growth. So these countries – and by association, the rest of Europe – are effectively condemning themselves to a period of stagnation or declining incomes, with all the economic and social problems that will generate.

How can such an illogical set of policies be taken so seriously? The problem is that the power of finance – in politics, in media and in determining national and international economic policies – remains undiminished despite its recent excesses and failures. That is why the restructuring of public debts is not on the agenda; that is why talk of fiscal balancing so rarely even mentions taxes on capital, and much less on the same financial sectors that benefited from large publicly funded bailouts and are now holding to ransom the hands that have fed them.

If the power of the financial class cannot be curbed in any fundamental sense (as seems to be the case at present) then the opportunity costs of continuing with a currency union without a political union become higher every day and may reach the turning point at which countries decide it is no longer worth it. So if the eurozone is to survive intact (without forcing the exit of some members like Greece) there must be much more significant fiscal federalism than has yet been seen. The relatively stingy attempts to provide emergency finance at interest rates that are still high do not constitute real fiscal federalism. Basically some institution in Europe must be able to play the role that the US federal government currently plays vis-à-vis Florida or California. Without such a (fairly major) commitment, it is difficult to see a long-term future for the current eurozone.

(Some sections of this article were originally published in the Guardian on 17 May 2010