Europe cannot afford to let Greece default

Europe cannot afford to let Greece default

Opinion piece (Financial Times)
15 January 2010

The eurozone cannot afford to make an example of crisis-hit Greece. Claims by officials and politicians in the currency bloc's fiscally more robust economies - including Wolfgang Schauble, Germany's finance minister - that the Greeks will have to find their own way out of the crisis, are not credible. They ignore the fact that Greece's problems cannot be solved by it alone. Nor would a Greek default be the cleansing experience that many people in the stronger member states appear to imagine.

Eurozone members are rightly furious with the Greek authorities for falsifying budget data. But Greece is just the starkest example of the problems facing economies that have lost competitiveness within the eurozone and now have weak public finances and poor growth prospects. They must cut budget deficits while lowering costs relative to the rest of the eurozone, and this when economies such as Germany and the Netherlands are flirting with deflation and investors are jittery about sovereign risk. Yesterday, Greece announced plans to cut its budget deficit from an estimated 12.7 per cent of gross domestic product in 2009 to just 2.8 per cent in 2012. Given the country's dire economic prospects, cuts in spending of this order would lead to slump and deflation - crippling for a highly indebted economy - and threaten social stability.

If the eurozone fails to support Greece or makes the terms of any bail-out politically impossible for the country's authorities to meet, Greece could default on its sovereign debt. The eurozone would then face a big problem. The financial markets would quickly turn their attention to other euro bloc economies with unsustainable fiscal positions and poor growth prospects. Italy, Spain and Portugal would find themselves paying dramatically higher borrowing costs, raising the likelihood of further fiscal crises. Such a scenario would almost certainly deter the European Union's remaining central and eastern European member states joining the eurozone any time soon. And the political fallout would be huge.

Moreover, if a eurozone member defaults, the risk of it leaving the currency union cannot be completely discounted. If Greece defaulted and remained in the eurozone it would still be deeply uncompetitive. The Greek government would still find it difficult to tap financial markets on affordable terms, because investors would be sceptical about growth prospects. Leaving the eurozone and devaluing would be very high risk but provide a route back to growth, at least short-term, and that could prove a political necessity. A partial unravelling of the eurozone would do the EU incalculable damage.

Of course, Greece, as well as Italy and Spain, have to get serious about boosting productivity and confronting widespread public-sector rent-seeking. But Germany (and other members running big structural current account surpluses) also need to accept they are part of the problem. It makes little sense to argue that weaker member states should try to emulate Germany. A big reason for the relative strength of Germany's public finances is the size of the country's trade surplus with the other eurozone economies. But this is hardly something all eurozone states can aspire to: one country's surplus is another's deficit.

One disturbing trend of the last few months is that Germany's surplus with the rest of the eurozone is rebounding rapidly from the crisis, despite extreme economic weakness elsewhere in the bloc. The German economy is recovering on the back of exports; private consumption is actually falling. The weakness of domestic demand will no doubt lead to renewed falls in real wages and to a further decline in Germany's trade-weighted exchange rate within the eurozone. But it will be all but impossible for the likes of Spain and Greece to put their public finances in order unless they can get their economies growing. For this, they must rebalance their trade with the rest of the eurozone.

The eurozone needs tougher fiscal rules. But it also has to set limits on intra-eurozone current account surpluses and deficits. Fiscal rules will mean little without the latter. The alternative to such rules is a fiscal (hence political) union. This would involve the "stronger" economies transferring money to the "weaker" ones on an ongoing basis, much as happens within individual member states. No one appears to want this, least of all the "strong" countries.