By Dimitris Kontogiannis
The market and many pundits think Greece’s exit from the euro is more likely after the election outcome on May 6 and the strength of the anti-bailout parties, especially the Coalition of the Radical Left (SYRIZA). Although this is unfortunately conceivable, there is still some room for a fair compromise between Greece and its creditors so the country stays in the eurozone and the euro project is not dealt a serious -- perhaps lethal -- blow along the lines described below.
There is no doubt the strong performance of anti-bailout parties in the last general election and the prospect of the Coalition of the Radical Left (SYRIZA) winning the next round on June 17 has shifted the balance toward a Greek exit. Feeling the pressure, the pro-euro political parties have put the renegotiation of the recent agreement with the troika high on their political agenda ahead of the next polls despite warnings by European Union leaders about a cutoff of loans if the country fails to respect its commitments.
“If Greece ends the reform process it has undertaken, then I can’t see that the respective tranches can be paid out,” German Foreign Minister Guido Westerwelle said recently. The communique after the G8 meeting this weekend was along the same lines: “We affirm our interest in Greece remaining in the eurozone while respecting its commitments.”
Analysts agree all these comments are aimed at warning Greek voters and political leaders alike that Greece’s eurozone membership will be in danger if voters elect a government next month which does not abide by the terms of the second bailout agreement. To this end, they are indirectly encouraging voters to support the pro-euro parties.
Many of them also agree that the direct cost of a Greek exit from the eurozone would be much greater than the cost of the bailout package to keep the country in the Union. Estimates put the eurozone’s total exposure to Greece at 300-500 billion euros or more, including the Greek central bank’s liabilities to the Target 2 payments system and ECB holdings of Greek government bonds.
In addition, the cost may turn out to be greater if contagion spreads to other eurozone periphery countries, especially Spain, necessitating unprecedented intervention by the ECB in the form of direct purchases of government bonds and the introduction of Eurobonds, which is strongly opposed by Germany at this point. Also, one should not discount the damaging economic and political ramifications for the euro project if a country’s membership turns out not to be irrevocable. On the other hand, the EU cannot afford to send the message to other periphery countries in bailout programs that they should expect to be funded without sticking to their reform commitments.
In this regard, we strongly believe there is room for a fair compromise between Greece and its creditors, which could take the following into account: First, the recognition that excessive austerity has made fiscal consolidation more difficult and contributed to a deeper and possibly more protracted loss of output than necessary. Second, there is no desire on the part of other eurozone governments to provide additional financing to cover Greece’s bigger-than-anticipated budget needs. Third, the implementation of structural reforms, barring some mutually agreed minor adjustments, cited in the second economic adjustment program is not negotiable.
In other words, the so-called MoU (memorandum of understanding) II will have to be split into two. Greece will reiterate its commitment to implementing the structural reforms promptly, especially those downsizing the public sector, but seek major changes in the fiscal policy framework to amplify its adverse impact on the economy without asking for extra EU/IMF funding and accumulating external debt payment arrears so it does not put IMF loans at risk.
One idea is to identify the excessive portion of austerity measures on the fiscal front by calculating the structural or cyclically adjusted budget balance. By recognizing that the actual budget balance is influenced by government policies as well the temporary ups and downs of the economy, policymakers can take restrictive permanent measures only for the structural component of the deficit and avoid inflicting greater pain on the economy than warranted. Thus they will facilitate the stabilization and recovery of the economy while pursuing fiscal consolidation.
The concept of the structural budget is not new in policymaking since it is already used in the eurozone for countries in the excessive deficit procedure. It is also an important part of the Fiscal Compact program pushed by Germany which requires that the annual structural deficit should not exceed 0.5 percent of GDP. Former deputy Finance Minister and economics professor Yiannis Mourmouras, who is advising New Democracy leader Antonis Samaras, is known to favor this approach in designing budget policy.
In Greece’s case, the actual budget deficit ended up at 9.1 percent of GDP in 2011 but the structural deficit stood at 5.4 percent of GDP, according to European Commission estimates based on the difference between actual and potential GDP growth rates. A similar pattern held in previous years, meaning fiscal policy should have been less restrictive than applied in addition to relying more on permanent expenditure cuts than tax hikes.
However, a financing gap is going to emerge, at least in the first year, if policymakers rely on the structural deficit rather than the actual budget deficit to prescribe austerity measures. One way to fill the gap created by the cyclical component of the budget without resorting to additional bailout financing, which is impossible given the circumstances, is that Greece could have been allowed to fund it via T-bills.
The latter could have been sold to local or foreign banks and the public. Greek banks could have used the emergency liquidity mechanism of the Bank of Greece instead of standard ECB repos so that the credit risk remained with the Greek central bank. Of course, quasi-money like bonds issued to pharmaceutical companies in the past could also have been used to fund the gap but this form of financing should have been avoided in our opinion.
There is no doubt Greece needs a strong, pro-reform government to emerge from the June elections. However, even if it is elected, it may not last long if it fails to come up with a realistic plan to turn the economy around without sacrificing fiscal consolidation and reforms. Greece’s EU partners should understand this and accept a fair compromise for the sake of the most important European project in history as well. Using the structural budget balance as a yardstick to design less punitive fiscal policies while the country pursues structural reforms may lead to a desirable outcome along with other pro-growth policies at the eurozone level such as the Growth Compact.