Lessons of the 1990s may provide direction for current problems

Greece is in a precarious situation despite the decision by EU leaders last week to pledge their strong support and essentially eliminate the risk of sovereign default. It is clear the country will have to make even tougher fiscal reforms to secure much-needed access to liquidity in the coming weeks. In this regard, it will be much more difficult for Greece to repeat the success of the previous decade in cutting the budget deficit and stimulating growth. However, the government has a lot to gain from taking a look at the lesson to be learnt from the 1990s. If the pundits are right, Greece will first have to consent to additional measures to cut its budget deficit by 4.0 percentage points of gross domestic product (GDP), irrespective of general economic conditions, and then have the EU cavalry provide any necessary funding. It should be remembered that the Treaty on European Union has an explicit «no bailout clause» in Article 125, which means that underwriting Greek debt is neither likely nor feasible. Greece also cannot expect direct help from the European Central Bank (ECB) but funding via repurchase agreements remains an option according to legal experts. However, the general clause in Article 122 of the Treaty provides a way to help a member country. «Where a member state is in difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council… may grant financial assistance to the member state concerned.» This aid could take the form of front-loading the 20 billion euros in structural funds designated for Greece between 2007-2013. Since the country had yet to absorb some 18 billion euros until recently, the EU Commission could decide to disburse an amount. Also, a private bank consortium could be formed to buy Greek bonds backed by some EU countries. However, a bilateral loan to Greece from EU countries, probably led by Germany and France, is the most probable solution but will be provided under punitive terms to push Greece toward taking painful measures. Thus, the loan might be easier sold by governments to the public in Germany and elsewhere. The punitive terms of the loan may explain the Greek Premier George Papandreou’s speech to the Cabinet on Friday, in which he implicitly criticized other European countries, the ECB and Eurostat. The speech, which appears to have made things worse by all accounts, has more than one interpretation. Some think it was an expression of dismay at the stricter measures demanded by some EU leaders. Others reckon it was intended to prepare the domestic audience for the tougher measures to come and blame it on prominent EU figures and institutions and others see it as a signal that he lost his cool. In the meantime, and as long as Greece does not give in to the demands of its EU partners, it is reasonable to expect that markets will keep up the pressure on Greece by keeping the spreads of local bonds over Germany at elevated levels, but also taking into account the strong statement of support of EU leaders. This means the markets may hesitate to take Greek yield spreads to recent post European Monetary Union highs, although this may become a reality if the country seeks to raise a good amount of money, that is 5 to 10 billion euros, by issuing a 10-year bond in the next couple of weeks. By taking stricter fiscal measures to close the budget gap, the local economy is more likely to undergo a more severe recession than many thought this year, and perhaps next. The government is pinning much of its hopes for a soft recession in 2010 to a boost in the tourist and shipping industries in the second half of the year, as the global economy and trade recover from the global financial crisis. They also hope the de-escalation of interest rates and bond yields following the adoption of the austerity measures and the strict implementation of the country’s Stability Program will help in coming months. Still, the pinch of more and higher taxes on consumers and businesses looks to be more severe than the Greek economy can withstand, despite some help from the tourist industry in the second half. The deep fiscal retrenchment means it will be more difficult for Greece to repeat the success of the 1990s, when it cut its budget deficit from some 14 percent of GDP in 1993-1994 to close to 3 percent in 2000 while growing. It did so by counting on falling inflation and nominal interest rates, though real interest rates remained high to support the strong drachma policy during most of that period. However, the current government can benefit in policy decision by looking at the lesson of the 90s, which is quite simple. The Greek economy can grow at a faster clip if you liberalize markets, such as the banking sector back then, and downsize the public sector to improve the allocation of resources, even if real interest rates are high and fiscal consolidation does not help.