Greece warned on credit and growth risks

Wise policies and targeted measures are fully compatible with each other in order to restore confidence to markets, suggests European Central Bank (ECB) Vice President Lucas Papademos, who is also Greek. He tells Kathimerini in this interview that countries with a high public debt and low competitiveness, such as Greece, cannot expect the euro to shield them forever. Over the past few years, some eurozone countries have experienced a combination of relatively high inflation and widening current account deficits, which, in some cases, came with excessive budget deficits. Do these countries face additional and specific risks during the ongoing financial crisis? How effectively a country can weather the global financial crisis depends on the strength of its productive and financial structures, its international competitiveness and the soundness of its macroeconomic policy. Eurozone countries that experienced higher inflation than the monetary union’s average over a long period of time lost international price competitiveness and this is reflected in the widening of their current account deficits. Fiscal imbalances also contributed to the buildup of inflationary pressures, the erosion of competitiveness and the increase in external indebtedness. In EU countries outside the eurozone, such developments would have entailed pressures on their currencies and their domestic money markets. The single European currency shields the eurozone countries from currency market pressures and inflation risks, but it can not protect those economies with low competitiveness and high public debt from growth risks and credit market pressures. In conclusion, the total impact of the global financial crisis on a country’s economic performance fundamentally reflects the degree of its international competitiveness and the magnitude of its internal macroeconomic imbalances. The specific type of risks and their relative impact on inflation and growth performance will depend on whether that country participates in the monetary union. Eurozone economies with lower competitiveness, wider current account deficits and significant fiscal problems are likely to face greater growth and credit risks. In recent months, the spread between the yields on Greek and German government bonds widened significantly. In the past week, this spread reached the highest level since Greece adopted the euro. What are the reasons for these developments and what are the potential consequences? In an environment of increased risk aversion, investors differentiate more than in the past on the prices they are willing to pay to buy financial assets associated with different perceived risks. Although there should be no doubt that Greece will honor its debt obligations, the widening spread reflects uncertainty and concern about the country’s fiscal situation, given the high level of Greek public debt. If the spread remains at high levels, the cost of servicing the public debt will increase and the budget deficit will widen, threatening the sustainability of public finances. Markets demand greater fiscal discipline and a systematic effort toward fiscal consolidation. Developments in the market for government securities confirm the view that the global financial crisis entails increased credit risks for countries with large budget deficits and high public debt. In these countries, credit risks should be addressed by implementing a consistent and credible medium-term fiscal policy that will ensure the sustainability of public finances. Some economists argue that eurozone countries with budget deficits can postpone their efforts to reduce them and should pursue an expansionary fiscal policy in order to address the adverse effects of the financial crisis on economic activity. What is your response to this point of view? Neither economic logic nor prevailing market sentiment support this point of view for countries with large budget deficits and high public debt. In these countries, an expansionary fiscal policy is not the proper way to address the potential impact of the global financial crisis on domestic economic activity. On the contrary, a prudent fiscal policy, which could also include some targeted measures to mitigate the effects of the crisis on vulnerable social groups, will boost confidence, reduce financing costs and thus support the recovery of economic activity. The ECB faced an unprecedented crisis of confidence in the banking system. How true is it that the ECB could not have predicted the crisis? In fact, the European Central Bank, as well as other central banks and international institutions, had warned well before the outbreak of the crisis – in some cases more than a year earlier – that there were several and growing risks and vulnerabilities in the financial system that could adversely affect its stability. We had warned on various occasions that the overvaluation of housing and nonresidential properties in a number of countries, the excessive credit expansion, the high and increasing leverage of financial institutions and the complexity of new structured credit products entailed risks and signaled financial market excesses. These developments partly reflected the insufficient appreciation and ineffective management of risk that sooner rather than later were going to lead to a substantial market correction. The warnings issued by the ECB and other authorities and the associated recommendations were largely ignored. Markets did not listen, or did not want to listen. Therefore, the official warnings did not affect the behavior of financial institutions and other market participants until certain events triggered the inevitable market adjustment. It is true, however, that the severity, scope and duration of the financial turmoil that followed had not been foreseen by the authorities. In view of the threat of a deeper crisis in the real economy, should the ECB not have cut its interest rates faster, as the US Federal Reserve and the Bank of England have done? The timing and size of a cut in the policy rates of a central bank depend on its own assessment of the prospects for achieving its main objective and other policy goals, as well as the perceived uncertainty and risks. Obviously, we cannot predict the future with certainty and assessments about the medium-term outlook are especially difficult during turbulent times. The relevant assessments of different central banks are not identical and they should not be expected to be the same. As for the future, the risks to price stability appear to be balanced, but they may tilt toward the downside. If this is confirmed, a further easing of monetary policy would be advisable. We will assess carefully the economic and monetary situation and the outlook for price stability on the basis of the latest data, other information and our comprehensive risk analysis.

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