Looking beyond the debt horizon in Greece
The public debate has so far overwhelmingly focused on the question of debt, and, indeed, this is the most pressing issue. But, focusing on the debt and how to deal with it often hides from view the medium-term obstacles to growth.
To focus attention on the difficulties involved in resuming growth, let us imagine the most favorable outcome to the debt problem and assume that Europe goes ahead with forgiving all Greek debt in excess of 60 percent of GDP (the Maastricht Treaty limit). Will that be enough to get on a growth path, so that Greek GDP per capita converges with the European average income?
The first priority would be to make sure that Greece regains the confidence of the markets and is able to borrow at ?reasonable? rates. The assumed large debt forgiveness would make an important contribution to obtaining lower interest rates but would be insufficient to squeeze the risk premium as low as possible. ?Reasonable? rates for Greece are not close to German rates because markets have experienced how unstable Greece can become. Consequently, strong actions would be needed to improve the country?s reputation. One useful step would be a constitutional amendment introducing a ban on public deficits. Other countries have done it. In fact, the initiative put forward by German Chancellor Angela Merkel and French President Nicolas Sarkozy foresees such a measure and it would certainly contribute in reducing the loss of credibility. With such a constitutional amendment and the reduction of debt to 60 percent of GDP, the risk premium would fall substantially, say, to 2 percentage points over the German rate. So, the cost of financing the public debt would be close to 3 percent of GDP (60 percent of debt times roughly 5 percent average cost in the medium-run). This means that, with a no-deficit rule, the primary surplus would come to about 3 percent.
A better reputation coupled with much lower interest rates are surely good for economic activity, but would this be enough for igniting significant growth? Bearing in mind that fiscal stimulation is out of reach (given the deficit constraint), in all likelihood the answer is no. The reason is that since joining the euro, wages were rising faster than productivity and, as a result, unit labor costs in Greece have increased by some 20 percent in relation to Germany. Having chosen to go into a monetary union with countries like Germany (and the Netherlands, Belgium, Austria and Finland), there is no way around the need to correct excessive unit labor costs in relation to partner countries. This is the crux of the problem. How to realign unit labor costs with those of Greece?s competitors in the monetary union?
The policies required to achieve this are unpopular and therefore politically difficult. First of all, there should be zero wage increases over the years to come. At the same time, taxes on labor should remain stable while social contributions or labor taxes should, if possible, be decreased. The resulting shortfall in tax revenue would only partly be augmented by increased employment. It would be necessary to strengthen public finances by pricing public services properly so as to cover costs or by privatizing them. The quality of services in the public sector is currently bad and services are over-used because they are provided free of charge or way below cost.
Secondly, to further stimulate productivity growth, a number of reforms are necessary to increase competition. These should include removing restrictive regulations and making the labor market considerably more flexible than it is at present. So-called ?closed? professions must be opened up and restrictions limiting competition in various fields of economic activities need to be abolished.
Thirdly, since a well-functioning economy needs a reliable and active public sector, the state needs to be reformed. Therefore, beyond privatization, a broad public sector reform is unavoidable for better future performance. The effective functioning of the judiciary and the police, the educational system at all levels from nursery school to university, the public provision of health services, the right incentives for research and innovation, the way parties are financed, the way public policy is audited, the bureaucratic obstacles to entrepreneurship, the age of retirement and the proper financing of the pension system, all have to be fundamentally improved. Implementing these reforms is certainly not easy, but there is one hope: that Europe will push them through in exchange for the generosity of debt forgiveness. As financier George Soros recently said, Germany (helped by the usual suspects) has two important and unpleasant jobs to accomplish: to pay for the extravagances of the European south and, much more importantly, to dictate what the trade-off in terms of political reforms ought to be.
Politically, it might be unacceptable to be told by Europe what to do to improve governance in exchange for generous financial transfers. Avoiding to push through meaningful reforms would imply that the economy does not get onto a growth path and, therefore, living standards in Greece would diverge from rather than converge with the north of Europe. But, it may well be that the political elite does not mind paying this price, if it sees it as necessary to its survival. In this case, the temptation to run a budget deficit and to resort to fiscal stimulation would be irresistible, as long as a little gain in credibility comes from the debt forgiveness. In that case, it would not be long before the debt increases again and the terms for public borrowing become prohibitive. It should, therefore, be clear that simply disposing of the debt problem with debt forgiveness is not a solution for Greece, if the difficult measures required for growth are not seriously implemented.
Would it be better for Greece to get out of the monetary union? In this case, it may be argued, competitiveness can be regained through devaluation without the need of painful reforms. There would be an initial shock to the banking system, financial flows would be disturbed and economic activity may be adversely affected. There is little doubt that the cost of this option is not negligible. Moreover, since the remaining debt (60 percent of GDP) is denominated in euros, its servicing and repayment would inevitably become more onerous. As a result, a debt restructuring would be necessary, delaying for years the possibility to return to the international debt market. The reputation loss, meanwhile, would be colossal. Greek residents and Greek institutions would be reluctant to subscribe to new government debt, while both domestic and foreign investors would also be reluctant to invest.
But is the longer-term outlook more promising? It is true that monetary policy could be conducted in view of Greek needs. But, it was not overly successful before the euro and, with weak institutions in the absence of necessary reforms, it is unlikely that it will be much better in the future. Nevertheless, it may be argued, the drachma could be devalued regularly to regain competitiveness. Unfortunately, the power of devaluation is easily exaggerated. To be effective, the devaluation-induced higher import prices must not be fully transmitted to wages and domestic prices. In other words, real wages must fall. There is, therefore, no escaping the fact that to regain competitiveness wage costs (as well as all local incomes and asset values in terms of foreign currency) need to be reduced. Moreover, the more often the currency is devalued the less effective it can be in improving competitiveness. This is because there would be increasing pressure for rapidly raising wages and prices in order to compensate for the loss in real income caused by devaluation. This loss of effectiveness would be particularly pronounced in the Greek economy, in which exports are often of limited added-value, while being heavily dependent on imported raw materials and intermediate products. Consequently, repeated devaluations would most likely soon lead to increasing inflationary pressure and before long to accelerating inflation. In these circumstances, capital movements would tend to be in stronger currencies, leading inexorably to the imposition of capital controls.
In conclusion, getting out of the euro does not offer an immediate easy solution or longer-term gain, while it risks derailing the Europeanization process which Greece embarked on 30 years ago. It only provides politicians with a policy tool that is easier to operate and relieves them of their responsibility to proceed immediately with the implementation of unpopular but necessary reforms. It is not difficult to see why this may be tempting to populist politicians, especially as it can be ideologically dressed in the mantle of ?national sovereignty.?
Finally, in view of what is required for growth, there is a clear implication regarding a widely shared position in the current political debate about the yet unresolved debt problem. It becomes apparent that the call for immediate growth as an alternative to implementing what has been agreed with the troika (an agreement which, if strictly implemented, could bring about the required conditions for future growth, as well as facilitate the solution of the debt problem), is a sham alternative and a smoke screen aimed at avoiding unpopular reforms. Nevertheless, If personal political survival counts for most politicians more than the economy?s survival, as regrettably seems to be the case so far, exit from the eurozone will be the inevitable outcome of a default.
* Thanos Skouras is Professor Emeritus, Athens University of Economics and Business. Alfred Steinherr is Honorary Chief Economist, European Investment Bank.
