Greece – A Mess With Consequences

Greek voters have soundly rejected a set of reforms from the European Central Bank, the European Commission and the International Monetary Fund. The “no” vote may mark the beginning of Greece’s exit from the eurozone, and the uncertainty of what happens next comes at a bad time for the global economy, warns economist David Dapice. Economists can only speculate about the possible political and economic outcomes. Some suggest the worst pain has been felt, and others worry about a troubling precedent of moral hazard. For the Greeks, the “no” vote does not necessarily mean a rejection of the euro. The rest of Europe may overlook the “no” vote and proceed with a modified bailout package, yet the relationship with the current Greek government is toxic, even with the resignation of the Greek finance minister. European partners are losing patience without some reforms in Greek governance and acknowledgment that better management is needed. – YaleGlobal

Greece – A Mess With Consequences

Greece is both defiant and desperate; EU leaders wonder if the small economy is worth saving
David Dapice
Tuesday, July 7, 2015

Petulant borrowers: Greeks celebrate their rejection of reforms proposed by European leaders (top), but that won't impress lenders; a banker tries to close doors to desperate pensioners (Reuters)

CAMBRIDGE: As Greece teeters on the edge of an abyss, the world collectively holds its breath. If Greece is expelled from the eurozone after its "no" vote on needed reforms, the ripple effect will reach far and beyond. The crisis comes at an especially bad time for a wobbly global economy. If there is a way forward, the European Union would have to ignore the “no” vote in the Sunday referendum.

The denouement may be reached this week, but the crisis has been a longtime coming.  Greece has had a dysfunctional political economy for years and should not have joined the euro with its obligations for controlled deficits and debt.  After Greece joined, borrowing was cheap and the government borrowed rather than cut generous spending or increase taxes on a population that did not like to pay their legal obligations.

Even so, the ratio of public debt to GDP was fairly constant at around 100 percent from 1993 to 2008. After the financial crisis, the debt ratio worsened to 130 percent in 2010 and the economy veered towards a crisis, but fear of contagion allowed for temporizing.  Austerity was imposed along with modest debt relief and an extension for repayment. From 2010 to 2015, Greece did cut spending and imposed tax increases with stiffer collection procedures, but its economy shrank by 25 percent. Debt soared to 177 percent of GDP. Unemployment is 25 percent and much higher for young people, who search for work in other countries.

More austerity will not result in solvency, and debt relief is needed – a position held by the International Monetary Fund, but politically difficult if not impossible within the eurozone, especially for Germans who feel that the Greeks are free-riding on European taxpayers. Other eurozone members who have endured austerity have little sympathy for Greece, the economy of which has been depressed for many years.

Prime Minister Alexis Tsipras was elected on an anti-austerity platform. He refused to agree to harsh austerity demands from the so-called “troika” – the European Commission, the International Monetary Fund and the European Central Bank – negotiating with him. He instead put the proposed austerity policy up to a referendum. This outraged Europeans who objected that the bargaining was not finished, that their offer had expired, and the referendum is meaningless. The Greeks voted "no" anyway.

Should Europeans maintain their current offer, it’s not clear what a “no” vote would mean. It may mean an exit from the euro, with further costs for the Greek economy because their banks would be insolvent – they are days away from collapse. Most Greeks have withdrawn euros from their accounts, and the Greek banks rely on the European Central Bank for their liquidity, but new support is ending since the Greeks did not accept the offered deal and did not pay the IMF obligation due June 30th. If Greece leaves the euro, it would partially default on debts to the ECB and set up the drachma as its new currency. Greeks would pay high interest rates on debt, though perhaps not much higher than the current 12 to 15 percent rates on 10-year government debt – a rate that clearly anticipates default.

Economists differ on what Greece should do next. Some suggest, and many Greeks believe, it would be better to somehow stay in the eurozone. This would require a softer line to the troika and hope for meaningful debt relief – something not yet offered. Staying in the euro, if on offer, would have other benefits, including likely lower financing costs for debt going forward and less political risk for foreign investors. Others say that the worst – a run on banks and utter economic disruption – has already happened. An independent currency would allow Greece to use the exchange rate to stabilize its economy, much as Iceland did. World stock and bond markets do not like the prospect of a Greek exit from the euro, even though the economy is tiny. It could set a bad precedent and weaken the entire euro project. Even German Chancellor Angela Merkel has said as much – “If the euro fails, Europe fails” – and urged Greece to compromise. That will be difficult given the entrenched positions.

In contrast to 2010, most Greek debt has been shifted from private to public entities, so there is less danger of  most non-Greek banks  failing. Greek banks, of course, are in need of a bailout as they hold mostly Greek government debt for assets. The weaker economies such as Spain and Ireland are in better shape now. The ECB with its “whatever it takes” Governor Mario Draghi can use bond-buying to tamp down possible collateral damage. So, a Greek exit from the euro may not entail severe short-term shocks.

The same is not certain for longer-term economic and medium-term political damage. Unless a Greek exit leads to a much tighter economic, financial and political union, there is a threat of further crises and exits – perhaps ultimately a threat to the entire euro project. Both France and Italy could face similar problems and also resist austerity. Many economists argue the euro was a bad idea from the start because of the vast differences in economic productivity across its membership and limited mobility of workers and fiscal transfers. At this point, this is more of a political than economic matter, and more integration might create the conditions for the euro to function more like the dollar within the United States.

Diplomatically, Greece would at least be tempted to flirt with other regimes such as Russia or China, perhaps opening Europe to challenges they would rather not face. The threat of Russian influence is more immediate with Ukraine, but the rise of China is perhaps more serious. China is pressing for European investment treaties and other ways to tighten links with the EU, and a wayward member welcoming state-linked foreign direct investment in sensitive areas could raise national security questions.

The crisis comes at a bad time for the global economy. China is slowing, and its volatile stock market may suggest more severe economic challenges than are evident from the suspiciously high reported GDP growth rates. Many commodity exporters had relied on soaring Chinese demand for exports for their own economic growth. The US Federal Reserve is likely to start raising dollar interest rates, and this will weaken many currencies in emerging markets, further boosting inflation and creating pressures for higher interest rates in those countries at a time of flagging exports.

Then there is the possible UK exit from the EU – unlikely, but another source of uncertainty. These developments could lead to softer growth or even recession in much of the world. Even within the US, the likely bankruptcy of Puerto Rico and the parlous finances of some states could weaken the recovery. Adding uncertainty and disruption in the eurozone to all of this is unwelcome and risky.

That the Greek electorate voted "no" in the referendum does not mean, to them, a rejection of the euro, though it may end up that way. Although Greek Finance Minister Yanis Varoufakis resigned to smooth negotiations, there is still a toxic relationship between the current government and the rest of Europe that makes compromise difficult. Outside of the euro, there are likely to be many more bumps before the Greek economy grows again.

David Dapice is the economist of the Vietnam Program at Harvard University's Kennedy School of Government.      

Copyright © 2015 YaleGlobal and the MacMillan Center

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