Greece as a Danger to Euro Stability

January 30, 2010

by Andreas Hoffmann*

Entering the Eurozone, Greece handed over monetary policy to the European Central Bank and introduced the euro. In a formerly unstable economy, without the danger of depreciation, the risk premium on Greek interest rates shrank to less than half a percent above that of Germany. This brought about convergence of the Greek interest rates. Thus investment and debt could be financed at lower rates. But the advantages from entering the eurozone also have a price. While countries are widely fiscally sovereign on what to spend taxes on, the Stability and Growth Pact is there to keep debt levels under control and to keep the currency area stable as a whole.

However, the Greek authorities, twisting the rules, used cheap refinancing conditions to expand heavily. In the mean time, e.g. public employees saw wage growth that was far beyond productivity growth. Further relatively cheap credit contributed to a booming economy and current account deficits against most other European partners. Thus the welfare gap between Greece and countries such as Germany seemed to close.

With a deficit of almost 15 percent of the budget in 2009, the Greek government does not only hold the European record in breaking the rules of its Stability and Growth Pact, also its refinancing conditions worsened. Since early 2009 interest rates on government bonds diverged strongly from the other Euroland member states. Therefore the risk of a state bankruptcy is discussed. The question of a bail-out by other members such as Germany arises, even though fiscal responsibility is not shared within the union.

The main argument for bailing out Greece is that a bankruptcy would cause defaults in bank balance sheets and bring about speculation against the next candidate, e.g. Ireland. A wave of speculation may wander from one country to the other, weakening the euro and making it a less attractive currency. Some commentators even see the end of the euro zone or an exit of some of its members.

In my opinion, Greece should try something to cope with its fiscal deficit that may seem odd to their socialist government: Austerity. There are two reasons: First a successful one-time bail-out for Greece would inevitably lead to a chain of related bail-outs. How can you give money to one state but not to another that is in the same situation? Thus Ireland’s plans for austerity would be shattered by a bail-out for Greece. One bail-out would lead to another (Mario’s slippery slope argument).

Second, to keep fiscal authorities from future excesses, liability is important. What Walter Eucken explains for private finance and investment (Die Politik der Wettbewerbsordnung — Die konstituierenden Prinzipien) is also true for state finance: The higher the level of liability the more thorough is state finance. Unfortunately there is no effective sanction mechanism for breaking the rules of the Stability and Growth Pact in Europe. Thus if Greece is not made liable for its excesses in the face of bankruptcy, moral hazard of other member states will lead to similar fiscal excesses. This would undermine the Stability and Growth Pact and mean the end of the euro as a stable currency.

*Andreas Hoffmann is visiting the Department of Economics, New York University from the Institute for Economic Policy, University of Leipzig during the current academic year. He is a Bradley Fellow and a Fellow of the Friedrich Naumann Foundation. Some of his work can be found here.

17 Responses to “Greece as a Danger to Euro Stability”

  1. Bogdan Enache Says:

    I have few comments:

    1. Has Greece’s deficit reached 15%? All reports (government, EC, rating agents) say it’s almost 13%. I know nobody trusts the Greek government now, but…15%?

    2. Ireland it’s rather ok; it has a big deficit, and the market is worry that the government can’t cut spending as much as it says it will, but the debt to GDP ratio is rather small compare to Italy, Spain etc. When bond spreads for these big economies will beging to rise, then it will be a totally different thing…

    3. This episode might give a new impetus to preponents of a common EU fiscal policy, although the lack of common fiscal policy is the good for monetary stability


  2. There is analogy to the fiscal condition of the states in the U.S. And there is a model for dealing with such events: the NYC insolvency in the 1970s.

    An independent board was created, which contolled the budget. The city lost it sovereignty until fiscal balance was restored.

    Whether something like that happens in Greece or not, we’re on track for it in the U.S. Take your pick for the first candidate: California, New York State, or a sunbelt state like Arizona or Nevada.

  3. Andreas Hoffmann Says:

    Bogdan,

    1) the 13 is correct. This is a typo. Sorry for that. But when it comes to Greek statistics it is better to round numbers up :)

    2) You are right, the big economies in Europe would be next in line, if bond spreads “worsen”. They already did. This is an argument for a bail-out. However with all its consequences. Then you would need to implement a sanction mechanism for the future to prevent fiscal excesses.

  4. Bogdan Enache Says:

    In the case of Greece, the bail out will be done most likely IMF-style, as in Hungary, Romania otr Latvia. Unlike the US or, let’s say, Germany over the Bundesländer, the EU has little direct power over member states – they basically retain full sovereignity. The money will come with conditions, a budget restructuring plan, EC monitoring, the Council’s political pressure etc but ultimately it will be up to the Greek government to solve the problem.

    There is a sanction mechanism – it’s the Stability Pact. The EC can launch – and it has – the so-called excessive deficit procedure and impose fines on any national government with more than 3% budget deficit and more than 60% public debt. This applies to non eurozone members as well, which can be cut-off from EU structural funds.

    In any case, it seems that despite Germany’s protest to this French proposal last year, some for of debt sharing arrangement will be adopted, rather than tougher sanctions for fiscal imbalances.

  5. Andreas Hoffmann Says:

    Bodgan,

    I agree. The Stability Pact is there to sanction to some extent. However, it seems to be not very effective. A lot of countries have preferred to take the sanction from the EU instead of balancing the budget. And where is the sanction on Greece at the moment?

    You are also right with the IMF. It is the institution that could bail out Greece. There is no such thing implemented in the EU yet. However there are voices asking for a European fund. I kind of prefer the idea Jerry O’Driscoll offered.

  6. Bob D Says:

    What I haven’t heard addressed is that violence occurred in Greece when the government tried to reign in costs. Perhaps an investment in Pinkertons or modern equivalent might be in order.

  7. Andreas Hoffmann Says:

    This is a serious issue. Violence and upraises are a major argument against cutting costs of social systems. There is certainly some truth in it. It is hard to imagine the effects of let us say a cut in unemployment benefits in e.g. Germany. This might lead to higher costs than the failing system. However, one could freeze costs and cut them wherever possible. A slow exit is better than no exit.

  8. Richard Says:

    Will Greece, other “south” nations and Ireland, as well as the “north” nations surrender national sovereignty to the European Union Commission — The EU Commission, in order to keep the Euro from disintegrating as a currency? … I rather think so!

  9. Pietro M. Says:

    Slippery slopes…

    Don’t save Greece -> Panic spreads through half of the eurozone.

    Unconditional bailout -> Moral hazard will destroy euro’s credibility and in the future the problem will get even worse than now.

    Conditional bailout -> It is time inconsistent: noone will force Greece to pay, once the crisis is over. The strategy is as inconsistent as attempting to have a lender of last resort without causing moral hazard. The day after the crisis, a wannabe Keynes will write “The economic consequences of the boom” to save Greece from the Treaty of Maastricht, and all the politicians of the most populist European states (especially the PIGS: Portugal, Italy, Greece, Spain) will try to set a precedent for buying votes at the euro’s credibility expense.

    Besides:

    Conditional bailout done by separate European states -> Coordination costs, which considering the present and usual weak statesmanship is unlikely.

    Conditional bailout done by the EU -> Concentration of power in the hands of the EU elite and end of the federal experiment, more or less like in the US.

    EU is paying the cost of not having being serious with the Maastricht Treaty, whose rules were designed to avoid free riding on the euro credibility by part of the single European governments. Now it is too late to avoid major problems, and most likely the result of myopia will be the centralization of power in the hands of the EU, which however given the heterogenity of European nations and interests is bound to be conflictual and dysfunctional.

  10. Bogdan Enache Says:

    I don’t know if this is exactly the place to ask, but how exactly is to be established the appropriat level of the social safty net according to ordoliberal/Walter Euken “canonical prescriptions” for a social market economy? Because this term, at least in Europe and especially Central Europe gets thrown around a lot, although the German policies for a social market economy were never something fixed, they evolved, changed and so on a lot since WW2.

  11. Andreas Hoffmann Says:

    Bogdan,

    this is correct. Actually there is a discussion on what the appropriate level should be. Maybe we can have someone from the Eucken Institute explain the positions here in another post. This would probably promote a discussion here.


  12. In yesterday’s Wall Street Journal Europe, Desmond Lachman predicts that Greece will default even if bailed out. He argues that it would take a 20-30% fall in prices and wages for labor competitiveness to be restored in the country. That would have devastating effects on GDP, tax collections and the debt.

  13. crisismaven Says:

    I’m not yet convinced if the Euro’s bad reputation can be tarnished more if “tiny Greece” defaults: Will Greece’s default bring down the Euro?.

  14. Andreas Hoffmann Says:

    Jerry,

    interesting, but not surprising. One has to consider that over the last years wages in Greece also skyrocketed. So if that wage raises were artificial they should be made undone. I know, it is easier said than done.

  15. Jodie Mahone Says:

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  16. Kevin Cleary Says:

    Montenegro functions with the Euro as its official currency, although not a member of the EU. I doubt if their fiscal rectitude is any better than that of Greece, but they don’t undermine the currency, any more than Ecuador or Panama’s use of the dollar does. Would the ultimate sanction for Greece, and other members of the Euro zone that refuse to toe the line, to relegate them to Montenegro’s currency status, while not affecting EU membership ?

  17. gcallah Says:

    Where is that screen where I can unsubscribe to comments?


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