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.