Europe's Gift for the Greeks

by Ali M.S. Fatemi, Ph.D.

Posted on March 5th, 2010

While Greece’s fiscal problems are being headlined all over the world, attention should be drawn to the fact that she is not alone in having lived beyond its means and by spending more than its tax collectors have been able to bring in. It is not the only country in Europe or for that matter the only one in the Euro-zone which has passed the convergence criteria for either budget deficit or debt to GDP ratio. As it has been noted, Spain, Portugal and possibly Italy and Ireland are not far behind. What makes the Greek case unique for EU is the manner in which it tries to resolve the issue. Drastic measures such as leaving the EMU and returning to devalued drachmas are neither legally feasible nor politically permissible. Debt default also is not a viable alternative because its main creditors are major German banks and their subsequent failures will lead to major contagion and shake the foundations of the financial markets. Subsequently there are very few other alternatives available but whichever is chosen will set a precedent for the future and similar cases. The most likely outcome will probably not directly involve the EU or the IMF (the International Monetary Fund). It will be the Greek citizens who will be faced with higher taxes, government cuts and economic hardship.

Beyond Greece and its difficulties, it is the EMU and the Euro which is facing its first real test. More than a decade ago when Euro was being seriously considered as Europe’s currency, there were many economists who were questioning its feasibility. For them, not only Europe was not an ideal “Optimum Currency Area,” but there was no precedent or theoretical proof that one could have a common monetary policy and a single currency without having a single fiscal authority. However, politics tramped economics and the single currency was adopted without even the slightest glimpse of hope that someday Europe will attain sufficient political cohesion to envision a common treasury.

In the meantime, going back in history is not of much use for resolving current crises. There are serious problems brewing in the Euro zone and if there are not resolved soon the foundations of the union will be affected.  At the time of this writing there is no clear indication as how Europe is going to face up with its first serious monetary and fiscal problem.  The Greek socialist government of Mr. Papandreou has announced a series of serious measures for curbing the unprecedented 13% budget deficit. Europe's average government budget deficit is currently around 6% which is twice as large as specified by the Stability Act. In its second attempt or the "enhanced austerity" plan it has announced a series of belt-tightening actions such as a 2% increase on TVA,( up to 21% )in addition to a 20% alcohol tax and a 6% additional fuel tax. On the spending side the government plans to cut the civil service pay by 12% and enact a 30% cut in bonuses. These are all well intended measures but some doubts remain as to whether the government can manage to implement them properly. Good project management is needed but past experience of the Greek government does not provide much ground for optimism. Needless to say that the reaction of Greek people to this drastic austerity plan has been sharp and fast. There has been already a week-long demonstration in the streets and it is to be followed by a general strike. The two austerity packages put together amount to less than €10 bill but, if effectuated, they might put the country's finances back in shape. The reaction of the markets has proven positive and there are signs that the spread between the Greek and the German bonds are already narrowing.

At the present, ruling out a loan from the IMF which is not welcomed by Greece's European partners, but has not been totally dismissed by the Greek government there remain three possible solutions for current problems that Greece is facing. These include direct financial aid from member countries, a joint effort by Euro zone members or, the most likely one, a pledge to buy Greek bonds by banks of other EU member countries. The manner and the speed with which this first test for the Euro zone countries is handled will be an indication of things to come in other venerable countries such as Portugal, Spain, Italy and possibly Ireland.

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