The Greek tragedy has opened our eyes to many things. No one can any longer mock the critics of high fiscal deficits. Not only was the fiscal deficit of Greece high but that there were attempts to manipulate the numbers to hide the reality. It took a long time before this could be uncovered.
It is now estimated that the budget deficit of Greece is in the range of 13.5 per cent of GDP. The stock of debt is equivalent to 115 per cent of GDP. Greece has reached a critical point where it cannot meet its repayment obligations without outside help. The eurozone and the IMF have put together an ambitious package to help Greece. It is not known at this stage how this will be implemented. The package of support will also require Greece to put through a series of austerity measures. Unfortunately, there is a strong resistance to such measures.
The debt problem of Greece is compounded by the fact that a good part of the government debt is held by foreign institutions, particularly foreign banks. It is estimated that ¤106 billion of government bonds may be held by foreign banks. A default by Greece will have serious consequences for its economy. It will dry up all sources of external funding which will then weaken the economy even more. Greece is also having to deal with a huge debt problem when it is hardly growing.
The 2008 financial crisis was triggered by the excesses of financial institutions and financial markets. It was thus the failure of the market and the private sector. Driven by the need to achieve higher profitability in the face of acute competition, private financial institutions, including banks, resorted to innovations which proved to be self-destructive of the financial system. On the other hand, the current Greek episode has been triggered by the excess of a public entity, which is the government of Greece itself. Thus, it is a case of “government failure” as opposed to “market failure”. However, the reactions of private financial markets and financial institutions have aggravated the crisis. It is also not clear what role investment banks have played in misleading investors into investing in government bonds of Greece.
In both cases, rating agencies played a dubious role. In the case of the international financial crisis, the rating agencies were irresponsible in creating a booming market in suspect derivative products. In the current episode, it was an error of omission. The rating agencies took a long time to discover the correct fiscal position of Greece.
There are several lessons to be learnt from the Greek episode. The first relates to the level of fiscal deficit and the second to the manner of financing the deficit. In substance, the US situation is in many ways similar to the Greek situation. The US was having a high fiscal deficit even before the crisis. It has now exploded and is close to 10 per cent of its GDP. The fiscal deficit is also being financed by foreign institutions, including central banks holding US government bonds. Of course, the saving grace for the US is that the US dollar serves as a reserve currency. Unlike Greece, the US may still be a desired destination of investors. But the inherent dangers should not be overlooked.
The US needs to correct the serious imbalance it faces on the fiscal and balance of payments fronts. At least with respect to balance of payments, the process of correction has started. It is now estimated that the current account deficit of the US might have come down to 3 per cent of GDP in 2009 from the peak of 6 per cent. The US is not Greece and it has many strengths. Nevertheless, the similarities should not be overlooked.
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The impact of the Greek crisis per se may be minimal on India. However, India has to watch out as to how the eurozone will handle the situation. If there is turmoil in Europe as a consequence of the crisis, it may adversely affect India’s trade and capital flows. The world may come in for another shock if the eurozone countries fail to come to grips with the problems forced by the Greek imbroglio.
The European Union (EU) was a conglomerate of nations with different levels of development and productivity. However, they decided to go in for a common currency in the belief that all these factors would soon converge, which, however, did not happen. For the last decade or more, since the economies of most of the countries were booming, the contradictions did not come to the surface. Of course, there were occasions when individual countries felt that the monetary policy being pursued at the EU-level was hurting them.
The pursuit of a single monetary policy for the EU as a whole is making the life of some other smaller countries with lower productivity uncomfortable. In a situation like the one faced by Greece, if Greece had its own currency, it would have devalued but that option is not available now. No doubt, these small countries benefited earlier being under the umbrella of the EU.
Given this situation, it may seem incumbent on the richer countries within the EU to come to the help of smaller countries. The question that will be raised is for how long and whether such assistance will be an open-ended one. The euro would perhaps survive as a common currency of the EU. But for it to continue as a common currency, several fundamental changes may have to be introduced.
The EU must have an overarching mechanism to monitor the fiscal performance of member countries. A simple Maastricht rule regarding fiscal deficit is not enough. Countries have found it possible to get around it through various mechanisms. The EU must also think in terms of creating a fund which can come to the aid of the member countries at the time of any crisis.
The one lesson from the Greek episode for all countries is the need to maintain fiscal prudence. There is merit in containing the fiscal deficit to a level that is consistent with a country’s ability to meet the debt service payments. It is wrong to assume that by running high fiscal deficits, a country can grow faster and ride out of the problems. The situation becomes even more complicated if a substantial part of the debt is held by foreigners. On the whole, there is wisdom in countries working towards maintaining an appropriate ratio of stock of public debt to GDP. To be prudent is to be wise. This is plain “old” economics.
The author is chairman, Prime Minister’s Economic Advisory Council