In their summit meeting a couple of weeks ago, eurozone leaders declared that they would take “determined and co-ordinated action, if needed, to safeguard financial stability in the euro area as a whole”. While good as a ringing policy declaration, it was short of any specific measures to help solve Greece’s fiscal crisis. The financial markets were not very convinced; the euro continued to remain weak and the credit default swaps (CDS) spreads on Greek — and some other European Union (EU) member — bonds remained stubbornly high. Greece itself is committed to bringing down the fiscal deficit from 12.7 per cent of GDP last year to less than 3 per cent by 2012. In 2010, the deficit is supposed to come down by as much as 4 per cent of GDP!
Clearly, extremely onerous demands, perhaps more stringent than any country short of a major balance of payments crisis has faced, are being made on the Greek government to deliver on its promises. The EU finance ministers will meet in the middle of March to review whether the steps taken are adequate to meet the 2010 target: A sharp tightening of the fiscal screw can only mean further slowdown in economic activity and an increase in unemployment which is already in double digits. In anticipation of wage cuts, public sector workers have resorted to industrial action.
For students of finance, the contrast between the benign neglect of California’s fiscal woes by the financial markets, and the impact of the Greek crisis, should be interesting. After all, California, as a percentage of the US’ GDP, is more than 10 per cent; Greece is barely 2 per cent of the eurozone. The difference arises from the fact that California is part of the US, a sovereign nation, while Greece is part of the eurozone with no central taxing authority. In many ways, the monetary union in Europe was quite a bold experiment, in the absence of a political union. The intellectual fathers of the eurozone recognised the weakness but hoped that the single currency would be a first step towards the political union, their ultimate dream.
The Maastricht Treaty of December 1991, which committed EU members who met the convergence criteria to a common currency, specifically provides that there can be no bailout of a member by the others. This provision does seem to constrict the ability of the larger eurozone economies, like Germany and France, to lend to Greece; nor would voters like such a gesture. In fact, worried about exactly the kind of problem that Greece is facing, the Germans had insisted upon eurozone members entering into a stability pact that would limit fiscal deficits to 3 per cent of GDP, and debt as a percentage of GDP to 70 per cent. As it happened, Germany itself was the first to breach the limit (in 2003), and thereby lost the moral authority to discipline other members. In the event, Greece not only breached the limit on fiscal deficit several times over, but its debt now stands at more than 100 per cent of GDP. One major worry about financial stability is that, in recent times, 60 per cent of Greece’s debt has been placed with non-Greek EU banks, whose total exposure to Greece’s risks is a few hundred billion euros. The big test of Greece’s success in restoring market confidence will be put to test in April and May, when it will need to raise fresh debt of 20-25 billion euros.
Greece’s current account deficit is almost 15 per cent of its GDP. If Greece were to have an independent currency, the obvious actions would have been a devaluation and a loan from the International Monetary Fund. The latter may be needed even now, if only to reassure financial markets. Meanwhile, just as the former Prime Minister of UK, Harold Wilson, blamed the “Gnomes of Zurich” for Britain’s balance-of-payment problems in the 1960s, Greece Prime Minister Papandreou is blaming “hegde funds are speculators” for Greece’s plight.
There are, of course, several questions about the common currency in the light of the Greek crisis. Some of the more important ones are:
How far would the problem in the eurozone affect the global economy?
Answers to two other questions are perhaps clearer:
But this apart, financial “innovations” allowed Greece to hide the true extent of its problems until recently. More on this next week.
