The European Monetary Union is stuck in a severe balance of payments crisis. Capital flight from Ireland and the huge current account deficits of Greece, Portugal and, partly, Spain were financed in the past three years, as I reported several times, with money-printing by the European Central Bank (ECB), to the tune of more than 100 billion euros per year. But the well is running dry for the ECB, prompting it to push the euro members to provide credit. The French banks, which had by far the largest exposure to Greek debt, have been doing their best to unload Greek sovereign debt on the euro-zone countries. And they have been successful. As a result of their pressure, a 110-billion-euro rescue package for Greece was agreed one year ago.
Now the intention is to safeguard the Greek living standard and to help the Greek creditors even further. No less than 120 billion euros are to be provided until 2014 to secure redeeming of sovereign bonds maturing in the coming three years. It is assumed that around 100 billion euros in Greek sovereign bonds will have to be returned to the creditors until that time. Fifty billion euros are to be made available by the European taxpayers in the form of fresh credit. Of this sum, thirty billion will be used for direct payments to creditors, and 20 billion will go into an investment fund that purchases AAA-rated sovereign bonds from other countries. The remaining 50 billion will not be redeemed but are to be reinvested by the banks in 30-year Greek government bonds. The AAA-rated investment fund serves the purpose of securing in increasing proportions the 50 billion over time, since compound interest will eventually turn the 20 billion into 50 billion. Even if a risk remains in the meantime, which irritates the rating agencies no end, this is a model sure to produce windfall profits for the bank system with taxpayer money, since Greece has been bankrupt for a year already.
Much worse, however, is the fact that Greece has lost its competitiveness. Its government took on massive debt under the euro, inflating Greek wages and prices. Greece’s current account deficit reached 10.5 percent of GDP in 2010. Aggregate consumption exceeded national income by 16.5 percent.
In order to solve the competitiveness problem, Greece will have to become twenty to thirty percent cheaper. It has to perform an internal or an external devaluation. There is no way around it. If Greece tries to perform an internal devaluation within the euro zone there will be much penury, since millions of wages and prices would have to be slashed. Furthermore, many companies in the real economy would be pushed into bankruptcy because the price of their real estate will fall while their bank debts remain. It would be similar to Germany under Brüning, who enforced a radical budget squeeze because the Dawes and Young plans that attempted to implement the treaty of Versailles forbade a devaluation. From 1929 to 1933, German prices fell by 23 percent and wages by around 30 percent. The country was pushed to the brink of a civil war. Those politicians who think Greece could get back on its feet through a severe austerity programme underestimate the dangers, while those politicians who think fresh money will make Greece more competitive overlook the fact that this money will take away the pressure to reform and will leave current account deficit untouched, which leads inevitably to a transfer union.
It is better for all concerned, in particular for Greece, if the country leaves the euro temporarily. It could then devalue, become competitive once more and later, at a suitable exchange rate, join again. Instead of slashing millions of prices and wages, it would be necessary to slash but one price, that of its currency. In addition, companies in the real economy would be out of the woods, since their debts with Greek banks would be devalued too.
Foreign debts, however, would increase relative to GDP. But the same would happen with an internal devaluation of wages and prices. A good portion of Greek debts must in any case be forgiven. The French and German governments would then have to themselves save their banks. But they can cope with that.
Exiting the currency union and devaluing the currency would trigger bank runs and drive the Greek banking system into insolvency, but that would not be much different under an internal devaluation, because many of the banks’ customers would go bankrupt and would not pay back their debts. The banks should be supported by the EU under all circumstances, and some of them may have to be sold or nationalized. In the end, it comes down to the question of whether only the balance sheets are to be scorched, or the bank buildings as well. Policy-makers will not be able to duck this realisation much longer.
Professor of Economics and Public Finance
President, Ifo Institute
Published as “Griechische Tragödie”, WirtschaftsWoche, No. 28, 11 Juli 2011, p. 37.