Thursday, May 13, 2010

Greece – Is it a failure of the Euro?

With the US markets suddenly losing ground on Greek fears, and for some time now, analyses connecting Greece’s woes to its decision to join the Euro are everywhere. Some suggest that Greece may not be able to find its way out of its problems without leaving the Euro. They suggest that Greece return to a national currency system and devalue it’s way out of debt.

While it’s true that for Greece to recover, leaving the Euro seems to be a solution, it is clearly not a very plausible one. Another solution is being tried out under which Greece would take the tough decisions required to improve its fiscal health, which would result in the other Euro countries and the IMF bailing it out. This solution has found support in Greek Parliament but has been greeted by riots and mayhem on the streets. The idea of living with lower government expenditure somehow seems abhorrent to the Greek as it would necessarily result in changes in Greece’s social security structure and public sector salaries.

The cause of Greece’s woes is not its membership of the Euro. Being a part of a monetary union where monetary policy is independent of the state is as close as a country can get to monetary utopia under the current system of fiat currencies and monetary monopoly. But when a nation undertakes to live with a currency outside its control, a lot of things change. For starters, all borrowings of the state and it’s citizens become the equivalent of external borrowings. This is because once the state loses its power to create currency or manipulate its price, it’s ability to repay becomes directly dependent on its capability to earn the currency required to repay it’s debt. In this situation, it is incumbent on the state not only to ensure that it’s revenues are maintained at the required level, it is also it’s responsibility to ensure that borrowings are made only as a last resort.

Countercyclical fiscal policy, which is recommended for all countries regardless of currency system, becomes a necessity in a currency system where the state has no control. And not only in the traditional sense of a balance being maintained in good years and deficits undertaken in bad years. When the state does not have control over currency, it is imperative that deficits of tough years are balanced by surpluses in good years to ensure that over a business cycle or two, government debt tends to zero.

Greece’s troubles today are not a result of their joining the Euro, and they will not be solved by them leaving it. Greece’s problems are fiscal in nature and have been brought upon themselves by irresponsible spending. The only sustainable course of action is to make genuine attempts to improve their fiscal position. And improvements not only to the extent of reduced fiscal deficits, which will only reduce the pace of increase in their debt burden. Greece has to chart a path towards fiscal surpluses which will result in a reduction of total debt.

Leaving the Euro now may not help them to the extent envisaged by various commentators. Yes, it will give them control over their currency which they can merrily devalue to increase exports and become more competitive. But since all their debt will still be in foreign currencies, devaluation will increase the value of their debt in terms of their new currency. With the total stock of debt exceeding GDP by 1.7 times (including private debt but not including interest payments), devaluation would only work if nominal GDP growth were to outstrip the extent of devaluation itself by a factor of 1.7. This may take some time and in the initial stages, the balance will not be in it’s favor. This will result in Greece borrowing to meet it’s obligations at an interest rate which will be worse than it’s existing rate. Since the starting point is one where bondholders are demanding over 15% for 2 year debt, one can only shudder to think what worsening would mean.

And interest rates add their own twist to the math. As long as average interest cost on outstanding debt remains above nominal GDP growth in the currency of obligation, the debt burden will keep on growing. Till as recently as December 2009, Greece was borrowing one year money at an interest rate lower than inflation. This has changed in 2010. Rates now are sky high pricing in a significant probability of default. To make matter worse, close to half of Greece’s outstanding debt matures in the next 5 years, which will have to be refinanced at rates which are far higher than that on the maturing debt.

All in all, Greece’s debt problems cannot be solved by either staying with or leaving the Euro. It’s problems are fiscal in nature and can be solved only through fiscal measures. Given public reaction to this path, there is a distinct possibility that this will not happen.

And the only option left will be default.

This note was posted on my Business Standard Blog on May 7, 2010.

No comments:

Post a Comment