The Greek tragedy

After a period of sharp decline, stock markets all over the world have rallied back to some extent following a massive $1 trillion war chest announced by the European Union (including help from IMF) to rescue the troubled European economies suffering from sovereign debt crisis.

Though the epicentre of the crisis was in Greece, the apprehension was that the tremor originating in Athens may spread to other weaker countries (like Spain and Portugal) of Europe as investors decide to withdraw funds from these countries and to re-lend money only at substantially higher interest rates. Because of this uncertainty, global investors were already moving funds to safer assets like the US treasury bills. The Euro was going down and the US dollar moving up.

Greece is currently the weakest link in the 16-country Eurozone. But there are other weak links. The problem in Greece was due to the massive government budget deficit (13.6 per cent of GDP, as against the EU norm of 3 per cent of GDP) financed mostly by external borrowing. The Greek government kept the true state of its finances under wraps for a long time.

As the truth began to unravel, the Greek government was forced to borrow 4 percentage points above the rate for Germany which was clearly not sustainable. The options before the EU were either a huge bailout package with IMF-style conditionalities to soothe the market and stop speculation against the Euro or to allow Greece (perhaps followed by other debt-ridden European countries like Spain and Portugal) to default on their debt, go out of Euro and go back to hugely devalued domestic currencies.

The second option would have been a big blow to the common currency experiment in Europe. This would have also meant huge losses for many banks (specially German banks) which had lent heavily to Greece and the other troubled countries.
Though the outward manifestations of bad economic health of the 5 PIIGS (Portugal, Ireland, Italy, Greece and Spain) countries are not exactly the same, all of them faced some common problems like wage increase going ahead of productivity growth and slipping cost competitiveness due to the entry of cheaper wage east European countries into the fold of the Eurozone.

These developments gave rise, in varying degrees, to more unemployment, falling tax revenues, rising stimulus expenditures, rising current account deficit, ballooning fiscal deficit and rising debt burden (as a share of GDP). As a result, the sovereign credit rating of the countries was dragged down and fresh loans became increasingly costlier.

Dangers of single currency
But there is a more fundamental issue. The unfolding crisis brings to the surface the basic difficulty of having a single currency for a group of highly disparate countries. The 16-member Euro-zone has Germany — a strong economy with big trade surplus — along with weak economies like Greece, Spain, Portugal and Italy.
A common currency means that even if a member country suffers from a big trade deficit and rising unemployment, it cannot devalue its currency to make its products cheaper and sell more. The only way to improve international cost competitiveness would be to reduce wages and other costs (deflationary policy) which is politically far more difficult to implement. Large scale riots have broken out in the streets of Greece against such austerity measures.

A comparison with the USA is instructive here. All the disparate states in USA also have a common currency — the US dollar. So, how come USA survives well with a common currency? There are three major differences: first, people from declining states or regions in USA can freely move to other regions within USA in search of jobs.

Because of ethnic, language and historical differences, such unrestricted labour mobility is absent in Europe. So, Greeks or Spaniards will not find it easy to get jobs in prosperous Germany. But, at the same time, EU has allowed unrestricted capital mobility. That means that capital would quickly move away from Greece to, say, Germany making life doubly difficult for labour trapped behind the national borders in Greece.

Second, the federal government in USA can easily make fiscal transfers between states. No mechanism for such fiscal transfer exists between sovereign countries in EU. Third, federal and State governments in USA can easily run budget deficits and borrow money from the central bank, as required.

But in the EU countries with widely different economic strengths and traditions of fiscal management have come together under one currency with strict limits on fiscal deficit. In addition, they have one European Central Bank whose pan-EU monetary policy — though pulled in different directions by countries like Germany and France — has a strong anti-inflation bias.

Because of these essential differences, the weaker economies in EU would periodically face crises which cannot be resolved easily within the confines of a single-currency system. The proponents of a single currency in Asia should not lose sight of this basic danger.
(The author is a former professor of economics at IIM, Calcutta)

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