The headlines are buzzing today with more news about the European crisis and speculation abounds on the fate of Greece within the Eurozone. Just reading this article in the New York Times today highlights just how badly the European leaders have failed so far to contain this crisis and put the peripheral economies on sound footing. This crisis has been going on for over a year now and who would have thought that it would have lasted this long, let alone threaten French banks to the point of downgrade? Yield increases on Italian and Spanish debt were not too surprising but could have been avoided if the Western European leaders, in particular Angela Merkel, had actually dealt with the underlying problems in the Eurozone instead of attempting to muddle through.
Just for clarification, does any actually think Greece can avoid default without some radical transformation of the European Union into some sort of transfer union designed to tax the Germans to pay for the Greeks? This issue has bothered me for quite a while now: The Germans refuse to allow either the Greeks to default/leave the Eurozone, while simultaneously refusing to turn the EU into something closer to a transfer union that might help peripheral economies to overcome their deficits. It shouldn’t take much macro thinking to see that this is a complete contradiction.
Usually in a recession or debt crisis, the affected country has a few tools available. One process, which might happen automatically, is that the currency should weaken relative to trading partners due to the weakness in the economy and the heavy debt burden. This should allow the affected country, Greece in this case, to improve its trade balance with its partners, providing extra growth. This essentially means exports should increase creating jobs and income. Of all the ways of paying down debt, growth is by far the best solution. If the currency, however; doesn’t weaken on its own, the government always has the option to print currency to pay debt, which causes a real decrease in the value of the debt and shortens the pay down time. Another, more controversial for a heavily indebted (>60% debt/GDP) country, is to undergo Keynesian stimulus to try and spur growth. Right now, Greece should be experiencing one of these three options for dealing with debt, but there is one huge obstacle: Germany and the Eurozone.
Since Greece is a part of the Eurozone, it has relinquished independent control of its monetary policy to institutions more heavily influenced by Germany and France than they are by Portugal, Ireland, and Greece. So instead of being more liberal with interest rates to encourage lending and consumption to revive growth, the ECB raised rates only just this summer! Meanwhile, as lending conditions become tighter in Europe, Greece’s lenders (Germany, France for instance) are asking for greater cuts in government spending to close the budget gap. For those of you with less macroeconomic knowledge GDP = consumption + investment + gov’t spending + net exports. Of course, in a time of low investment and consumption, government spending is the only other actor (besides exports, which we already mentioned) that could create growth. So the European leaders deny Greece the option of increasing its exports (lack of independent monetary authority) while simultaneously asking for Greece to cut government spending! This is completely absurd.
And now the real point: Greece needs to leave the Eurozone today and default on its debt. period. This would of course cause a sharp decrease in output initially, but would allow Greece the option of competing on the world market with its own prices (as opposed to German prices). This may seem ridiculous to some of you, but I provide you with a little recent historical example of how defaulting and floating the currency in an indebted country without independent monetary policy can really help. In Argentina pre-2002, the leaders pegged the peso at an extremely rigid exchange rate to the U.S. dollar eventually reaching 1:1. This of course hurt exports and growth, similar to how the strong Euro hurts Greek products and services. Argentina also had a debt problem at the time. However, the Argentine government didn’t have rich partners to bail it out like the Greeks do, so eventually they had to default and negotiate for debt restructuring. The got rid of the 1:1 peso to dollar peg and the results are apparent in this graph:
You clearly see a moderate recession lingering until the Argentine default in 2001 which led to a deep, but short v-shaped recession. Immediately after this deep recession, growth rebounded strongly and continued at levels equal to and high than before the crisis. compare this to the Greek situation and you will immediately notice the differences. The Greek crisis remains precisely because of the inability of the European leaders to recognize or admit to the inconsistencies in their demands on the weakened Greek economy. I doubt Greece will recover at all until something gives one way or the other in favor of default or the creation of a transfer union. Though it may be tempting to attempt at preserving the current make up of the Eurozone, the Germans must realize that it will be increasingly difficult for Greece to avoid default unless it finds someway to create growth. Let the Greeks go, let them retake control of their own currency, let them restructure their debt and maybe this financial crisis will finally end!