Can Athens become synonymous with austerity? That is the challenge facing the Greek government — and its European Union partners — after years of massaging its deficit numbers and using complex derivatives transactions to mask its debts.
At a meeting of the EU’s Economic and Financial Affairs Council last month, finance ministers from the 27-nation bloc said Greece must show by mid-March that it is on track to reduce its deficit from a staggering 12.7 percent of GDP in 2009 to 8.7 percent this year, and reduce it further, to less than 3 percent of GDP, by 2012. In early March, Greece’s cabinet approved a sweeping new austerity program of tax increases and cuts in public-sector pay aimed at meeting the 2010 target. The package won praise from EU officials but no immediate commitment of financial support. Instead, they appeared to prefer to wait and see if Greece can tap bond markets on its own to refinance €10 billion ($13.7 billion) in debt maturing in April. This hands-off approach was set by France’s President Nicolas Sarkozy and Germany’s Chancellor Angela Merkel last month, when they gave only vague assurances that coordinated EU action would be taken, if needed, to safeguard the stability of the euro area as a whole.
The EU’s reticence highlighted rising tensions between core members of the euro area, like France and Germany, and peripheral members, like Greece and Portugal, whose budgetary follies risk infecting the entire region’s economy. Nowhere was the discontent more obvious than in Germany, where opinion polls last month revealed that two thirds of the populace were vehemently opposed to any EU financial assistance for Greece.
“This is truly a defining moment for the economic and monetary union,” avows Julian Callow, chief European economist for Barclays Capital in London, “because there has always been this big flaw in the concept of the union: You don’t yet have political integration, via a federal government, to match the monetary union.”
Unlike the U.S., where the federal tax and benefit system cushions recession-hit states, the EU has no fiscal mechanism to provide emergency transfers to members in crisis. But the risk of a default by one of the euro zone’s members could throw the entire group into disarray. Were Greece to default (or threaten to do so), speculative pressure would mount swiftly and inexorably on other high-deficit countries such as Ireland, Portugal and Spain — and unleash chaos in the markets.
“Not only do you have contagion risk to the other peripheral countries, you have risk of contagion to the financial sector as well, because German and French banks own a lot of government debt and have significant exposure to the peripherals,” notes Andrew Balls, head of European portfolio management for Pacific Investment Management Co. in London. “Those risks alone could lead to major instability in the euro zone.”
That prospect reportedly prompted German policymakers to consider using state-owned development bank KfW Bankengruppe to buy Greek debt, or to extend guarantees to German banks that do so.
Such an effort would help Greece handle its big refinancing needs in the short run, but longer-term reform will be painful. The only way for Greece to regain its economic competitiveness and reduce its indebtedness is to lower domestic prices relative to those of its EU partners, explains David Shairp, global strategist at J.P. Morgan Asset Management in London. “Greece is really a classic reminder that real currency risk, in a broad sense, has not been abolished by the adoption of a single currency,” says Shairp.
The political shortcomings of the euro zone ensure continued brinkmanship ahead, with European finance ministers likely to maintain pressure on Greece for greater austerity while being stingy with pledges of support.
At least a few economists, like BarCap’s Callow, believe that greater fiscal federalism — though politically unpalatable — offers the EU the best long-term solution to systemic risk. Others, like Tomas Jelf, chief economist of London-based hedge fund firm Prologue Capital, believe that fiscal federalism is a dream. Instead, he considers it far more likely that some countries, like Greece, might simply lose their fiscal sovereignty for a period of time if direct euro-zone aid is required, until their deficits can be addressed and the markets calmed.
“Is greater fiscal federalism absolutely needed for the EU to survive?” he asks. “No, I don’t think it is. But we have all been reminded of something that I think we all knew: The euro zone is not an optimal currency area.”
