The rescue package requested by Greece will, if endorsed, buy the eurozone six months, perhaps a year at most. By then, the Greek government will have exhausted the aid and be forced to ask for more or to borrow at astronomical rates. This assumes that, before then, Greece does not precipitate into an even deeper confidence crisis, causing a meltdown of its banks and tax base, and that the contagious fever affecting other countries is contained.
But even if it does restore a measure of confidence, the rescue package will not have addressed the fundamental causes of the eurozone crisis, of which Greece is only the harbinger. Fiscal problems and widening sovereign spreads are the crisis’s most evident symptom but they are inextricably associated with a deeper malady, the slowdown in productivity and loss of competitiveness in Greece, Ireland, Italy, Portugal and Spain. Since the euro’s inception, these countries have to a massive degree lost competitiveness against Germany and, even more so, against the US, China and Japan.
The implication of this loss of competitiveness is a decline in their potential growth rate, and, consequently, of their ability to accumulate not only public but also private debt. This has been evident for at least five years in Italy and Portugal, but was concealed until recently by an unsustainable demand and housing boom in the other three countries. In all five countries, the effect of the ‘Great Recession’ was to lay bare the fragility of their post-euro growth model and to expose or underscore the unsustainable trends of their debts.
As experts and the public have known for a long time, dealing with these problems requires major structural as well as fiscal reforms. That is daunting enough. But the situation is now complicated by the conclusion reached by numerous analysts that Greece is insolvent and that its debts will sooner or later have to be restructured, and by the contagious decline of confidence in other countries.
The question, then, is how to use the six months gained by the Greek rescue package. Here is a plan that, while not guaranteed to work, would greatly increase the likelihood of the eurozone surviving in its current form.
First, task the International Monetary Fund to come up with a recovery plan that is far-reaching but also provides the time needed for the Greeks to execute it credibly. Just to stabilise its debt ratio at 150% of gross domestic product (GDP) would require Greece to make a huge fiscal adjustment, equivalent to at least 12% of GDP. That implies even larger declines in output. That is why an agreed rescheduling of Greek debts (extending the maturity of the outstanding debt while maintaining interest payments), and perhaps ‘haircuts’ (creditors taking losses on the principal), appear inevitable.
Although eurozone leaders are refusing even to discuss a restructuring, the financial markets have already discounted very large losses on Greek debts. They will not lend to Greece at reasonable rates until there is clarity about how it will manage its way out of the mess. The alternative would be for the eurozone to cover Greece’s financing requirement over the next three years, some €60 billion each year.
Second, as part of a pre-emptive programme to contain contagion from Greece, other vulnerable countries should accelerate measures to address their fiscal and competitiveness problems.
A good guideline for them should be to reduce the primary balance – the budget balance excluding interest payments – by enough to ensure that the debt-to-GDP ratio is firmly on a downward path within three years. In the case of Spain, for example, this means reducing the primary balance by some 8% over three years, and in Italy by 4%. In both cases, that is more than is currently being contemplated.
The other, equally important reform relates to competitiveness and productivity. A good guideline is that countries should now aim to recover competitiveness vis-à-vis Germany at the rate they have lost it. Since unit labour costs in Germany are about flat in nominal terms (nominal wages rise almost in line with productivity), this means that unit labour costs in the vulnerable countries need to decline by 5%-7% over three years. This calls either for modest wage cuts or – better – for structural reforms to boost productivity (or for both). The main structural reforms should relate to increasing flexibility and competition in the non-tradable sector, including a smaller and more efficient government, and reforms of the labour market. Some of these reforms would take time to bear fruit, but enacting them over the next year would help reassure markets that the tide was turning.
Third, Germany and the other surplus countries should support a three-year programme to expand demand by about 1% of the eurozone’s GDP in order to offset the deflationary impact of fiscal adjustments in the vulnerable countries.
Hopefully accompanied by a world trade recovery, the aim of such a programme should be to keep the aggregate European growth rate in the 2%+ range, even at the risk of slightly higher inflation in surplus countries. Reforms favouring consumption and domestic investment in countries with budget surpluses, a continuation of a policy of low interest rates in the eurozone and an explicit favouring of a weaker euro would help boost growth. The G20 should support the programme as a means of avoiding a string of sovereign-debt crises endangering the global recovery.
It is high time for the eurozone leaders to move from denial to action – not only in Greece, but, just as importantly, at home.
If all goes well, this episode may be remembered as the eurozone’ s adolescent crisis.
Uri Dadush is a senior associate in and the director of Carnegie’s International Economics Program.