The Magic of the Market
After the Greek Default
Martin Feldstein
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CAMBRIDGE – The Greek government, the European Commission, and the International Monetary Fund are all denying what markets perceive clearly: Greece will eventually default on its debts to its private and public creditors. The politicians prefer to postpone the inevitable by putting public money where private money will no longer go, because doing so allows creditors to maintain the fiction that the accounting value of the Greek bonds that they hold need not be reduced. That, in turn, avoids triggering requirements of more bank capital.
But, even though the additional loans that Greece will soon receive from the European Union and the IMF carry low interest rates, the level of Greek debt will rise rapidly to unsustainable levels. That’s why market interest rates on privately held Greek bonds and prices for credit-default swaps indicate that a massive default is coming.
And a massive default, together with a very large sustained cut in the annual budget deficit, is, in fact, needed to restore Greek fiscal sustainability. More specifically, even if a default brings the country’s debt down to 60% of GDP, Greece would still have to reduce its annual budget deficit from the current 10% of GDP to about 3% if it is to prevent the debt ratio from rising again. In that case, Greece should be able to finance its future annual government deficits from domestic sources alone.
But fiscal sustainability is no cure for Greece’s chronically large trade deficit. Greece’s imports now exceed its exports by more than 4% of its GDP, the largest trade deficit among eurozone member countries. If that trade gap persists, Greece will have to borrow the full amount from foreign lenders every year in the future, even if the post-default budget deficits could be financed by borrowing at home.
Eliminating or reducing this trade gap without depressing economic activity and employment in Greece requires that the country export more and import less. That, in turn, requires making Greek goods and services more competitive relative to those of the country’s trading partners. A country with a flexible currency can achieve that by allowing the exchange rate to depreciate. But Greece’s membership in the eurozone makes that impossible.
So Greece faces the difficult task of lowering the prices of its goods and services relative to those in other countries by other means, namely a large cut in the wages and salaries of Greek private-sector employees.
But, even if that could be achieved, it would close the trade gap only for as long as Greek prices remained competitive. To maintain price competitiveness, the gap between Greek wage growth and the rise in Greek productivity – i.e., output per employee hour – must not be greater than the gap in other eurozone countries.
That will not be easy. Greece’s trade deficit developed over the past decade because Greek prices have been rising faster than those of its trading partners. And that has happened precisely because wages have been rising faster in Greece, relative to productivity growth, than in other eurozone countries.
To see why it will be difficult for Greece to remain competitive, assume that the rest of the eurozone experiences annual productivity gains of 2%, while monetary policy limits annual price inflation to 2%. In that case, wages in the rest of the eurozone can rise by 4% a year. But if productivity in Greece rises at just 1%, Greek wages can increase at only 3%. Any higher rate would cause Greek prices to rise more rapidly than those of its eurozone trading partners.
So Greece faces a triple challenge: the fiscal challenge of cutting its government debt and future deficits; the price-level challenge of reducing its prices enough to wipe out the current trade gap; and the wage-productivity challenge of keeping future wage growth below the eurozone average or raising its productivity growth rate.
Ever since the Greek crisis began, the country has shown that it cannot solve its problems as the IMF and the European Commission had hoped. The countries that faced similar problems in other parts of the world always combined fiscal contractions with currency devaluations, which membership in a monetary union rules out.
A temporary leave of absence from the eurozone would allow Greece to achieve a price-level decline relative to other eurozone countries, and would make it easier to adjust the relative price level if Greek wages cannot be limited. The Maastricht treaty explicitly prohibits a eurozone country from leaving the euro, but says nothing about a temporary leave of absence (and therefore doesn’t prohibit one). It is time for Greece, other eurozone members, and the European Commission to start thinking seriously about that option.
Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisers and is former President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
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deniscooper 02:33 30 May 11
Professor Feldstein writes: "The Maastricht treaty explicitly prohibits a eurozone country from leaving the euro, but says nothing about a temporary leave of absence (and therefore doesn’t prohibit one)."
I stand to be corrected on this, because there may be some line buried in some article somewhere in the main body of the treaties or in a protocol which I haven't yet noticed and which does indeed "explicitly" prohibit a eurozone country from abandoning the euro, but as far as I'm aware the prohibition is implicit rather than being explicitly stated.
What is certain is that all EU member states apart from the UK and Denmark are legally committed to joining the euro once the entry conditions are deemed to be met, and Article 140 TFEU starting on page 108 here:
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2010:083:0047:0200:EN:PDF
lays out the procedure for a member state to be pushed or pulled into the eurozone, but there is no corresponding procedure for a member state to leave either permanently or temporarily as the professor suggests.
The legal irreversibility of joining the eurozone is implied in phrases such as
"... and abrogate the derogations of the Member States concerned."
in Article 140.2 TFEU:
"After consulting the European Parliament and after discussion in the European Council, the Council shall, on a proposal from the Commission, decide which Member States with a derogation fulfil the necessary conditions on the basis of the criteria set out in paragraph 1, and abrogate the derogations of the Member States concerned."
and
"... irrevocably fix the rate at which the euro shall be substituted for the currency of the Member State concerned ... "
in Article 140.3 TFEU; but of course that irreversibility would apply just as much to a "temporary leave of absence" as to a permanent departure.
Clearly the EU treaties should include a mechanism for a member state to make an orderly withdrawal from the eurozone in the light of experience, and that is one of the treaty amendments which Cameron should have demanded as part of a quid pro quo for his co-operation over the radical treaty amendment needed by the eurozone states to legalise bail-outs and strengthen EU economic governance.
Instead at the March 24/25 meeting of the European Council he weakly agreed to give them whatever they wanted while asking for nothing in exchange:
http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/120296.pdf
"16. Recalling the importance of ensuring financial stability in the euro area, the European Council adopted the decision amending the TFEU with regard to the setting up of the European Stability Mechanism. It calls for the rapid launch of national approval procedures with a view to its entry into force on 1 January 2013."
In the case of the UK the Minister for Europe David Lidington made it clear on March 16th that the national approval procedure for this treaty amendment will take the form of an Act of Parliament without a referendum.
DerekLantin 04:55 03 Jun 11
Sir
Margaret Thatcher was right, as indeed she often was.
In opposing the common European currency (now the Euro), Mrs. Thatcher pointed out that a single currency would place an impossible burden on the poorer countries, such as Greece and Portugal.
Stripped of their ability to manage their own economies and currencies, the poorer countries in Europe clearly cannot compete.
The only recourse for Greece would be to leave the Euro and re-introduce it’s own currency. Greece will then be able to control it’s own economy through the money supply and interest rates and will be able to protect itself by keeping its new currency fully floating.
At the same time, Greece could use its new-found independence to ignore the absurd red-tape that emanates from Brussels and which makes the task of running a business in Europe difficult, if not impossible.
Freed from its shackles, Greece would enjoy healthy exports and tourism receipts due to its relatively cheap exchange rate, and a surge in new business enterprise.
The only losers would be the (unelected) bureaucrats in Brussels.
Sincerely, Derek Lantin. http://dereklantin.booksabuzz.com
hullevad 03:21 09 Jun 11
I met a german in Bangkok last year in april (we were ashed in). We talked about the Greek crisis. He has a german friend there running a hotel/restaurant bussiness! He has for the past more than 10 years NOT payed taxes/vat or roadtax on his german registered cars. His employees is paid in cash. Paperwork in Greece? No way!
So it has not been a great surprise to me that the system is rotten and ineeficient. They better start printing some New Drachmer!
rcshelburne 11:35 30 May 11
Dr. Feldstein is correct in pointing out that the Greek problem is as much of a current account problem as a sovereign debt problem, however he is incorrect in saying that countries that faced similar problems always combined fiscal contractions with currency devaluations. The recent experiences of the Baltic economies demonstrate that internal depreciation is a possible alternative. Nevertheless, it may be the case that currently Greek society lacks the social cohesion necessary to pursue that option. However, an option to leaving the eurozone would be for Greece to develop that level of cohesion by ensuring that the sacrifices were spread more evenly over the society instead of being targeted mostly to civil servants and the working class. Robert C. Shelburne