Adjust and Reschedule or Delay and Default

BRUSSELS – As Greece activates its €45 billion rescue package with the International Monetary Fund and the European Union, it is becoming clear that a new, far more comprehensive approach is needed. Two problems need to be addressed: the credibility of Greece’s fiscal stabilization program, and how to cover the country’s medium-term financing gap.

The magnitude of the fiscal adjustment effort being demanded of Greece is now well known. The deficit has to be reduced by at least 10 percentage points of GDP (from around 13% of GDP to less than 3% of GDP). The key problem, which has not been addressed so far, is that a fiscal adjustment on this scale requires the government to take two steps that can be implemented only with wide social approval: a cut in wages and a cut in social expenditure. Both steps are now as unpopular in Greece as they are unavoidable.

The country’s competitiveness problems are also well known. Unit labor costs have increased by 10-20% more than in Germany. Assuming that Greece wishes to stay within the eurozone, an “internal devaluation,” i.e., a significant cut in nominal wages, is inevitable.

The government can (and has) cut wages in the public sector, but this is not sufficient. A large cut in private-sector wages also is urgently needed to stimulate exports (which currently amount to less than 20% of GDP, even if one counts both goods and services) to create at least one source of growth.