The Greek melodrama continues. To understand the current situation, we must go back to the period between 1994 and 1998, when the EU countries wanting to adopt the euro had satisfy the Maastricht criteria.
The Maastricht criteria were meant to be a robust assessment of the extent to which a country could safely abandon its exchange rate to adopt the single currency, effectively relinquishing an important policy tool. When the first assessment was made in 1998, Greece failed. That was the first warning sign that the Greek euro experience was going to be anything but smooth.
In 2000, Greece asked for a re-evaluation, and managed to scrape by. However, it was simply not credible that an economy could achieve a turnaround within just two years. That was the first mistake made by European policymakers.
The second warning sign came few years later when Greece was accused of falsifying its fiscal deficit, leading to the EU spokesperson to famously exclaim in 2004: “Greece would not have joined the euro with the figures we now have.”
Greece should have been put under much closer surveillance at that time. Far from being committed to sound policy, the Greek economy continued to be sucked down a vortex of bad policymaking. The 2007 report prepared by the International Monetary Fund (IMF), stated: “Over the longer term, a persistent loss of competitiveness raises the prospect of a prolonged period of slow growth. Averting this risk requires improving cost competitiveness through wage moderation, an environment that encourages product upgrading, and a broadened effort to reform product and labour markets.”
The IMF experts had correctly identified a root problem: high wage increases which were “relatively large and often exceeded productivity growth”.
Since 2010, eurozone member states and the IMF have been providing financial support
Economic theory suggests that the currency of a country can exert strong discipline on wage growth. Excessive wage growth leads to loss of competitiveness, which is neutralised through a constantly depreciating exchange rate. Hence, to preserve the exchange rate, economic agents would be cautious with wage claims.
The problem in Greece was that this channel was no longer operative with the adoption of the euro, since the euro exchange rate is influenced by the general economic conditions in the eurozone and not by the specificities of a single small country.
In short, anyone with a basic economic knowledge knew that the conditions were there for a perfect storm and the information was publicly available for anyone to analyse. Investors ignored the warning signs, as the risk-return combination appeared attractive. But the financial markets suddenly realised that Greece had reached the point of no return. International liquidity dried up suddenly, leaving the Greek government unable to fund itself.
At that point, the European economy was in disarray, and the financial markets clouded with uncertainty. The short-term solution was to offer assistance to Greece – not to be confused with the long standing assistance it receives in the form of EU funds. Since 2010, eurozone member states and the IMF have been providing financial support. In 2012, further assistance was offered in conjunction with ‘private sector involvement’, a euphemism which meant private sector investors experienced a cut in the value of their Greek bond holdings.
Recent news suggests Greece wants to renegotiate further which, despite the huge marketing drive, in practice implies that lenders are being asked to make further sacrifices. In particular, the idea of growth-indexed bonds means that the risk of lower returns (in the eventuality that GDP growth is low) is passed on to the lenders.
So the Maltese government has borrowed money at a certain rate in order to fund the loan to Greece, but the rate at which Greece will repay this loan is determined by Greece itself.
Other talks of extending the repayment period likewise entail a cost to the lenders in the form of a decline in the net present value of the bond holding.
The situation has become tragicomic: a tieless prime minister feeling strong enough to boast that ‘you either do as I say or else you suffer’.
But providing further breathing space at this point is tantamount to a gambler who lost but who wants to play again to recover his money. We must also not underestimate the damaging effect of moral hazard: if a country is allowed to twist the rules in its favour for the umpteenth time, it would not be possible to stop other countries from doing the same in future.
Joining the EU and the eurozone is an act of belief, based on mutual respect and obedience of the common rules. Anything else would undermine this project.
The countries which blame Germany for their current woes are completely misguided. Germany’s success is the result of sound policy making, not luck.
In the end Grexit must not be ruled out.