Greece's Long Road to Default

Markets are understandably focused right now on the question of whether or not Greece will be bailed out by its European partners. However, they seem to be ducking an even bigger question that has profound implications for the long-run future of the euro in its present form. Following many years of budget profligacy, can Greece in the end really avoid defaulting on its sovereign debt even if it does get the periodic European bailout? Sadly, a careful look at Greece's economic numbers does not give grounds for much optimism.

There can be little question that Greece's public finances are on an unsustainable path. This is clearly suggested by a budget deficit that is now close to 13% of gross domestic product, or more than four times the Maastricht criteria's limit of 3% of GDP. It is also underlined by a public-debt-to-GDP ratio that is expected to exceed 120% by end-2010.

Equally disturbing for Greece's long-run solvency is the fact that its budget profligacy, coupled with years of inappropriately low ECB interest rates for Greece, has resulted in persistently higher wage and price inflation in Greece than in the rest of the euro zone. Since adopting the euro in 2001, Greece is estimated to have lost around 30 percentage points in unit labor competitiveness, which has contributed to a widening in its external current account deficit to well into the double digits in relation to GDP.

The only way that Greece can regain international competitiveness without currency devaluation is by engineering over time a 20%-30% fall in domestic wages and prices.

The sad reality is that Greece's domestic and external imbalances have reached such a dimension that their correction within the straightjacket of euro-zone membership will necessarily involve many years of painful deflation and of deep economic recession. Lacking its own currency, Greece cannot restore international competitiveness through currency depreciation. Nor can it use exchange-rate devaluation to stimulate its export sector as a means to offset the negative impact on domestic demand of massive budget consolidation.

In the context of an ECB that aims at price stability for the euro zone, the only way that Greece can regain international competitiveness without currency devaluation is by engineering over time a 20%-30% fall in domestic wages and prices. This would necessarily involve many years of painfully slow economic growth and very high unemployment. It would also have the effect of boosting Greece's public-debt-to-GDP ratio to over 150%.

An even surer recipe for many years of a depressed economy and extraordinarily high unemployment levels would be an attempt by the Greek government to reduce its budget deficit by the 10 percentage points of GDP needed to bring that deficit into line with the Maastricht criteria. Even if one were to assume that the Keynesian multiplier for Greece was 1.2, a 10 percentage point of GDP cut in public spending must be expected to directly cause Greece's GDP to contract by 12% over that period.

Since tax collections in Greece are around 35% of its GDP, were GDP indeed to decline by 12%, Greece would lose around four percentage points of GDP in tax collections. The net upshot would be that Greece's budget balance would only have improved by six percentage points of GDP, thereby necessitating a further round of public spending cuts. Taking this line of reasoning to its logical conclusion, if Greece is indeed to keep cutting budget spending to meet the Maastricht criteria, Greece could very well see its GDP declining by between 15% and 20%.

It is difficult to believe that Greece's social and political fabric would hold together were Greece's recession to be very deep. It is also difficult to believe that a major Greek recession would not result in a wave of household defaults that would shake the Greek banking system to its very roots.

Within this somber picture, however, there is one silver lining for the Greek government. It is the knowledge that Greece's European partners are as fearful of the consequences of a Greek sovereign debt default as is the Greek government itself. For not only would a Greek sovereign default deal a major blow to a still very fragile European banking system. It would also focus the market's full fury on the other highly vulnerable euro-zone members, such as Spain, Ireland, Portugal, and Italy.

Armed with this knowledge, one can be sure that the Greek government will exert its leverage to extract a bailout from the European Commission. Since, despite all of the European official institutions' present huffing and puffing about Greece's lack of policy commitment, they know that when the chips are down the very continuation of the euro-zone experiment in its present form is in question.

Sadly, when Greece does get bailed out there will be a basic question that will not be asked by either the Greek government or by the European Commission: Whether Greece's long-term economic interests are best served by delaying what seems to be Greece's inevitable need to restructure its sovereign debt. Not only will a bailout needlessly put the Greek economy through the wringer and worsen the starting point from which an eventual Greek economic recovery might begin, it will also cruelly saddle Greece with a mountain of official debt that Greece will not be allowed to reschedule.

Desmond Lachman is a resident fellow at AEI.

Photo Credit: iStockphoto/Alex Culla i Vinals

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