Is There Any Hope for Greece?

Absent a radical change in policy direction, the Greek economy faces the real risk of a lost decade. The application to date of the International Monetary Fund's policy prescription of draconian budget cuts and deep structural reforms, but absolutely no default and no devaluation, has already sapped the lifeblood out of the Greek economy. Further application of this failed policy approach, as Greece's European partners are now insisting on further bailout support, is almost certain to plunge the Greek economy ever deeper into recession.

Over the past 18 months, the Greek economy has contracted by a staggering 9 percent, while unemployment has risen to almost 15 percent of the labor force. A primary factor contributing to this dismal economic performance has been the attempt by Greece to undertake major budget adjustment within the straightjacket of euro membership. Stuck within the euro, Greece is unable to boost its exports by currency devaluation as a much-needed offset to the adverse impact on its economy of major budget belt-tightening.

The virtual collapse of Greece's economy has substantially eroded the country's tax base and seriously undermined its political willingness to stay the course. It has also raised serious doubts in the markets about Greece's ability to service its sovereign debt. At 25 percent, market interest rates for two-year Greek government debt suggest that the market is now attaching a high probability to Greece defaulting within the next two years.

While a substantial write down of Greece's debt would be welcome in that it would lessen the amount of budget adjustment that Greece would need to make to restore fiscal sustainability, it would do nothing to reduce Greece's sizable non-interest payment or "primary" budget deficit. This would still leave the country with the basic problem of having to make a large fiscal adjustment within the most rigid of fixed exchange rate systems. For that reason, Greece should give serious consideration to the advantages of leaving the euro, which would at least give the country the chance of an early return to economic growth.

An early exit from the euro now would be preferable to Greece going through another few years of wrenching recession only to find later that it did not have the ability to tolerate the rigors of continued euro membership.

Desmond Lachman is a resident fellow at AEI

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