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Rudi Dornbusch, the late renowned MIT economist, used to say of the Mexican central bank board that he could understand their making mistakes. After all they were only human. However, what he could not understand was how the same people could make the same mistakes time after time.
One has to wonder whether the same might not be said of the IMF in relation to its recently announced US$150 billion led Greek bailout. After its disastrous experiences with major fiscal adjustment programs under fixed exchange rate regimes in both Argentina in 2000 and in Latvia in 2008, the IMF is now prescribing the same recipe of hair-shirt budget-retrenchment in the far more intractable Greek case. And throwing any semblance of caution to the wind, the IMF is gambling US$40 billion of its own money on the Greek program.
Greece’s two basic problems are its extraordinarily bad public finances and its large loss in international competitiveness within the straightjacket of Euro-zone membership. Despite the European Stability and Growth Pact’s strictures, Greece’s budget deficit has ballooned to 14 percent of GDP, while its public debt to GDP ratio has increased to 115 percent. At the same time, Greece has managed to lose around 30 percent in wage and price competitiveness over the past decade, which has resulted in a widening in Greece’s external current account deficit to over 12 percent of GDP.
Not wishing to countenance the idea of either debt restructuring or Euro exit as part of a policy package, the IMF is prescribing draconian fiscal retrenchment as the cure-all to Greece’s economic ills. Indeed, it is requiring Greece to cut its budget deficit by no less than 11 percent of GDP over the next three years, with half of that adjustment to occur in the program’s first year.
By now one would have thought that the IMF had learned that undertaking a Herculean sized budget adjustment, without the benefit of a currency-depreciation to boost exports, will plunge the Greek economy into a major economic recession. This will be particularly the case at a time when Greece’s borrowing costs have soared and its banks are losing deposits. Compounding matters, a deep recession will substantially erode Greece’s tax base that will then require a further round of painful budget cuts. In short, if Greece hews to the IMF’s path one could very well see Greece’s GDP contracting by between 15 and 20 percent over the next three years.
If the Greek authorities have any doubt on this score, all they need do is look at the sorry experience of Latvia and Ireland where output has collapsed by over 20 and 10 percent, respectively, over the past two years. It has done so precisely as a result of IMF-style budget deficit reduction, on a lesser scale than that now being proposed for Greece, in the context of a fixed exchange rate system.
At the same time that it is proposing radical budget adjustment, the IMF is urging that Greece restores the 30 percent that it has lost in international competitiveness over the past decade through an “internal devaluation.” Given the limitations on Greece’s ability to increase labor productivity through structural reform, this will necessarily involve major wage and price deflation over the next few years.
The basic flaw in the IMF sponsored program is that if successfully implemented it will have the unwanted effect of substantially increasing rather than reducing Greece’s public debt to GDP ratio. Since if Greece’s nominal GDP were to decline over the next few years by 30 percent, as a result of a deep recession and price deflation, Greece’s public debt to GDP ratio would arithmetically rise from its present level of around 120 percent towards 175 percent. It is calculations of this sort that have recently led Standard and Poor’s to warn Greek bond holders that they might eventually retrieve only 30 to 50 cents on the dollar on their bond holdings.
A major write down of Greece’s US$400 billion sovereign debt would deal a serious body blow to an already enfeebled European banking system, which holds the majority of that debt. The even greater risk to the European banking system from a Greek default is that it would bring very much into play Portugal, Spain, and Ireland. These countries, which between them have around US$1.5 trillion in sovereign debt, suffer from similar, albeit less acute, public finance and international competitiveness problems as does Greece.
The very real risk that a debt restructuring poses to the European economy explains why the IMF is trying to kick the Greek can forward through large scale financing. However, particularly in light of the IMF’s earlier failures with fixed exchange rate programs, the IMF is being disingenuous in expecting us to believe that Greece can successfully restore internal and external balance to its economy through severe budget cutting without resort to a debt restructuring or a Euro exit.
Desmond Lachman is a resident fellow at AEI.
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