Upon entering the Eurozone in 2001, Greece appeared to have found the magic formula for growth. After woeful performance throughout the 1980s and 1990s, the Greek economy grew at an average of almost 4 percent annually between 2001 and 2008–the second highest rate in the Eurozone. Then came a double shock in 2009 that culminated in a sovereign debt crisis. Greece suddenly found itself at the center of an international financial storm.
The effects have been devastating. Since 2008, Greece’s unemployment rate has risen from under 8 percent to more than 27 percent, and the country has experienced a 26 percent contraction in real gross domestic product. In a Becker Brown Bag talk on November 18, George Tavlas, a member of the Monetary Policy Council at the Bank of Greece, said that the sudden shift from prosperity into a downturn comparable to the depths of the Great Depression of the 1930s. The crisis exposed serious structural problems with the Eurozone’s fixed exchange rate regime.
George Tavlas
More specifically, Tavlas argued that the Eurozone lacked an automatic adjustment mechanism for correcting external imbalances, like that observed under the classical gold standard of the late 19th and early 20th centuries. “The absence of such a mechanism has been the Achilles’ heel of Europe’s fixed exchange rate regime.”
Tavlas said that the “magic formula for growth” that Greek authorities employed in the pre-crisis period relied heavily on increased government spending financed by borrowing at low interest rates available as a benefit of association with the stability of Eurozone countries. But as government expenditures grew, and both the external deficit and sovereign debt as percentages of GDP ballooned, no mechanism existed to reverse the flow of money and credit inward; Greece could just keep borrowing and borrowing seemingly without consequence.
According to Tavlas, a reckoning came in the form of two shocks, exposing the fragility of a growth model based on government spending. In October 2009, newly elected Greek socialist leaders revealed that the fiscal deficit of for 2009 would double the previous government’s projections; the final figure would be 15.6 percent of GDP. Then, in November, Dubai’s request for a six-month moratorium on its debt had soured the global market for investments in highly-indebted countries. “Investors began dumping risky assets, and with the surprise news about Greece’s fiscal situation, the country found itself suddenly in a position that it never thought it would be–at the center of an international financial storm,” said Tavlas.
“We often hear that the Eurozone lacks sufficient wage and price flexibility to function as an optimal currency union,” said Tavlas. “That may be true, but my point is that even if there had been perfect wage and price flexibility, the flows of money and credit acted to exacerbate rather than correct the fiscal imbalance.”
Tavlas argued that the gold standard—another fixed exchange rate regime—provided a historical example of what went wrong for Greece. Under the classical gold standard, participant countries maintained their own currencies, and when external imbalances and sovereign debt expanded, central banks acted to reduce the money supply in order to avoid devaluing their currencies against gold. Interest rates rose as a result, curtailing excessive borrowing.
The trouble with the Eurozone is that smaller member countries use the same currency as larger, more solvent ones, with no adjustment mechanism to curtail the borrowing of a country with high sovereign spreads. Prior to the outbreak of the Greek sovereign debt crisis, borrowing continued unchecked until an external shock–in this case, foreign investors suddenly deeming Greek debt too risky–and the entire force of the Greek devaluation needed to restore competitiveness came down on domestic prices and wages.
The possible endgame of Greece exiting the Euro wouldn’t have addressed the structural issues in the Greek economy, said Tavlas. A corrective mechanism for fiscal imbalances would still be absent, and a sudden shift from the euro would carry significant credibility costs both with citizens and with foreign investors, further limiting access to capital to drive the recovery. Pressure to implement reforms, needed to strengthen competitiveness, would be relaxed–perhaps abandoned– condemning the country to a poor economic performance for many years.
The Greek crisis has taught us that for wage and price flexibility to work, we must first have a well-functioning adjustment mechanism, said Tavlas. Devaluation of their currency would not have addressed the competitive weakness in the economy that allowed the situation to become so dire in the first place.
Things are looking brighter for Greece according to Tavlas—the economy is beginning to recover, bond spreads are down, and equity prices are up by 150 percent. Transformative banking reform has eliminated excess capacity in the banking sector; four well-capitalized core banks remain, with several smaller, specialized banks that are also well-capitalized. Over the past year and a half, deposits are up by 10 percent and Euro system borrowing by Greek banks is down by 50 percent overall.
But the crisis’ impact on unemployment took its toll in the form of political pressures to speed the recovery by any means necessary, including reconsideration of the option to exit the Euro entirely. “The main risks facing Greece today are political,” said Tavlas.