Whereto Greece?

Nouriel Roubini and Arnab Das of RGE opined in a recent article in Financial Times that the resolution of Greece's problems is crucial for the fate of its neighbours, Euorozone and even the European Union. Here are some excerpts from the article:

Greece has long been an accident waiting to happen due to heavy public debt and lack of competitiveness. Fiscal incontinence and uncompetitiveness are interlinked across southern Europe. Euro accession and bull-market “convergence trades” pushed the bond yields of Portugal, Italy, Greece and Spain towards German bunds. The ensuing credit boom supported consumption but papered over wage inflation that outstripped productivity growth and priced Greece out of traditional export markets.

Excessive bureaucracy and rigidities in labour, product and service markets, meanwhile, discouraged investment in high value added sectors, despite wages well below the EU average. The resulting noxious mix of large current account and budget deficits led to rising foreign debt. Dramatic euro appreciation in 2008-09 compounded these problems.

As bond yields rise, Greece and its peers face difficult choices. The best course would be to follow Ireland, Hungary and Latvia with a credible fiscal plan heavy on spending cuts that government can control, rather than tax hikes and loophole closures that depend on historically weak compliance. This could achieve an internal devaluation with deep real wage cuts and structural reforms to boost competitiveness, as Germany has since unification.

The easy option would be to resort to financial engineering and fiscal fudges, delaying adjustment. Greece would then have to turn to other member states for direct loans (denied – at least so far); to the IMF (ruled out – so far); or to non-traditional creditors, say China (denied). Alternatively, it could devalue, default and re-denominate liabilities into a “new drachma,” à la Argentina (unthinkable).

A credible plan would restore solidarity with EU countries that are adjusting, improve the rhetoric of the European Central Bank and key member states, and bring Greek bond spreads back to earth. This approach is working in Ireland – spreads exploded as public debt ballooned to save its banks, but came back in as public spending was cut by 20 per cent. But it is no cakewalk: Portugal has been deflating to boost competitiveness for a decade. Harsh medicine is best ingested quickly.

Failure to take the tough decisions necessary would draw attention to an uncomfortable historical truth: that no currency union has survived without a fiscal and political union.

The story of the other eurozone stragglers is different in degree but not principle. All are highly leveraged – the fundamental source of financial contagion. Spain, like Ireland, has a massive contingent public liability in its banking sector, arising from mortgage debt. Its growth model – residential construction driven by a house price boom – is defunct. Spain, too, needs fiscal consolidation and structural reform to restore debt sustainability, reinvigorate growth and reduce its 20 per cent unemployment rate. Italy’s government is highly leveraged so it too must cut spending and regain competitiveness. Portugal urgently needs structural reform to restore economic dynamism and fiscal health.