by Thanos Skouras and Alfred Steinherr*
Rather, they must be spurred by enabling the (so far still too weak) reform coalition at home, argue Thanos Skouras and Alfred Steinherr.
The public discussion over Greece's future path has so far overwhelmingly focused on the question of debt. Indeed, this is the most pressing issue. But this focus on debt, and on how to deal with it, often hides from view the medium-term obstacles to growth.
To comprehend the difficulties involved in resuming economic growth, let us imagine the most favorable outcome to the debt problem — that Europe offers debt forgiveness for all Greek debt in excess of 60% of GDP (the Maastricht Treaty limit). Will that be enough to put Greece on a growth trajectory so that the country’s per capita income converges to the European average?
The first priority would be to make sure that Greece regains the markets’ confidence, which would enable it to borrow at “reasonable” rates. And yet, even though the courageous assumption of large debt forgiveness would make an important contribution to getting to lower interest rates, this step alone would be insufficient to squeeze out the risk premium. Such a reasonable rate cannot be expected to be as low as German rates — because markets have witnessed how unstable Greece can become.
Consequently, strong actions will be required to improve the country’s reputation in financial markets. One useful step would be a constitutional amendment in Greece introducing a prohibition of public deficits. Other countries have done it, the recent Merkel/Sarkozy initiative foresees such a measure — and it would certainly be instrumental in restoring the country’s reputation.
With such a constitutional amendment, and the reduction of debt to 60% of GDP, the risk premium could fall substantially, say, to around two percentage points over the German rate. On that basis, the cost of financing the public debt should be close to 3% of GDP (a debt level of 60% of GDP multiplied by interest costs of roughly 5% over the medium term). With a no-budget-deficit rule in place, this means the primary surplus would be about 3%.
A reputational gain and much lower interest rates are surely good for economic activity. But would this be enough to spark strong economic growth in Greece? Bearing in mind that fiscal stimulus is out of reach (given the deficit constraints), in all likelihood the answer is no.
The reason is that unit labor costs in Greece have increased by some 20% in relation to Germany’s. That is, Greece’s wages have grown by 20% more than productivity over the last ten years. Having chosen to enter into a monetary union with countries like Germany (and the likes of Netherlands, Belgium, Austria and Finland), there is no way around the need to correct the excessive unit labor costs in relationship to partner countries by both moderating wage costs and increasing productivity. This is the crux of the problem: How to realign unit labor costs with those of competitors in the monetary union?
What is required in order to achieve such an outcome is unpopular and hence politically difficult. First, it would mean zero wage increases for years. At the same time, taxes on labor should not be increased, while social contributions or labor taxes should, if possible, be decreased. The resulting shortfall in tax revenues will only partly be made up for by increased employment.
It will be necessary to strengthen public finances, either by properly pricing public services so as to cover their actual costs — or by privatizing them. At present, the quality of public sector performance is bad, and services are overused because they are provided free of charge (or way below cost).
Second, to further stimulate productivity growth in Greece, a number of reforms are necessary to increase competition. The labor market needs to become considerably more flexible than it is at present. Closed professions must be opened up, and restrictions limiting competition in various fields of economic activity need to be abolished.
Third, since a well-functioning economy needs a reliable and performing public sector, the state itself needs to be reformed. Therefore, beyond privatization, large-scale public sector reform is unavoidable. The functioning of the judiciary and the police, the education system at all levels (from kindergarten to university), the public provision of health services, the incentives for research and innovation, the way political parties are financed, the way public policy is audited, the retirement age and the proper financing of the pension system — all must be fundamentally improved.
Implementing these reforms will certainly not be easy, but there is one hope — that Europe will force it through, in exchange for granting debt forgiveness. As George Soros recently argued, Germany (helped by the usual suspects) has two important and unpleasant jobs to accomplish: to pay up for the extravagances of the European south — and, much more important, to define and monitor the implementation of what the required political reforms ought to be.
Politically, it might be unacceptable for any country to be told by Europe (or whoever else) how to improve governance in exchange for generous financial transfers. And yet, such conditionality has been regularly practiced in other parts of the world — and on lesser “sinners” than the Greeks turned out to be. There is nothing about being “Western” or “developed” that can shield one from the application of such bitter medicine.
In particular, getting into such dire straits often, and certainly in Greece’s case, reflects the fundamental failure of the domestic political economy — and especially a disastrous tradition of political and governmental elites gaming the system for their own benefit, and to the people’s detriment.
Therefore, the reforms that need to be undertaken cannot be imposed from abroad. Rather, they must be spurred by enabling the (so far still too weak) reform coalition at home. In other words, the key is to change the political calculus, not the economic one.
To see why this is so, just consider the following: Any further delay in, or avoidance of, meaningful reforms will merely result in the economy not getting onto a proper, self-sustaining growth path. Hence, living standards in Greece for everyone but the elites will tend to diverge, rather than converge, with those of the north of Europe.
Of course, it may well be that the country’s political elite does not mind paying this price, if it considers that as necessary to secure its own survival. In this case, the temptation to run a budget deficit and resort to fiscal stimulation, despite the commitments to do the opposite entered into after considerable debt forgiveness, will prove irresistible. As has been the case until now, the elites would trade off a little short-term gain in credibility, available from the debt forgiveness, for a severe long-term loss.
However, even then it will not be long before debt increases again — and the terms of public borrowing become prohibitive. It should, therefore, be clear that simply disposing of the debt problem with debt forgiveness is not even a solution for Greece itself, if the difficult reform measures required for growth are not seriously implemented.
Would it be better for Greece to get out of the monetary union? In this case, it may be argued, competitiveness can be regained through devaluation, obviating the need to undertake painful reforms. There would be an initial severe shock to the banking system, financial flows would be interrupted, and economic activity may be adversely affected. Hence, there is little doubt that the cost of this option is not negligible.
Moreover, since the remaining debt (60% of GDP) is denominated in euros, servicing and repayment of that debt would become inevitably more onerous. As a result, debt restructuring would be necessary, delaying for years the possibility of returning to the international debt markets. The reputational loss would be colossal right from the beginning. Greek residents and Greek institutions will be reluctant to subscribe to new government debt, while both domestic and foreign investors will be reluctant to invest.
But is the longer-term outlook more promising? It is true that, if the country is no longer part of the eurozone, monetary policy could be conducted in light of “Greek needs.” But that, lest we forget, was not an overly successful strategy before the euro’s launch. Plus, with institutions continually weak in the absence of necessary reforms, it is unlikely that it will be much better in the future.
Nevertheless, it may be argued, the drachma could be devalued regularly to regain competitiveness. Unfortunately, the power of devaluation is easily exaggerated. To be effective, the devaluation-induced higher import prices must not be fully transmitted to wages and domestic prices. In other words, real wages must fall.
That, however, is precisely the outcome the advocates of a devaluation strategy seek to avoid in the first place. There is thus no escaping the fact that, in order to regain competitiveness, wage costs (as well as all local incomes and asset values in terms of foreign currency) need to fall.
Moreover, the more often the currency is devalued, the less effective it will be in improving competitiveness. Just look at the United Kingdom and the prolonged decline in competitiveness there over the decades, despite a policy preference favoring currency devaluation.
Devaluation is not a viable economic strategy because it will lead to increasing pressures in favor of rapidly increasing wages and prices, in order to compensate for the loss in real income caused by devaluation.
This loss of effectiveness would be particularly pronounced in the Greek economy, in which exports are often of limited value-added, while at the same time being heavily dependent on imported raw materials and intermediate products (and hence higher prices to be paid for those inputs).
Consequently, repeated devaluations will most likely soon lead to increasing inflationary pressures and, before long, to accelerating inflation. In these circumstances, capital movements will tend to be out of the drachma into stronger currencies — and this will inescapably lead to the imposition of capital controls.
In conclusion, getting out of the euro would offer neither an immediate easy solution nor a longer-term gain. It would also derail all of the already realized and potential future benefits of the Europeanization process on which Greece embarked 30 years ago — and which, in all likelihood, is the only ticket to the future.
The only beneficiaries from a euro exit might be Greece’s political elite, because it would relieve them of their collective responsibility to proceed immediately with the implementation of unpopular, but unfortunately necessary, reforms.
* Thanos Skouras is a professor at the Athens University of Economics and Business and has been vice-rector and president of the University Research Centre. Alfred Steinherr is professor of economics at the Free University of Bolzano in Italy and research professor at the Deutsche Institut für Wirtschaftsforschung (DIW) in Berlin, Germany. He also serves on several academic and business boards.
By: N. Peter Kramer
