 | | Glen Hodgson
Senior Vice-President and Chief Economist
Forecasting and Analysis |
Greece, Italy and a few other euro-zone members are facing a hard period of fiscal austerity in an effort to remain in the eurozone and restore their credibility with private financial markets. Fiscal austerity will be painful, prolonged, and will hit many citizens in these countries very hard. But there is no easy way out. The only other option—to leave the eurozone and likely default on their public debt—would be no less painful, would destroy their financial reputation for a generation, and would have massive negative global effects.
How did Greece and Italy get into this mess? Through two key decisions. First, they agreed to join the eurozone, a common currency area with many other EU members. At the time, the creation of the euro appeared to provide political and economic stability among its members, but it also created a common monetary policy that was often inappropriate for each of the many diverse economies. Critically, the eurozone’s architects failed to build a strong common fiscal policy platform among the members. Moreover, the euro's creation took away the potential for a member country to use exchange rate adjustment to restore international creditworthiness, as they were locked into the common euro exchange rate against other currencies.
And second, governments in Greece and Italy did not implement adequate fiscal discipline within their own country as eurozone participants. They continued to run fiscal deficits that were funded largely by EU banks, leading to mounting public debt denominated in euros. Greek public debt is now approaching 160 per cent of GDP and continues to rise rapidly, and Italian public debt has reached 120 per cent of GDP.
When investors lost confidence in the capacity of these countries to meet their debt payment obligations on time, capital markets severely curtailed their access to private credit. Greece hit the wall in March 2010 and ever since it has been on financial life-support from other EU members, the European Central Bank and the IMF. Italy saw investor confidence evaporate over the past two weeks due to inaction on its austerity plans, although it is still able to raise some private financing—but at a huge price, reflecting a massive perceived increase in risk. Italy just paid an interest rate over 6 per cent for a one year bond issue, or nearly 500 basis points more than Germany would have to pay.
A heavy political price is already being paid in both countries. Their respective prime ministers have been pushed out of office, to be replaced in each case by an economist with a strong technical pedigree, but with no political experience. And financial markets around the world continue to be exceptionally nervous about the capacity to implement and sustain a serious austerity package—one that entails deep cuts to spending, significant roll-back of entitlements, and tax increases.
The dominant powers in the eurozone (Germany and France) made clear to the Greek leadership two weeks ago that there is a simple but stark choice. Greece can stay within the eurozone by implementing measures to balance the fiscal books by 2014, rebuilding investor confidence and ensuring ongoing financial support from the other euro-zone member governments. To ease its debt service burden, Greece has already been offered a "voluntary" write-down of 50 per cent of the government debt owed to banks, subject to implementing its austerity package.
Or, Greece can leave the eurozone. That move would require Greece to recreate its own currency, likely at a sharply devalued exchange rate, and to rebalance its budget without the financial assistance of the EU partners. Devaluation would wipe out a significant share of domestic savings, raise domestic prices, but would also make Greek exports like tourism more price competitive. Greece would likely default on its public debt, erasing its debt service payments but also destroying access to credit for many years to come. A default would have a severe impact on many EU banks and governments, feeding a contagion effect with global consequences. The investors that hold Greek public debt would take a larger hit, and EU governments would have to take additional efforts to shore up their financial system.
At 1.8 trillion euros, Italy's public debt is much larger than that of Greece in nominal terms, if smaller as a share of the national economy. Any significant write-down of Italy's massive public debt could threaten the stability of numerous European banks, so it is not on the table as an option for now. Italy is simply going to have to balance its budget and meet its payment obligations to creditors—or create a calamity.
Under either option—staying within the euro, or leaving it—governments in Greece, Italy and any other heavily indebted eurozone countries like Portugal have no choice but to bring their fiscal deficits under control. If they choose to stay within the eurozone, other EU governments will offer help to ease the pain of adjustment. But if they leave the euro, no such assistance will be offered. EU banks will be even more threatened, and the fiscal austerity will be even more severe—since Greece and Italy would have to balance their budgets even more rapidly, likely under the firm guidance of the IMF.
In short, the choice is stark. Greece and Italy made poor policy choices over many years, alone and with their eurozone partners, as did their bankers. And now there is a high price to pay for all of them—with no easy way out.