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Economic Turbulence in Greece

The current approaches to the Greek and eurozone crises that are being pushed by Germany, France and the European Union are failing because they suffer from a fatal misdiagnosis. The central problem is not profligate spending in the periphery, but the very set-up of the European Monetary Union. Without attending to current account imbalances within the eurozone, austerity will be self-defeating. Deflation and depressed growth will heighten the debt problem while continuing to ignite social ruin. The eu must become an entity with a unified and expanded fiscal policy and a central bank willing and able to act as lender of last resort. If austerity and structural reform continue to be the only options, Greece will bear witness to a lost generation and a likely end to the euro project in its present form.


Economic Turbulence in Greece

Rania Antonopoulos, Dimitri B Papadimitriou

The current approaches to the Greek and eurozone crises that are being pushed by Germany, France and the European Union are failing because they suffer from a fatal misdiagnosis. The central problem is not profligate spending in the periphery, but the very set-up of the European Monetary Union. Without attending to current account imbalances within the eurozone, austerity will be self-defeating. Deflation and depressed growth will heighten the debt problem while continuing to ignite social ruin. The EU must become an entity with a unified and expanded fiscal policy and a central bank willing and able to act as lender of last resort. If austerity and structural reform continue to be the only options, Greece will bear witness to a lost generation and a likely end to the euro project in its present form.

Rania Antonopoulos ( is senior scholar at the Levy Economics Institute. Dimitri B Papadimitriou is president of the Levy Institute and also Jerome Levy Professor of Economics at Bard College. The Levy Economics Institute and Bard College are at Annandale-on-Hudson in New York state, the United States.

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urope’s crisis has spread from Greece to Spain, Italy, and beyond, with a high probability of a fallout to the other side of the Atlantic pond, striking the United States’ already teetering financial system. Greece, a small country of roughly 10.8 million, is in the centre of the vortex. Despite her minimal contribution of only 2% of European Union (EU) gross domestic product (GDP), for more than two years the country’s sovereign debt crisis has inflicted instability on the global financial markets and threatened to unravel Europe’s Economic and Monetary U nion (EMU) throwing the European financial system into complete disarray. When and how the country’s public debt became unsustainable is not discussed, while the policy response i mposed by the European leaders has pushed the country into a deepening recession and led to deep cuts in basic services like healthcare and education for more than three years. The disturbing social and economic trends emanating from accelerating l evels of unemployment, decreasing incomes, daily worker strikes and/or stoppages, a jump in suicides among men and a dramatic increase in crime are all characteristics of a dysfunctional society. Citizen unrest is unparalleled in recent memory, matched only by events that took place during the civil war in the mid-late 1940s and the military junta period of 1967-74.

The messages that are being sent on a regular basis from the European leaders – including the latest one subsequent to the new rescue package crafted for Greece along with the proposed expansion of the European Financial Stability Facility (EFSF) – were that the EU can be held together with a combination of bailouts and continued austerity that will isolate the highly indebted countries, and leave the rest of Europe economically intact. This, of course, has been shown to be pure fantasy. Since then, we are witnessing a slow-motion train wreck that will dissolve an economically united Europe, a union that, despite its many downsides, is in the best interests of the con tinent’s countries – rich and poor – and the global economy (Papadimitriou 2011a).

The need to push forward on Greece’s solvency problem is a positive development, but the current fix basically amounts to extending the life support for a little longer. Assuming the new technocratic Greek government passes the programme, with more austerity measures and structural reforms attached to it, Greece’s payments on its debt principle will be postponed, interest payments maybe lowered by the “haircut” of its debt held by private sector investors – still to be negotiated and highly resisted by private banks – it will have a limited impact. It is possible that in 2013-14, the structural deficit in public finances will be brought under control or even eliminated. This is no achievement to be proud, however, since it will come at the cost of unprecedented levels of unemployment and poverty. And, most significantly, the underlying problem of an economy with no growth will not have been addressed (Papadimitriou 2011b).

Treating the symptom while ignoring the fundamental causes behind the crisis has led to the wrong medicine. The misdiagnosis, however, is not accidental. The EU’s neo-liberal thinkers are using the crisis not only to impose austerity but also to roll back social legislation while privatising as much of the economy as possible. They, then, move the focus away from the problems with the private sector – especially with the excesses perpetrated by financial institutions that created the global financial crisis – and on to governments’ profligacy and “coddling” of the population in the form of a decent social safety net.

So, “big government” and “inflexible labour markets” have been presumed by European leaders to be the true culprits, demanding immediate deficit reduction and structural reform policies that have proved to be ineffective. On the other hand, the rules set out by the 1993 Maastricht treaty and signed on by all EMU members, have recently been made more painful by the E uropean Union Parliament that voted to make sanctions more automatic on countries that exceed the treaty’s criteria for debts and deficits (Stearns 2011). This is ironic since only four of the 27 member states meet the Maastricht deficit criteria (Liu 2011). Germany does not meet the criteria and will have to pay the fines. And it was Germany that originally had the rules relaxed when its own slow growth period caused it to chronically exceed Maastricht limits on deficits and debts. What is more ironic is that loosening the rules allowed Greece and Portugal to build to higher debt ratios that Germany and France now admonish. Whether inspired leadership will emerge in Greece in the next few months or whether the European project as is currently constructed will be sustainable are the two key issues that are in the minds of the players in the financial markets.

A Chronology of Events1

The new government of George Papandreou, once voted into power in October 2009, announced that it would embark on s evere spending cuts and concentrate on tax evasion and avoidance to increase public revenues as necessary steps to deal with a projected public deficit of 12.7%, much larger than originally estimated by the outgoing conservative government. Papandreou, nonetheless, reaffirmed that he will stand firm to the “commitments for more social justice”, a pre-election campaign promise for a social contract that got his party PASOK elected. A month later it was revealed that the Greek Statistical Agency had misreported economic data and that the country for the previous year, at least, was in recession during which time the deficit GDP ratio had grown rapidly. Declaring the country to be in a financial crisis and a threat to “national sovereignty”, he put forward a budget proposal that would cut the public deficit to 9.1% of GDP. His administration anticipated neither the financial markets’ response nor the tenacious inaction of the EU. By the time the EU responded with a rescue package of ¤ 110 billion crafted in concert with IMF and ECB (the “troika” plan as it is referred to in Greece), the three main credit rating agencies, Fitch, Standard & Poor’s and Moody’s, had significantly downgraded Greece’s sovereign debt, signalling the high risk involved in holding such debt and making it difficult for the Greek government to borrow in international markets. The rescue plan called for austerity measures and the adoption of neo-liberal structural reforms along with periodic progress reports as a condition for releasing funds. What, in retrospect, proved to be “mild” austerity measures was met with general strikes by public and private sector workers and professional unions with riot police violently clashing with demonstrators. Periodic progress reviews by representatives of the troika that followed revealed serious shortcomings in meeting deficit reduction targets, necessitating the government to introduce even more severe austerity measures that were, and still are, met with further demonstrations, general strikes and at times violent events and uncontrollable civil unrest.

The rescue package notwithstanding, Greece, as the media r eported, “fails to reassure investors” that austerity measures are effective and the deficit crisis can be handled, pushing stock m arkets around the globe down while the Standard & Poor’s cuts the status of Greece’s government bonds to the level of “junk”.

While the omens for the necessity of a debt restructuring were clear, the Papandreou government’s willingness to consider it was absent: it was portrayed from the beginning as anathema and to the contrary, avoiding any type of restructuring of the debt and giving assurances against “defaulting” became a matter of national pride according to Papandreou. The calls for reconsideration of the severe austerity measures and labour market r eforms by members of the Papandreou party were deemed unpatriotic and were met with expulsion leaving him in Parliament with a thin majority. For example, speaking up against the stringent conditionalities of the EU/ECB/IMF bailout, Louka Katseli, the courageous minister of labour, was ousted from her post in the summer of 2011 only to be expelled from the PASOK party by Papandreou in October 2011 when she voted against Article 37, which was calling for the elimination of collective bargaining, by the EU/ECB/IMF bailout memorandum. Even in January 2012, d espite continuing civil unrest, there is little social dialogue about the future of the country silencing harshly voices of dissent.

Austerity measures and reforms, and calls to continue or i ncrease them will not work. Raising taxes in a country known for its flagrant tax evasion has only boosted the shadow economy. Wage and pension cuts are further lowering tax receipts. Worse, these measures are depressing production levels, demand and r etail sales resulting in more unemployment (Papadimitriou 2011b). A little too late, on 26 October 2011, the leaders of France and Germany came up with a second rescue package for Greece. We will return to the details of this newest European rescue later.

The Social and Economic Context

In the period of mid-1990s to mid-2000s, Greece’s economy was growing faster than the other eurozone countries and was treated as a poster child by the EU. Among other developments, the government capitalised on this advantage and borrowed cheaply. International banks and investment houses were happy to oblige. The government was running a deficit above 3% of GDP but so were many other countries, including on occasion Germany, with no penalties enforced and no news reporting about the dangers

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ahead. Tax revenues, despite pervasive tax evasion and a 30% shadow economy, were stable. But, when the world economy slowed in late 2007 and early 2008, and when the global financial crisis hit Greece, tax receipts declined abruptly. In the meantime, government spending did not. This was a proper reaction to the cooling off of the economy. It is precisely in these circumstances that countercyclical policy is called for. Instead of acknowledging its necessity, it was branded later “a continuation of the profligate Greek state”. The result was that the country’s deficit began to grow rapidly in 2008. This was not disclosed as we discussed earlier and in early 2010, “concerns” about Greece’s sustainability of huge national debt became headline news around the globe.

Greek citizens found themselves in the midst of a severe structural adjustment programme, one that was embraced wholeheartedly by the ruling elites. The explanation and therefore justification was that the sovereign debt crisis was brought about by

(a) a profligate state and (b) very much below European average productivity workers. The prescription? The State must spend less and tax more; workers must either become more productive or accept wage cuts and even higher joblessness. Policies and measures were announced, so as to shrink the government’s share in GDP by firing or retiring early public sector workers and suppressing the wages of those who remained. Further measures included cutting appropriations to health, education, infrastructure maintenance, unemployment insurance, old age minimum pensions, and other social protection benefits to low income families while simultaneously increasing VAT, lowering the taxexempt annual income from ¤ 12,000 to ¤ 5,000 and imposing special “solidarity” taxes to close the deficit. The result has been incomes of middle class households have come down by 40% and there has been a further expansion of the shadow economy. Other measures include the sale of public assets to decrease outstanding debt that stood at ¤ 366 billion, together with new legislative changes aimed at improving “labour market functioning” and competitiveness via eliminating national collective bargaining agreements and more generally, reducing other kinds of l abour market “rigidities”.

A concrete example is instructive here: to transform oligopolistic labour markets, the occupation chosen to be transformed was that of pharmacists. As a result, new legislation was announced that imposed longer hours of operation of pharmacies and removal of zoning restrictions that previously prohibited opening a pharmacy within two blocks or so of an existing one. Besides longer hours of work imposed on the owners, the vast majority being women, of the traditional one-to three-person small enterprises, increased competition is set to bankrupt these small-scale establishments, enforcing in effect sector consolidation and capital centralisation. Presumably the system that had worked so well until now and allowed for neighbourhood-based close p ersonal care provisioning of patients by pharmacists, is to be r estructured because it is holding back market competition. M ultinationals and their franchise businesses will do a better job. This has brought about massive mobilisation and resistance by the pharmacists’ union.

To be sure, some changes may be necessary, but not on such a wholesale scale. In this regard we are not defending the indefensible

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oligopolistic business behaviour and tax evasion nor condoning the pervasive clientilism and the corruption-prone behaviour of the Greek state, both of which are often used to secure political allegiance. Tax evasion for a variety of historical reasons and petty corruption of public sector employees (including tax collectors) has been disturbingly rampant and Greek citizens are themselves complicit. This is an inconvenient truth, because systemic corruption worked for all parties involved. It is clearly preferable to pay lower taxes, including the bribe, than paying the official taxes due. There are historical, sociological and cultural elements to tax compliance by business and citizens, but a discussion of them is beyond the scope of this article. Suffice it to say that tax revenue problems are multifaceted in Greece and cannot be reduced to a vague “tax avoidance” culture. The Greek shipping industry, for e xample, is unquestionably one of the largest and most significant in the world, representing 22.4% of EU gross tonnage for vessels under the EU flag and holding 16% of the world’s total tonnage. Apart from its size, it is also a key component for the Greek economy as it employs almost 5% of the Greek population. Above all, it produces 8% of GDP. Yet, it pays zero taxes. Legally, that is. Whenever an elected government administration has tried to negotiate transforming the tax code, the leverage exerted was excessively strong. The response has been that companies and capital are m obile and relocation to another country that provides a tax haven would simply result in unemployment for Greece and empty business buildings around the main port of Athens.

A Traumatised People

Whatever the causes for the rapid increase in the deficit position of the country – we will discuss this further in the next section – the wrath of the troika on the Greek population was devastating. In 2011 alone, the cumulative decline in GDP as of the third quarter was a recorded 5.5%, as per EL-STAT, the Hellenic Statistical Authority and expected to have hit over 6% for the year. Unemployment has risen to over 18% and in some provinces the 50% mark. Youth unemployment is over 52% and among young women (aged 20-24 years of age) it is about 49% (Antonopoulos et al 20011). A recent poll – reported in a respected Greek newspaper – found one in three adults aged 22-34 with a university degree migrating or making plans to migrate within the year to Australia or anywhere outside Greece. Negative social and economic trends are already in sight, with poverty, homelessness and crime accelerating rapidly. Soup kitchens have been set up around Athens and are visited by even well-dressed Athenians, working adults and those looking for work, who line up early in the morning along with immigrants and the homeless. Combined with dangerous ideological anti-immigrant sentiments (immigrant population in Greece is about 7%) and shifts to the extreme right, such trends threaten to wreak havoc, dismantle social c ohesion and destabilise the nation. While the course of policy action has been charted – with the very stringent austerity measures dictated by the EU/ECB/IMF – the question still remains: what will happen to Greece in the years ahead?

On the eve of November 2011, Group of 20 summit, the Institute of International Finance’s (IIF) managing director, Charles Dallara, wrote to world leaders gathered in Cannes, France (http://www. that the IIF believed the summit “should focus squarely on setting out strong, convincing measures to revitalise growth”. Even this is on record saying so (on several occasions, including as reported in Kathimerini, 30 November 2011). They know what “a lost decade” is all about; it happened in the 1980s and 1990s in many countries around the globe and Latin America was especially hard-hit. Austerity programmes produce deep and prolonged recessions. Indeed it is the reason they are implemented. They “help” reduce consumer spending and trade deficits by lowering incomes and demand for imports, reducing both external and internal imbalances by minimising government spending and shrinking the economy. But the added pressure on Greece and the other eurozone highly indebted n ations is that with no sovereign currencies, they are left with no policy tools to use. No monetary policy, no ability to m onetise debt, no ability to borrow and no ability to devalue the s overeign currency. With no policy space for monetary policy, counter cyclical fiscal policy, currency devaluation and no central bank to act as the lender of last resort, what remains? The means of “rebalancing” the economy is to restart the engine of production in a much smaller size economy, create a fire sale on all sorts of productive assets and land, and lower employment costs that will make investment profitable. Ultimately, this amounts to i nternal devaluation: suppressed wages and drastic reduction of productive assets’ capital value.

This is the trajectory Greece is now on. As we will see, in what follows, it is the wrong remedy. Besides “socialising” the cost by spreading misery on even the most vulnerable segments of society, this is not only a “Greek” crisis but also a eurozone crisis.

Greece and the European Monetary Union: A Closer Look of What Each Party Contributes to the Crisis

Following the original rescue plan for ¤ 110 billion, another r escue plan of 130 billion for Greece was crafted and approved by the EU economic finance ministers (Ecofin) in late 2011. At the insistence of Germany, the new rescue plan requires the private sector investors (PSI) – mostly financial institutions – to accept a voluntary “haircut” of 50% on their Greek sovereign debt holdings. The PSI holdings of Greek debt is now 40% of the public debt, representing a possible relief of only 20% (the PSI have been resisting and have yet to agree to the plan). The remaining 60% not subject to any haircut is or will be on the balance sheets of the EFSF and the IMF. This 20% reduction is not large enough to render the country’s remaining debt level sustainable. Our own estimate for its sustainability requires a haircut that will reduce its total public sector debt by 60% or close to ¤ 200 b illion. A r ecent article in Kathimerini reports that officials of IMF doubt that the proposed 50% haircut of the PSI would render the country’s debt level sustainable.

Ongoing negotiations for disbursements of funds emanating from the troika’s periodic reviews and the imposition of more austerity have been met with more demonstrations and workers’ strikes paralysing public administration and creating chaos. Attempting to reverse the explosive climate of the European leaders’ intransigence to continued and even harsher austerity, the then prime minister (first) Papandreou announced last November that he would hold a referendum on the new European rescue deal. The European leaders were stunned and imposed a different dictum. The referendum should be structured in such a manner so that the question should be framed as: “Do the Greeks want to remain in the eurozone and meet the country’s obligations or exit the euro”? The overwhelming m ajority of Greeks wants to stay in the eurozone.

Papandreou swiftly reversed course as the Europeans lost their nerve and stock markets went into turmoil: What if Greeks cast a vote of no to the euro? After a rebellion within his own Socialist Party over the referendum, the prime minister ignored repeated calls for resignation and immediate elections, but instead called for a vote of confidence promising to resign and allow for a unity government representing the main parties to be headed by a technocrat. On 10 November 2011, former European Central Bank vice-president Loukas Papademos was named the new prime minister. In late 2011, the new prime minister had a new budget approved for 2012 showing the budget deficit falling sharply and even beginning to show a primary surplus. But this, as we have argued here, is not a “Euro Success Story” that solves Greece’s problems and prevents a larger eurozone crisis.

Greece lacks both an industrial base and the widespread availability of technology. It simply cannot be productive enough to compete with neighbours like Germany, France, or the Netherlands. The expected “convergence” has not taken place. That it could have taken place is yet another fantasy based on assumptions of allocative efficiency of investment. Without planning that was guided by a strong government’s visible hand, markets did not invest and did not generate jobs. The state, instead of engaging and renegotiating high value-added agricultural production and investment in energy, tourism and green technologies kept absorbing surplus labour by adding new public sector jobs. This is a failure of markets and public policy but to argue that the public sector is “crowding-out” private investment is misleading. The public sector has been making up for deindustrialisation and the decline in agriculture. Textile manufacturing has migrated on a large scale to Turkey. Cheap imports from China displaced small-scale production enterprises, and financialisation has seen the buy out, chopping up, parcelling out and overall reduction of heavy industrial production. Tourism has been taken over by g lobal multinational concerns. These are globally-induced trends. In a deep recession Greece does not have the resources to grow out of it, even with an easing of its still-enormous debt level. As discussed above, calls for reform and most of the austerity measures have huge social costs and will continue to remain ineffective from a macroeconomic standpoint.

As the financial market behaviour has shown, thus far, the c risis has spread to Italy, Spain and even France unless European leaders greatly increase the funds available for bailouts. The amount of ¤ 3 trillion has been suggested. To put that in perspective, the US collective bailout of its financial system after 2008 came to $29 trillion. The ¤ 1 trillion of the leveraged EFSF will most certainly prove to be wishful thinking, if sovereign debt goes bad. All the major European banks are too closely entwined and will be hit – and so will the $3 trillion US money market m utual funds, which have about half their funds invested in E uropean banks. There is other US bank exposure to Europe with

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a potential of a total $3 trillion hit to US finance. No wonder the US administration has taken a keen interest in Euroland, with the US Federal Reserve ramping up lending to European financial institutions. This includes the December 2011 coordinated effort with five other central banks to improve liquidity in the market and bring down interest rates. Critics (of this move) point out that despite the temporary infusion of cash into the system on the brink, the temporary fix fails to address investors’ loss of confidence in the ability of Greece, Portugal, Italy, and Spain to pay back loans.

The October 2011 initiative of the EU ordered Europe’s banks to recapitalise to prevent this scenario. Are there sufficient private investors to do so? Or will financial institutions need support from their governments, creating yet a new layer of financial d emands on Europe’s taxpayers? There is also a provision to i ncrease the resources of the eurozone’s emergency fund, the EFSF by leveraging its remaining uncommitted funds of approximately ¤ 250 billion (out of ¤ 440 billion) to a multiple reaching the order of ¤ 1 trillion. The experience in the US has shown that while leverage is great on its way up, it is painful on its way down. Thus far, only vague ideas have been offered. The tricky decisions – to say the least – on who will pick up which tab remain to be worked out.

In the rest of this essay we want to briefly summarise the situation in Euroland. The main argument will be that the problem is not due to profligate spending by some nations, and not even by Greece, but rather with the set-up of the EMU itself. We will then conclude that difficult times lie ahead if all remains as it is and that there is a high probability that another collapse may be triggered by events in Euroland. Finally, we will offer an assessment of possible ways out.

The View from the Euroland2

It is becoming increasingly clear that the EU authorities are merely trying to buy time to figure out how they can save the financial system from a cascade of likely sovereign defaults. Meanwhile, they demand far-reaching reforms and austerity in the periphery countries. They know this will do no good at all. Indeed, it will increase the eventual costs of the bailout while stoking north-south hostility. Leaders like German Chancellor Merkel and French President Sarkozy are insisting on these measures for purely domestic political consumption. If the EMU is eventually saved, however, the rancour will make it very difficult to mend fences.

To them, there is no alternative to debt relief for Greece and other periphery countries. Even though Merkel reportedly told her parliament that she could not exclude the possibility of a Greek default – at the same time warning Greece that the rescue package approved last October would not be enacted if Athens failed to agree to deficit reduction targets – all her economic advisors recommended significant debt relief for Greece. But Merkel continues to insist that to punish profligate consumption fuelled by runaway government spending and avoid moral hazard, austerity is necessary and if that forces default, so be it.

Even as Europe’s leaders were putting together the latest rescue package (the process started last July), the EU Parliament voted to make sanctions more automatic on countries that

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exceeded Maastricht criteria, debts and deficits. Previously, although penalties were threatened, they were never actually imposed.

The recent higher yields on Italy’s sovereign bonds have r esulted in many voices singing the same tune in demanding the country move more quickly to a balanced budget. They also urged adoption of the favourite neo-liberal package of policies, i ncluding “full liberalisation of local public services”, “a thorough review of the rules regulating the hiring and dismissal of employees”, “administrative efficiency”, and “structural reforms”. And of course what they demanded has come to pass.

How Did the Euroland Get into Such a Mess?

While the story of fiscal excess is a stretch even in the case of Greece, it certainly cannot apply to Ireland and Iceland – or even to Spain. These nations adopted the neo-liberal attitude towards banks that was pushed by policymakers in Europe and the United States, with disastrous results. The banks blew up in a speculative fever and then expected their governments to absorb all the losses.

Further, as Ambrose Evans-Pritchard (2011) argues, even Greece’s total outstanding debt (private plus sovereign) is not high: 250% of GDP (versus nearly 400% in the US); Spain’s government debt ratio is just 65%, and together with the private level of 215% is higher than that of Greece. And while it is true that Italy’s government debt ratio is high, its household debt ratio of 105% is very low by western standards. Before the economic crisis, only Greece and Italy significantly exceeded 60% of the GDP Maastricht limit. However, the other countries in the eurozone had private sector debt ratios above 100% and by the time the crisis hit, a good number of them including Spain, the Netherlands, Ireland and Portugal had ratios above 200%. To label this a sovereign debt crisis is rather strange. Remarkably, Italy and Greece have the lowest private debt ratios, which is not consistent with the view that consumers in those nations are profligate. As we discuss below, it is not surprising that these two nations have this combination of relatively high government debt ratios and low private debt ratios as these are related through the “three sectors identity”.

If you take the west as a whole what you find is that over the past 30 years there has been a long-term upward trend growth of debt relative to GDP, from just under 180% of GDP in 1980 to almost 320% today. It is true that government has contributed to that, growing from some 40% of GDP to about 90% – a doubling to be sure. But the private sector’s debt ratio grew from a bit over 100% to around 230% of GDP.

The dynamics are surely complex, but it is clear that there is something that is driving debt growth in the developed world that cannot be reduced to runaway government budget deficits. The obsessive focus on sovereign debt and austerity also betrays a lack of understanding of the current account imbalances that plague the eurozone. There is a nearly unacknowledged identity that shows ex-post relations (without necessarily saying anything about the complex endogenous dynamics): the domestic private balance equals the sum of the domestic government balance less the external balance. To put it succinctly, if a nation runs a current account deficit, then its domestic private balance (households plus firms) equals its government balance less the current account deficit. To make this concrete, when Greece runs a current account deficit of 10% of GDP and a budget deficit of 9% of GDP its domestic sector has a deficit of 1% of GDP (roughly the balances presently). Or if the current account deficit is 10% of GDP and its budget deficit is 3% (the Maastricht limit) then the private sector must have a deficit of 7% – running up its debt.

The proponents of austerity see the solution for these deficits in belt-tightening. But that tends to slow growth, increase unemployment, and hence increase the burden of private sector debt. The idea is that austerity will reduce government debt and deficit ratios, but in practice that may not work due to impacts on the domestic private sector. Tightening the fiscal stance can

o ccur in conjunction with reduction of private sector debts and deficits only if somehow this reduces current account deficits. Yet many nations around the world rely on current account surpluses to fuel domestic growth and to keep domestic government and private sector balance sheets strong. They therefore react to fiscal tightening by trying to pass it on to the trading partners – either by depreciating their exchange rates or by l owering their costs. In the end, this sets off a sort of modern mercantilist dynamic that leads to a race-to-the-bottom policies that few western nations can win.

Germany has specialised in such dynamics and has played its cards very well. It has held the line on nominal wages while greatly increasing productivity. As a result, in spite of reasonably high living standards it has become a low-cost producer in E urope. Given productivity advantages it can go toe-to-toe against non-Euro countries in spite of what looks like an overvalued currency. For Germany, however, the euro is significantly undervalued – even though most euro nations find it overvalued. The result is that Germany has operated with a current account surplus that has allowed its domestic private sector and government to run deficits that were relatively small. Hence Germany’s overall debt ratio is at 200% of GDP, approximately 50% of GDP lower than the eurozone average.

Not surprisingly, the “three sectors balances identity” hit the periphery nations particularly hard, as they suffer from what is for them an overvalued euro and lower productivity than what Germany enjoys. With current accounts biased towards deficits it is not a surprise to find that the Mediterranean countries have bigger government and private sector debt loads. If Europe’s centre understood balance sheets, it would be obvious that Germany’s relatively “better” balances rely to a large degree on the periphery’s relatively “worse” balances. If each had separate currencies, the solution would be to adjust exchange rates so that the debtors would have depreciation and Germany would have an appreciating currency. Since within the euro this is not possible, the only price adjustment that can work would either be increasing wages and prices in Germany or falling wages and prices in the periphery. But the ECB, Bundesbank and EU policy, more generally, will not allow significant wage and price inflation in the centre. Hence, the only solution is persistent deflationary pressures on the periphery. These dynamics lead to slow growth and hence compound the debt burdens.

But if Germany refuses to inflate and if Greece and other p eriphery nations cannot depreciate their currencies, then debt deflation dynamics become the only way to counter increasingly non-competitive wages and prices.

Those non-competitive wages and prices almost guarantee current account deficits that, in turn, according to the identity explored earlier, guarantee rising debt – either by the government or by the private sector. And if debt grows faster than GDP, the debt ratio rises. Note that these are statements informed by identities. They are not meant to be policy statements. But policy cannot avoid identities. Reduction of deficits and debts in periphery nations requires changes to balances outside the periphery. If we want Greece, Portugal and Italy to lower debt ratios they must change current account balances. That, in turn, requires that some nations reduce their current account surpluses. For example, if Germany was willing to run large current account deficits, it would be easier for periphery nations to reduce domestic deficit spending. A way to even out trade imbalances would be by “refluxing” the surpluses of countries such as Germany, France and the Netherlands to deficit countries by, for example, investing euros in them. Germany did this with the former East G ermany following reunification.

Proposed Solutions to the Euro Problem

Rather than doing the obvious, Europe’s centre insists on underfunded bailouts plus austerity imposed on the periphery. But the periphery is left with too much debt and at the same time, it faces German intransigence on changing the internal dynamics. Given these dynamics, debt relief – which might take the form of d efault

– is the only way that Greece, Ireland, Portugal and perhaps Spain and Italy can remain within the EMU. But it is not at all clear that the nuclear option – dissolution – will be avoided. Even the most mainstream commentators are providing analyses of a Euroland divorce with a resolution ranging from a complete break-up to a split between a “Teutonic Union” embracing fiscal rectitude with an overvalued currency and a “South Union” with a greatly devalued currency. In a recent poll, global investors put a 72% probability on a country leaving the euro within five years and over 75% expect a recession in Euroland within 2012 while PIMCO thinks the recession has already begun (Kennedy 2011).

A report from Credit Suisse (2011) dares to ask “What if?” there is a disorderly break-up of the EMU, with the narrowly defined periphery (Portugal, Ireland, Greece and Spain) abandoning the euro and each adopting its own currency. The report paints a bleak picture. The currencies on the periphery would depreciate, raising the cost of servicing euro debt and leading to a snowball of sovereign defaults across highly indebted euro nations. With the weaker nations gone, the euro used by the stronger nations would appreciate, hurting their exports. That would increase the pressures for trade wars, and for a Great Depression No 2 (the report puts this probability at an optimum level of 10%). The report assumes Italy does not default, but if it did, losses on sovereign debt would be very, very much higher. With the assumption that Italy remains on the euro and manages to avoid default, total losses to the core European banks would be ¤ 300 billion and ¤ 630 billion for the periphery

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nations’ banks (excluding Italy), while the ECB’s losses would be 150 billion. This is serious money.

A popular but ultimately misguided proposal is to take the EFSF’s funding as capital to create a sort of structured investment vehicle (SIV) (following the instructive example of US mortgage securitisers!) that buys sovereign debt and issues its own bonds secured by the ¤ 440 billion bailout fund serving as equity. If leveraged, total funding available to buy risky government debt could be several trillions of euros. But as we found during the US crisis in mortgage-backed securities, leverage is great on the way up, but very painful on the way down. When a crisis hits, the SIV cannot continue to finance its position so it must sell assets into declining markets. If leverage is eight to one, its capital is quickly wiped out by a fairly small reduction (12%) of the value of its assets; problems are reinforced by price reductions that lower capital and reduced willingness of lenders to hold the SIV’s debt.

So this proposal only works if: (a) the SIV buys the assets at fire-sale prices now, so that (b) the risks of further large price declines are remote. If the SIV’s own debt is long-term, it does not need to worry about refinancing its position. But that will make the initial financing more expensive since the risk is shifted to creditors. One of the reasons that the American SIVs seemed to work is that they rely on very short-term, and thus cheap finance. However, that permitted a run out of the SIVs as soon as the crisis hit. In the case of this European proposal it is difficult to see why lenders to the SIVs would prefer to get stuck in bonds that effectively place highly leveraged bets on troubled assets. Anyone who wants to take a chance on Greek debt can just go out and buy it. Furthermore, the fate of EMU nations is highly interconnected – with the exception of those with little debt plus Germany and possibly France. If one of the dominoes falls, however, there will be a run out of the other dominoes ending the charade.

A different solution offered by Jacques Delpla and Jakob von Weizsaacker (

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ernment debt – equal to the Maastricht criterion of 60% of GDP. This would be allocated to a “blue bond” classification, with any debt above that classified as the “red bond”. The idea is that the blue bonds would be low risk, with holders serviced first. Holders of red bonds would only be paid once the blue bonds are serviced. About half the current EMU members would have quite small issues of red bonds; about a quarter would not even be close to their limit on blue bond issues at current debt ratios.

The proposal draws on the US experiment with “tranching” of mortgages to produce “safe” triple-A mortgage-backed securities protected by “overcollateralisation” since the lower-grade securities supposedly took all the risks. Needless to say, that did not turn out so well. The idea is that markets will discipline debt issues, since blue bonds will enjoy low interest rates and red bonds will pay higher rates. Again, the US experience proves that markets are far too clever for that. If anything market discipline delivered precisely the opposite. The risks on the lower tranches were underestimated and vastly underpriced. In search for yield, financial institutions held onto a lot of trash. Still, this proposal should not be dismissed. Since the scheme has some potential if the full faith and credit of the entire EMU (including most importantly that of the ECB) were put behind the blue

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bonds, and substantial non-market discipline (strong and enforceable regulation) was put on the red bonds.

Yanis Varoufakis and Stuart Holland (2011) have issued a similar proposal in that the ECB would buy member sovereign debt in a volume up to 60% of the member’s GDP. These would be held as eurobonds and nations would continue to service them, albeit at a lower rate to reflect the ECB’s lower costs of issuing its own liabilities. By moving so much debt to the ECB, nations would meet the Maastricht criteria (excluding Greece) that would be applied only to remaining debt outstanding in markets. The ECB, in turn, could sell Eurobonds to provide liquid and safe euro-denominated debt to markets; attracting foreign investors, especially central banks and sovereign wealth funds. That would help to finance the European Recovery Programme, providing new funding to the European Investment Bank. So Varoufakis and Holland not only address the current insolvency problems, the recapitalisation and Europeanisation of the banking system, but also tackle the problem of recovery. Our preferred solution would involve a similar issuance of bonds backed by the ECB, as we will describe below.

After the failure to expand the EFSF from ¤ 440 billion to the trillions needed to backstop Italy and Spain, the European Commission (EC) proposed an alternative to allow every eurozone country to issue “Eurobonds” guaranteed by all 17 members with the requirement that the Commission would control national budgets.

Even the IMF has come out with its own strategy in creating a fund to lend to troubled eurozone member nations financing it through loans from the ECB. This would ingeniously circumvent the Maastricht treaty’s rules against bailouts and the purchase of new government bonds. It will, however, entail the control of national budgets of the borrowing member states by both the commission and IMF with conditionalities and sanctions.

The EC and IMF proposals would deny governments the ability to institute their own tax and spending policies. The civil disobedience in Athens and other European cities suggest what would happen if the Brussels bureaucracy and German finance ministry came to have veto power over national economic policies (Feldstein 2011).

A Path to Recovery

The proposed solutions, for Euroland and Greece in particular, are difficult because as discussed above, these nations do not individually have the fiscal capacity to deal with their problems. So when the signals from the institutions charged with running the EU inspire no confidence, it becomes imperative to consider alternative strategies. Greece’s exit from the euro either as a temporary or permanent strategy has been suggested by many economists, both from the left and right (Roubini 2011; Feldstein 2011). The transition would be disruptive, with near-term costs. We should expect an immediate devaluation of the national currency, inflationary pressures, runs on its banks and their nationalisation together with perilous economic and social trends characteristic of a dysfunctional economy. The benefit would be to create domestic fiscal and monetary policy space to deal with the crisis. Default on euro-denominated debt would be necessary and retaliation by the EU is possible. However, in our view, this is preferable to the two currency scheme discussed above – which would simply tie Greece to another external currency. It would have no more fiscal or monetary policy space than it now has, a lbeit with a currency that would be devalued relative to the euro.

If dissolution is not chosen, then the only real solution is to reformulate the EMU. Many critics of the EMU have long blamed the ECB for sluggish growth, especially on the periphery. But a comparable analysis of the ECB and the US Federal Reserve interest rate policy showed that the real problem is in the set-up of the EMU with fiscal policy constraints (Sardoni and Wray 2005). The eurozone architecture even though it resembles the US states, differed in two key ways: first, while US states rely on inter-regional redistribution channels to households for social welfare expenditures (health, retirement, poverty alleviation programmes) and expenditures for the military from Washington, commanding a budget (from tax revenues) of more than 20% of US GDP, and usually running a budget deficit of several per cent of GDP that contrasts sharply with the EU Parliament’s budget of less than 1% of GDP. While individual nations tried to fill the gap with deficits by their own governments, these created the problems we see t oday. As deficits and debt rose markets reacted by increasing i nterest rates, precisely because they recognised that unlike the sovereign countries like the US, Japan, or the UK, the EMU members were users of an external currency.

Once the EMU weakness is understood, it is not hard to see the solutions. They include ramping up fiscal policy space of the EU Parliament – for example, increasing its budget to 15% of GDP with a capacity to issue debt. Whether the spending decisions should be centralised is a political matter. Funds could simply be transferred to individual states on a per capita basis.

ECB rules could also be changed to allow it to buy an amount equal to a maximum of 6% of Euroland GDP each year in the form of government debt issued by EMU members. As the buyer, it can set the interest rate. It might be best to mandate that at the ECB’s overnight interest rate target or some mark-up above the target. Again, the allocation would be on a per capita basis across the members.

One can conceive of variations on this theme, such as creation of some EMU-wide funding authority backed by the ECB that issues debt to buy government debt from individual nations – along the lines of the blue bond proposal. What is essential, however, is that the backing comes from the centre. The ECB or the EU stands behind the debt. That will keep interest rates low, removing “market discipline” and vicious debt cycles due to exploding interest rates. With lending spread across nations on some formula (i e, per capita) every member state should have the same interest rate.

All of these are technically simple and economically sound proposals. They are politically difficult. The longer the EU waits, the more difficult these solutions become. Crises only increase the forces of disunion or dissolution, increasing the likelihood of eventual divorce and increasing hostility that in turn forestalls a real solution and makes a Great Depression even more probable.


The grand experiment of a unified Europe with a shared common currency has run its course. If the current trajectory continues, the disintegration of the euro is inevitable. The newest “rescue plan” embraced by Greece and now set to be enforced by the technocratic prime minister, Loukas Papademos, certainly will not save the system, and it will not save Greece from a sovereign default. The bailout conditions demanded by the troika that holds the purse strings include continuous surveillance of the country’s adherence of the agreed reforms and austerity measures. Their periodic progress reviews will show that Greece has no hope of meeting its targets.

Greece’s sovereign debt problem is not limited to Greek lenders solely, but it affects the entire eurozone, requiring a eurozonewide solution. The immediate problem of Greece can be resolved along the lines of the US programme, buying bonds to calm volatility – as the ECB has been performing but going to pains denying it – until a bold, permanent solution is crafted. The ECB’s message would quickly calm the financial turbulence and solve the eurozone markets problem. But such a bold approach is not forthcoming from the ECB or from the continuing uninspired leadership of Germany and France.

European Union politicians and the IMF are cognisant of the fact that irrespective of the success or failure of the harsh austerity, the country’s debt level is increasing while the European financial system remains at risk and will, in all likelihood, see the unravelling of the euro project. In November 2011, newly revised and updated figures indicated deficit reduction targets are not met. In the meantime, the proportion to tax revenues dedicated to repayment of debt obligations paints a rather grim picture. According to the “Public Finance Monitor” semi-annual, the IMF figures tell the story: the debt to GDP ratio increased from about 122% of GDP in 2009, to 145% in 2010 to an estimated 166% in 2011, and will reach 189% of GDP in 2012.

Notwithstanding these projections, it is remarkable that German Chancellor Merkel has not already recognised that, as the EU’s largest exporter, her insistence on fiscal austerity for its troubled neighbours is a losing proposition. Ireland, the poster child of the eurozone’s austerity drive, saw its economy shrink in the third quarter of 2011. Yet, Merkel praised Ireland as an “outstanding example” of a country that has fulfilled the terms of its bailout (Chu 2011).

In a climate of denial, the ECB is keeping the show on the road, but the cascade across the continent of credit downgrades will keep yields and credit default swaps increasing. The political fallout will quickly become unworkable for both stronger and weaker nations.

So in sum, the collapse of the euro project will evolve in one of two ways. First, and looking increasingly likely, and least desirable, is that nations will leave the euro in a coordinated dissolution that might ideally resemble an amicable divorce. As with most divorces, it would leave all the participants financially worse off. But it will give back sovereignty for charting alternative course of action to countries that needed it badly, including Greece.

Second, and less likely, but more desirable, would be a major European institutional and economic restructuring. The doomed rescue plans we are seeing do not address the central problem. Nations like Greece are not positioned to compete with countries

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that are more productive, like Germany, or have lower produc-e conomic laboratory. It is ironic that it is the absence of political tion costs, like Latvia. Any workable plan to save the euro has to action by them that makes the union unsustainable. Their refusal address those differences. to consider EU as an entity with a unified fiscal policy and a fully

The founding of the EU was a political venture that emerged functioning central bank that includes the function of lender of from the ambitious heads of the two leading continental powers, last resort and its mandate goes beyond addressing the German Germany and France. Their creation grew into a promising fears of inflation, might turn out to be the EU’s endgame.


1 Much of the information here can be found in the Financial Times, “Interactive Timeline: Greek Debt Crisis”, YDOOAO and draws mostly from various issues of Kathimerini, a daily premier Greek newspaper,

2 The sections hereafter are drawn largely from Papadimitriou and Wray (2011), Papadimitriou et al (2011) and Antonopoulos et al (2011).


Antonopoulos, R, D Papadimitriou and T Toay (2011): “Direct Job Creation for Turbulent Times in Greece”, a report prepared for the Observatory of Economic and Social Developments of the Labour Institute of the Greek General Confederation of Workers, available on the Levy website, http://

Chu, Ben (2011): “Austerity Discredited: Ireland Goes into Reverse”, The Independent, 17 December.

Credit, Suisse (2011): “Global Equity Strategy”, Global Equity Research, 23 September.

Delpla, J and J von Weizsacker (2011): “Eurobonds: The Blue Bond Concept and Its Implications”,, 21 March,

publications/publication-detail/publication/ 509-eurobonds-the-blue-bond-concept-and-itsimplications/

Evans-Pritchard, A (2011): “Frau Merkel, It Really Is a Euro Crisis”, London Telegraph Blog, 27 September, ambroseevans-pritchard/100012223/fraumerkel-it-really-is-a-euro-crisis/

Feldstein, M (2010): “Let Greece Take a Eurozone H oliday”, Financial Times, 16 February.

– (2011): “Italy Can Save Itself and the Euro”, Financial Times, 30 November. Kathimerini (2011): “IMF: The 50% ‘Haircut’ Is Not Sufficient”, 30 December (in Greek).

Kennedy, S (2011): “Europe Meltdown Seen Converging with Recession in Survey”, Bloomberg, 29 September, 2011-09-29/world-recession-seen-triggered-byeurope-breakdown-in-global-investor-poll.html

Liu, H C K (2011): “The Eurozone Sovereign Debt Crisis: Part I: A Currency Union Not Backed by Political Union”, Henry Liu: Independent Critical Analysis and Commentary, 29 September, http://henryckliu. com/page250.html

Papadimitriou, D (2011a): “Greece and the EMU Crisis”, Speech given at the Observatory of Economic and Social Developments, INE-GSEE Conference “The Debt Crisis in Greece and the Eurozone: Is There A Solution?”, 8 December.

– (2011b): “The Achilles’ Heel of the Eurozone”, Los Angeles Times, 2 November.

Papadimitriou, Dimitri B and L Randall Wray (2011): “Euroland in Crisis as the Global Meltdown Picks Up Speed”, Levy Economics Institute, Working Paper No 693, October.

Papadimitriou, Dimitri, L Randall Wray and Yeva Nersiyan (2011): “Endgame for the Euro? Without Major Restructuring, the Eurozone Is Doomed”, Levy Economics Institute, Public Policy Brief No 113, Levy Economics Institute, July.

Roubini, N (2011): “Greece Should Default and Abandon the Euro”, Financial Times, 19 September.

Sardoni, C and L R Wray (2005): “Monetary Policy Strategies of the European Central Bank and the Federal Reserve System of the US”, Working Paper No 431, Levy Economics Institute of Bard College, Annandale-on-Hudson, NY.

Stearns, J (2011): “EU Stiffens Deficit, Debt Rules to Prevent Further Crises”, Bloomberg, 28 September,

Varoufakis, Y and S Holland (2011): “A Modest Proposal for Overcoming the Euro Crisis”, Policy Note No 4, Levy Economics Institute of Bard College, Annandale-on-Hudson, NY.

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