Greek tragedy – Act II?

This column first appeared in Business Standard, on January 11, 2015. Like other products of the Brookings Institution India Center, this is intended to contribute to discussion and stimulate debate on important issues. The views are those of the author.

Developments in Europe have dominated the headlines over the past couple of weeks, and not in a good way. Before the attack on the office of the magazine Charlie Hebdo, the major story was the prospect of Greece exiting the euro zone after a new government takes office. This is hardly surprising, given the increasing difficulties that the country seems to be facing in executing its revival plan. But, surprise or not, the looming possibility of exit apparently frightened global financial markets enough to cause serious turbulence for a couple of days. As things stand, the nervousness seems to have abated, but we should under no circumstances assume that the story has ended. After provoking significant global turbulence in 2010, the Greek economic situation is back centre stage.

To put these concerns into perspective, let’s look at the performance of the Greek economy over the past few years. It has operated for a part of this period under the plan formulated by the troika – the European Union, the European Central Bank and the International Monetary Fund. Gross domestic product (GDP) declined by 5.4 per cent in 2010, 8.9 per cent in 2011, 6.6 per cent in 2012 and 3.3 per cent in 2013. 2014 is likely to have seen no change in GDP, which may actually reflect an improvement, given the relentless decline over the past four years. Does this mean the revival is underway? Perhaps, but when you take into account the fact that GDP is now almost 25 per cent less than it was in 2009, any disenchantment on the part of Greek citizens with their economic condition and prospects is entirely understandable.

The fragility of the economy is further reflected in other parameters. The unemployment rate is almost 26 per cent. Youth unemployment is almost 50 per cent. About 20 per cent of the workforce is classified as being in long-term unemployment, having been out of work for over a year. The fiscal deficit is over 12 per cent of GDP, with the debt-GDP ratio at 175 per cent. From the Greek citizens’ perspective, this looks like a situation from which any tangible improvements in standards of living, let alone a return to the pre-2010 levels, are going to be slow, uncertain and unevenly distributed. The commitment to the current economic framework, then, has to be very weak. The counterfactual claim – that things could become even worse in the alternative scenario of an exit from the euro zone – presumably does not carry much weight.

How does one compare the two alternative trajectories? Predicting outcomes and time frames is hazardous even with the help of sophisticated models, but broad patterns can be visualised. The key to staying on in the euro arrangement is the ability to get sovereign debt under control, that is, achieve a sustained reduction in the debt-GDP ratio. A well-known requirement for this, to put it simply, is that the growth rate of GDP must be higher than the real interest rate.

Over the past few years, with interest rates at close to zero and the rate of inflation at around a negative one per cent, with the growth rates indicated earlier, this condition was far from being satisfied. However, in 2014, with the inflation and interest rate scenario remaining more or less the same, growth seems to have accelerated; even zero growth is a significant improvement over the record of the past four years! If this situation persists, with the expected inflation and monetary policy trajectory for Europe, it should rein in the sovereign-debt burden.

However, this turnaround may not mean much in terms of the standard of living. The consequent benefits that the economy can obtain in terms of staving off a severe public expenditure compression may allow some government services to be maintained, but certainly not enough to restore them to pre-crisis levels. In other words, a positive macroeconomic development may not be enough to generate political support for the status quo in and of itself.

As regards the exit option, the most significant benefit to Greece will be from the sharp depreciation of the new national currency vis-à-vis the euro. As has often been pointed out, the entry into a currency union brings with it the risk of a misalignment between domestic macroeconomic conditions and the exchange rate. Greece, as well as other euro-zone economies, have struggled with this misalignment for the last few years. In contrast, economies like Poland, Hungary and the Czech Republic, which are part of the European customs union but not the monetary one, have done relatively well in the post-crisis years; an important reason for this is because their currencies float with respect to the euro.

A sharp depreciation of the Greek exchange rate will clearly have significant expansionary effects, as Greek exports, including tourism, will suddenly become much more attractive. The impact may, of course, be diluted by the relatively weak demand conditions in the rest of Europe, which, under any circumstances, will remain Greece’s largest trading partner. However, a depreciated exchange rate is not an unambiguous benefit. Obviously, imports will become more expensive, contributing to an acceleration in inflation, which will neutralise some of the benefits of a more competitive exchange rate over time.

From a structural perspective, four or more years of decline, with very little new investment may constrain domestic producers from exploiting opportunities provided by exchange rate movements. In this case, the costs will be borne immediately, while the benefits are neither certain nor quick.

The bottom line is that Greek citizens have no obvious choice in front of them. The upheaval in global financial markets caused by the prospect of an exit was perhaps more reflective of a fear of the unknown than any visible consensus about the tangible impact of an exit. The fact that things stabilised quite quickly reinforces this perception of indecisiveness. Persistent market instability can have significant adverse impacts on trade and investment, but, compared with 2008, conditions in both financial and commodity markets suggest far less vulnerability to such spillovers.

Ultimately, the Greeks will have to make the choice that they collectively believe is in their best interests. Going by the experience of the three largest Eastern European economies, the best arrangement for Greece, as well as some others, could be the customs union. This could also be the least disruptive outcome globally.