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This week Greek bond spreads have widened to record levels—407 basis points over German bonds—not seen since before it became apparent that Greece would join the eurozone in 2001. Clearly, financial markets are signaling their skepticism about Greece's prospects. For this, eurozone leaders share a lot of the blame.
First, markets have predictably not been fooled by the announcement of "the Greek deal" on March 25 alone and the deal has therefore not by itself lowered Greece's cost of capital. The text of the agreement is simply too vague, uncertain, and too much of a political compromise to impress the notoriously "uncertainty averse" financial markets. For example, there are no details about what precisely triggers financial aid (what does "insufficient market financing" mean?) and what conditions would be attached to it (how high is a "non-concessional interest rate, containing no subsidy element"?).
Probably the best illustration of this (and of why Herman van Rompuy is precisely the right president of the European Union Council) was van Rompuy's suggested "asymmetric translation" of the final eurozone statement. The asymmetry took the form of the English version reading this way: "We [the heads of state and government of the euro area] consider that the European Council must improve the economic governance of the European Union." Evidently, the use of the word "governance" suggests that the European Union must make better use of its existing structures and institutions. Yet, the French translation of the same section reads: "Nous [the heads of state and government of the euro area] considérons que le Conseil européen doit renforcer le gouvernement économique de l'Union européenne." The politically charged word "gouvernement" implies a more expansive definition that would include new structures and institutions.
In short, when EU leaders can't even agree on what they pretend to agree on, we should not be surprised that financial markets wish to test the agreement's practical implications. We will, moreover, continue to see such skepticism at least until after the German regional elections in North Rhine Westphalia on May 9, after which a clarification of the eurozone declaration seems likely.
More important, the rising bond market spreads on Greek debt reflects skepticism about the fundamental prospects of Greece exiting its current crisis without defaulting in some shape or form on its sovereign commitments.
The financial market sustainability concerns over Greece tend to focus on the vicious cycle occurring when a high-debt country tries to "save its way out of a debt crisis" through fiscal austerity. The dangers are obvious for a country with Greece's current total debt levels of perhaps 120 percent of GDP and the need for a rapid fiscal correction of as high as 13 to 15 percent. Severe cuts in government spending will precipitate a severe recession, which will shrink the Greek economy and depress government revenues, further increasing Greece's excessively high debt-to-GDP ratio. Greece will be caught in a trap of needing to lower its record high refinancing costs at a time of rising resistance in financial markets.
In short, if Greece relies solely on austerity to save itself, it looks increasingly likely to fail—and more likely to seek the financial assistance of its eurozone partners and the IMF to refinance its debts.
A program of "austerity only" will thus do nothing to prevent Greece getting crushed under a mountain of debt. What Greece needs in addition is a dose of progrowth structural reform policies to complement the contractionary effects of its austerity programs. Without new sources of nominal GDP growth, Greece will not succeed.
Fortunately for the Greek government, there are opportunities to improve the management of its economy. Greece—unlike the United Kingdom, Ireland, or the United States—hardly needs to reinvent the economic textbooks to achieve the "new foundation for growth" that President Obama has proclaimed as an American goal. Indeed Greece is probably the most poorly regulated developed economy in the world. Simply implementing standard economic orthodoxy would do wonders.
As laid out by the comparative structural economic policy measures of the Organization for Economic Cooperation and Development (OECD), Greece has the most regulated product markets in the OECD (figure 1), the most state-controlled economy in the OECD (figure 2) and most domestic economic regulation in the OECD (figure 3).
Source: Wölfl, A., I. Wanner, T. Kozluk, and G. Nicoletti. 2009. Ten years of product market reform in OECD countries—insights from a revised PMR indicator. OECD Economics Department Working Paper 695. Paris: Organization for Economic Cooperation and Development.
Moreover, it is clear from figures 1–3 that Greece restricts its domestic economic policies more than the other so-called PIIGS (Portugal, Italy, Ireland, Greece, and Spain) countries and hence faces a comparatively larger structural reform challenge. This is one important fundamental reason that the bond spreads between Greece and the other Mediterranean countries have also widened recently.
Then there is the often reviled Greek public pension system, which is actually a misnomer in Greece, as Greece stands out in the OECD as a country without any accumulated private pension assets and the "public pension system" correspondingly equals the entire "Greek pension system." It is probably not possible to overstate the damage of this pension system to the broader Greek economy, arising from its huge drain on public finances, but more importantly through the perverse incentives the pension system presents the Greek public with.
Figure 4 shows how Greeks earning the average wage face an implicit 100 percent tax rate on any wage income after early retirement at age 55 and through the regular pension available at age 60. And this 100 percent implied tax on continuing to work is true even for Greeks earning double or more of the average wage . Thus there is no incentive for Greeks to continue working and producing for the economy after the retirement age of 55.
Figure 4 also illustrates how this disincentive makes Greece an extreme outlier in the OECD. Fundamental pension reform for Greece is the equivalent of controlling healthcare costs in the United States—unless you succeed in it, none of the other stuff you do really matters.
Without truly dramatic and expeditious changes to its pension system, Greece cannot hope to exit from this crisis. Fortunately, unlike the United States' struggle to achieve healthcare cost control, the challenge to reform Greek pensions is not complicated and requires no leap of faith into the unknown. While certainly politically and socially painful, the effort could be largely achieved through already known—if dramatic—measures, say, the elimination of the option for early retirement and very large reductions in the guaranteed regular pension benefit levels of high earners, or perhaps the overnight introduction of a notional defined contribution system (as Italy began phasing in 1995).
Austerity is not enough for Greece and its government needs to think beyond austerity in its domestic policies to avoid a catastrophe. This will be a wasted crisis unless it compels Athens to—in addition to required fiscal austerity—embark on a dramatic economic liberalization program for its domestic economy to raise growth.
