Greece: Caught Between the Scylla of Austerity and the Charybdis of Credibility
The emergency loan package offered to Greece in March from the International Monetary Fund (IMF) and Greece's European partners was conceived as a "bridge" over troubled financial waters, buying time for the Athens government to carry out a severe fiscal correction. In order to receive this help, the Greek government has committed itself to reducing its deficit by 10 percent of GDP in three years. It is understandable that the urgency of the liquidity crisis has dictated that time frame. But three years to accomplish such a huge fiscal adjustment is an impossible request.
In a sense, three years is both too short and too long to do any good. First, the short timeframe will invite a vicious circle of negative growth and deflation. At the same time, three years is too long a period of time to be spent under the daily risk of a liquidity shortage characterized by a constant rollover of the public debt. The timeframe of the European help must be revised.
Greece is being asked to cut its public deficit from 12.7 percent to 2.9 percent in 2012. In simple mechanical terms, because of the very low saving rate of the private economy, such a fiscal correction would cause a fall in output of about one-fifth. But the loss of output would make it even more difficult to accomplish the tax adjustment necessary for balancing the public budget. A vicious circle is unavoidable. Greece could otherwise adjust the fiscal balance while borrowing abroad. But based on the current situation—even after the EU-IMF involvement—foreign investors still require a substantial risk premium on Greek debt. Once more, paying a 6 percent rate—as requested explicitly by the German government—with negative growth and zero inflation will make debts more unstable, not more stable.
The fearful rush to fix the Greek problem has not only produced a wrong prescription, it is also a symptom of the deficiency of analytical instruments in the hands of the euro partners, and of their reluctance to acknowledge a common responsibility. The euro partners should create a six-year path to restore fiscal solidity in Greece and assume control and responsibility for it. Spreading the adjustment over six years would make it tolerable and more consistent with the need to shift resources from consumption to investments and promote structural reforms. Increasing Greece's growth potential is the only way to avoid a further downward spiral.
A longer period allowing Greece to accomplish its fiscal adjustment has a relevant political implication regarding the credibility of the commitment. A six-year period—longer than any legislature—would make the current Greek government unaccountable for the long-term outcome of its policies. After six years the brunt of a failure of the program endorsed today would fall on a different government. This weakens the credibility of today's obligations. But this credibility is absolutely crucial to the success of the rescue.
The only way to preserve the credibility of the program is to tie the hands of national political actors, dissolving their discretionary leeway into a European—or even better, a euro area—political commitment. The euro area governments have to mold, endorse, and control the economic policy of Greece over the next six years. In other words, Europe has to assume the political responsibility for what Greece must carry out.
The twin goals should be to make Greece's fiscal correction tolerable for its economy and still credible in terms of its non-Greek tutoring. The Greek situation is so precarious and dire that IMF involvement is not sufficient to supply the quantity of financial help that Greece needs or the political credibility that must accompany a long-term commitment. The latest high-risk premium on Greek bonds shows that the markets are alerted. The fall in bond prices after the recent auctions suggests that some investors may have responded to political suasion in subscribing to the bonds at first—but then decided to sell them soon afterward. The short term challenge of a smooth financing of Greek public debt requires a long-term political credibility that cannot come from Greece alone.