Greece, the EMU and Hard Choices

By May 16, 2010, 10:43 PM Author's Blog  

Ambrose Evans-Pritchard is always a worthy read when it comes to European economics and the serial crises of the past few years. He has a column today which neatly encapsulates the events of the past week and then offers this bit of opinion as to a near-term path:

There is a way out of this crisis, but it is not the policy of wage deflation imposed on Ireland, Greece, Portugal, and Spain, with Italy now also mulling an austerity package. This can only lead to a debt-deflation spiral. The IMF admits that Greece’s public debt will rise to 150pc of GDP even after its squeeze, and that Spain’s budget deficit will still be 7.7pc of GDP in 2015.

The only viable policies – short of breaking up EMU or imposing capital controls – is to offset fiscal cuts with monetary stimulus for as long it takes. Will it happen, given the conflicting ideologies of Germany and Club Med? Probably not. The ECB denies that it is engaged in Fed-style quantitative easing, vowing to sterilise its bond purchases “euro for euro”. If they mean it, they must doom southern Europe to depression. No democracy will immolate itself on the altar of monetary union for long.

I tend to think that he is right to suggest that the EMU will not hang together if the PIIGS are pummelled. I just wonder if that’s reason enough not to cause strenuous adjustments to their economies.

From the outset, the response of governments to the crisis in its various iterations has been extraordinary fiscal stimulus, accompanied in some countries by an equal or greater amount of monetary grease. To the extent it was necessary to stave off perceived incipient meltdowns of vital parts of economies it made sense. To the extent it was intended to set economies back on a growth path is of less certain value.

What I see in Evans-Pritchard’s argument is what I see in the actions of most Western governments, an attempt to return economic activity to the status quo ante with the promise that once there the heavy lifting of reforming the economy will take place. Once relieved of duress we are asked to believe that the political class will undertake to tax more, reduce their spending profligacy and generally make life a bit less luxurious for the electorate.

Whether it be Greece, California, the US or a host of other economies, the norm that current policy seems to want to recreate is best described as fictional. The economies weren’t based on sustainable models. Each has their unique flaws but generally share traits that include overpromising, inadequate taxation and excessive reliance on debt to finance everything from asset acquisition at the private level to funding government deficits.

And so stimulus was sold as the first step that would return all to life as we knew it. And thus, Evans-Pritchard and others argue that the medicine prescribed for Greece and potentially others is too harsh. The edge has to be taken off with an equal dose of stimulus. Greece will be made to suffer not much as the errors of its ways are revealed to it and thus enlightened will move towards economic rectitude.

The European Union will not in the long-run suffer greatly should Greece default on its debt and ultimately decide to leave the Union. Nor would it necessarily dissolve should other members follow. It will on the other hand become a weak sister among the world’s economies if it finds itself supporting economies that make no rational sense.

It may well be fortunate that money for stimulus is simply running out. Effectively, the easy way out is slowly being foreclosed and hard choices may be imposed for lack of an alternative. Whether that means tough years for Greece or the imposition of reason upon California’s legislature one would hope that such a turn of events precludes further attempts to defer the inevitable. The pain will be palpable, and the unforeseen consequences at the very least unpleasant but we sooner or later we have to discover reality. We haven’t made any attempts to do so at this juncture.

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