Playing chicken in the eurozone

The Toronto Star

June 29, 2011

Another critical week looms in euroland now that Greece’s parliament has decided on even more stringent austerity measures, the previous ones having missed their targets.

Despite a significant fall in real gross domestic product, Greece has managed to reduce its deficit but has only modestly raised its capacity to raise revenues. There is little reason to believe that the current targets are achievable. After all, the previous ones were not met so it is difficult to see how the current package can be seen as credible.

The Greek crisis is beginning to look like a game of chicken, with each actor in the tragedy that’s being played out in world markets preferring not to yield to the others. As a result, the worst possible outcome may still occur.

The ongoing “internal devaluation,” referred to as such because Greece is unable to devalue the euro, is proving to be painful beyond what any country might be willing to endure, economically and politically.

The policies being promoted by other euro-area members are explained by a desire to assure the non-Greek public that fiscal irresponsibility will not be rewarded. Never mind that these same policy-makers let Greece borrow far beyond its means when they allowed the country to adopt the euro and benefit from low interest rates, while turning a blind eye to the structural deficiencies of Greek public administration.

If the austerity demanded by its euro-area partners is deemed unacceptable, Greece could voluntarily leave the eurozone. At least then it could devalue a new drachma, which would eventually boost its chances of recovery — especially if the country reneges on its debt obligations, currently denominated in euros.

Argentina did this in 2001 and its sovereign debt was eventually renegotiated. Unfortunately, Greece has neither the natural resources of Argentina, which benefited from a devalued currency, nor the sophisticated financial sector of, say, Hong Kong, to deal with the painful adjustments required under a fixed exchange rate, to manage such an outcome.

Thus we are left on one hand with Greece, playing the role of reluctant partner that pretends to yield to outside demands to deal with its debt — knowing full well that the situation is unsustainable — and on the other with eurozone members pretending to play tough while softening the requirement on providing Greece with the loans that will keep the country afloat. Each player is unwilling to yield sufficiently to produce a better outcome.

The real tragedy is that solutions are readily available.

These include debt restructuring, which amounts to a partial default, and the creation of a single market for euro-denominated bonds instead of sovereign bonds for individual eurozone members, among other reforms that likely will be inescapable in the months to come.

Politicians, however, are determined to stick with a failed governance model. Rolling over Greece’s existing short-term debt into long-term bonds is a shameful idea, as it guarantees that the consequences of past bad behaviour are shouldered by future generations.

Other schemes, such as France’s insistence that two Italians cannot sit on the board of the European Central Bank, fly in the face of the ECB’s much-cherished independence and illustrates how the major players insist on carrying on with failed policies.

The euro area, built over decades, is broken. Markets have correctly seen through the words of politicians. As in any game of chicken, the worst possible outcome is still in play.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

About the Author

Pierre Siklos is a CIGI senior fellow. His research interests include applied time series analysis and monetary policy, with a focus on inflation and financial markets.