THE Greek government needs to escape from an otherwise
impossible situation. It has an unmanageable level of government debt (150% of
gross domestic product, rising this year by ten percentage points), a
collapsing economy (with GDP down by more than 7% this year, pushing the
unemployment rate up to 16%), a chronic balance-of-payments deficit (now at 8%
of GDP), and insolvent banks that are rapidly losing deposits.
The only way out is for Greece to default on its sovereign
debt. When it does, it must write down the principal value of that debt by at
least 50%. The current plan to reduce the present value of privately held bonds
by 20% is just a first small step toward this outcome.
If Greece leaves the euro after it defaults, it can devalue
its new currency, thereby stimulating demand and shifting eventually to a trade
surplus.
Such a strategy of "default and devalue" has been
standard fare for countries in other parts of the world when they were faced
with unmanageably large government debt and a chronic current account deficit.
It hasn't happened in Greece, only because Greece is trapped in the single
currency.
The markets are fully aware that Greece, being insolvent,
will eventually default. That's why the interest rate on Greek three-year
government debt recently soared past 100% and the yield on ten-year bonds is
22%, implying that a €100 principal payable in 10 years is worth less than €14
today.
Why, then, are political leaders in France and Germany trying so hard to prevent - or, more accurately, to postpone - the inevitable? There are two reasons.
First, the banks and other financial institutions in Germany
and France have large exposures to Greek government debt, both directly and
through the credit that they have extended to Greek and other eurozone banks.
Postponing a default gives the French and German financial institutions time to
build up their capital, reduce their exposure to Greek banks by not renewing
credit when loans come due, and sell Greek bonds to the European Central Bank.
The second, and more important, reason for the Franco-German
struggle to postpone a Greek default is the risk that a Greek default would
induce sovereign defaults in other countries and runs on other banking systems,
particularly in Spain and Italy. This risk was highlighted by the recent
downgrade of Italy's credit rating by Standard & Poor's.
A default by either of those large countries would have
disastrous implications for the banks and other financial institutions in
France and Germany. The European Financial Stability Fund (EFSF) is large
enough to cover Greece's financing needs but not large enough to finance Italy
and Spain if they lose access to private markets.
So European politicians hope that by showing that even Greece can avoid default, private markets will gain enough confidence in the viability of Italy and Spain to continue lending to their governments at reasonable rates and financing their banks.
If Greece is allowed to default in the coming weeks,
financial markets will indeed regard defaults by Spain and Italy as much more
likely. That could cause their interest rates to spike upward and their
national debts to rise rapidly, thus making them effectively insolvent. By
postponing a Greek default for two years, Europe's politicians hope to give
Spain and Italy time to prove that they are financially viable.
Two years could allow markets to see whether Spain's banks
can handle the decline of local real estate prices or whether mortgage defaults
will lead to widespread bank failures, requiring the Spanish government to
finance large deposit guarantees.
The next two years would also disclose the financial
conditions of Spain's regional governments, which have incurred debts that are
ultimately guaranteed by the central government.
Likewise, two years could provide time for Italy to
demonstrate whether it can achieve a balanced budget. The Berlusconi government
recently passed a budget bill designed to raise tax revenue and to bring the
economy to a balanced budget by 2013.
That will be hard to achieve, because fiscal tightening will
reduce Italian GDP, which is now barely growing, in turn shrinking tax revenue.
So, in two years, we can expect a debate about whether budget balance has then
been achieved on a cyclically adjusted basis. Those two years would also
indicate whether Italian banks are in better shape than many now fear.
If Spain and Italy do look sound enough at the end of two
years, European political leaders can allow Greece to default without fear of
dangerous contagion. Portugal might follow Greece in a sovereign default and in
leaving the eurozone. But the larger countries would be able to fund themselves
at reasonable interest rates, and the current eurozone system could continue.
If, however, Spain or Italy does not persuade markets over the next two years that they are financially sound, interest rates for their governments and banks will rise sharply, and it will be clear that they are insolvent. At that point, they will default. They would also be at least temporarily unable to borrow and would be strongly tempted to leave the single currency.
But there is a greater and more immediate danger: even if
Spain and Italy are fundamentally sound, there may not be two years to find
out. The level of Greek interest rates shows that markets believe Greece will
default very soon. And even before that default occurs, interest rates on
Spanish or Italian debt could rise sharply, putting these countries on a
financially impossible path. The eurozone's politicians may learn the hard way
that trying to fool markets is a dangerous strategy.
- Reuters
This piece comes from Project Syndicate.
* Martin Feldstein, a professor of economics at Harvard, was chairperson of former president Ronald Reagan's Council of Economic Advisers and is the former president of the National Bureau for Economic Research.
The opinions expressed are his own.