By Desmond Lachman
By any reasonable measure, the IMF-European Union (EU) bailout package for Greece has been an unmitigated disaster.As the IMF itself now acknowledges in a commendably frank report, over the past four years Greece’s economy has contracted by 25 percent and its unemployment rate has risen to a staggering 27-½ percent of the labor force. Yet despite this economic collapse, no meaningful economic recovery is in prospect anytime soon as Greece’s teetering coalition government is still obliged to pursue budget austerity and as Greek banks continue to restrict credit to both households and enterprises.
Greece’s economic tragedy, which is by now on the same relative scale as was the Great Depression for the United States, is bound to exact the heaviest of long-run social and political costs on the country. Considering that a number of other European countries like Cyprus, Ireland, and Portugal are all now also under IMF -EU tutelage, the Greek tragedy would be all the more tragic if these countries did not pay close heed to the following five lessons from Greece’s experience in the hope that they can avoid anything similar to Greece’s tragic fate.
Budget austerity in a currency straitjacket does not work
If there is a single lesson that should have been learnt from Greece’s failed economic program it is that severe budget austerity within a euro straitjacket simply does not work. For without the ability to devalue its currency so as to boost export growth or the tourist sector as an offset to the negative impact of fiscal tightening on domestic demand, the country’s economy runs the real risk of entering a debilitating deflationary spiral. This is particularly the case in the context of a weak banking system that is confronted with increased amounts of non-performing loans and that restricts credit to households and companies.
The IMF now belatedly acknowledges that the negative impact of budget tightening on European economic growth has been much higher than it had previously thought. It also recognizes that severe budget austerity has been counterproductive in Greece in the sense that by eroding the country’s tax base a weaker Greek economy has thwarted the attainment of the desired objective of public finance sustainability.
This recognition is now inducing the IMF to propose that the fiscal tightening needed to restore budget balance in the rest of the European periphery should be spread out over a number of years rather than be undertaken upfront. While this softening of the IMF’s policy stance is to be welcomed in that it implies a lesser degree of budget tightening than heretofore, it should not obscure the fact that it will now involve a fiscal headwind to economic recovery for a longer period than was previously the case. This would imply little prospect of relief from the Southern European countries’ currently unusually high unemployment levels, which are so clearly now straining their social fabric and corroding their body politic.
Large official bailout packages have their price
A second lesson that European countries with very high public debt levels should draw from Greece’s experience is that large IMF-EU bailout packages to cover the government’s financing needs for a number of years comes with a high long-run price tag. For those bailout packages in effect replace privately owned debt, which is governed by domestic law and which is relatively easy to restructure, with officially owned debt, which is covered by international law and which is correspondingly very difficult to restructure. As Greece is now belatedly learning to its long-run economic detriment, accepting IMF-EU money has saddled the country with a mountain of official debt that the country will not be able to service and that it will have the greatest of difficulties in restructuring.
Delaying debt reduction is costly
To its credit, the IMF now acknowledges that a crucial mistake it made in Greece was not to recognize right from the start that the country was insolvent. This delayed the inevitable writing down of the country’s debt and it imposed on the country a greater degree of fiscal tightening than was strictly necessary. This lesson would appear to be particularly relevant today for countries like Ireland, Italy, and Portugal, which all have public debt to GDP ratios that exceed 125 percent and that remain on a rising trajectory. It is far from clear that delaying a restructuring of this debt is in these countries’ best long-run economic interest.
Deflation is a real risk
As was to be expected, very high unemployment and a depressed economy have led to chronic deflation in Greece with consumer prices now having declined over the past six months. Judging by Japan’s experience with deflation over the past two decades, deflation makes it difficult to engineer an economic recovery and it highly complicates the task of restoring public debt sustainability. This should lend a greater sense of urgency than is presently the case across Europe, and particularly in those countries on the cusp of deflation, to find a way of soon getting a meaningful economic recovery going.
Economic dislocation is not good for political stability
Years of economic malaise and endless rounds of budget austerity and painful economic reform have exacted a high cost on Greece’s body politic. Today Greece’s two traditional political parties, which at the start of the crisis commanded 70 percent of the electoral vote, now have barely 30 percent popular support, while parties on the extreme right and left of the political spectrum continue to gain in popularity. This fragmentation of Greek politics should be a very clear warming to the Italian, Portuguese, and Spanish governments, which all have already lost major public support, about the real dangers of persisting with an IMF-EU policy mix that is inimical to economic recovery.
Hopefully policymakers in the rest of the European periphery are paying close attention to Greece’s economic and political drama and are not dismissing Greece as an exceptional case. For then at least there would be some hope that they would consider a timely U-turn in the policy mix on which they are embarked and which is all too likely leading them down a blind and costly policy alley.
American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.
- Banking & Budgeting