The financial/economic crisis in Greece defies the comprehension of even professional economists!

The on-going Greece Crisis (actually a full blown European Monetary Union crisis now) is increasingly becoming unintelligible. The genesis of the crisis was clear, as Greece was living beyond its means for many years, but the resolution of the crisis has been just beyond comprehension.

The crisis started around the beginning of 2010 when markets started to understand that Greece was running fiscal deficits that were too large, and would not be able to pay off its debts. The high deficits were nothing new, as Greece was running large deficits ever since it joined the European Monetary Union (EMU) and adopted the Euro in 2001. Under the EMU, all countries were expected to follow the Stability and Growth Pact (SGP), which specified that EMU economies should maintain deficits at 3% of GDP and 60% of debt. Greece made some financial adjustments (along with France and many others) to qualify for EMU, and even as it qualified, it violated guidelines of the SGP ever since it joined.

Why wasn’t Greece penalized? Well, the SGP pact was first violated by large economies like Germany and France around 2003-04 when their deficits breached SGP levels. They threatened to break out of EMU if there were any actions taken against them. As a result, despite warnings from economists, SGP’s main objectives were diluted and it remained just a toothless pact. Since then, EMU economies have lived carefree lives, borrowing at rates equal to Germany (which reformed after the 2003 debt problems), despite having much bigger debt and productivity problems. Germany ignored these troubles, as breaking out of the EMU would imply much a stronger currency, which would have dented their export-led growth.

By the eve of the crisis in 2007, the EMU ran its own imbalances, with Germany exporting to other EMU economies running either large budget or current account deficits, and more dangerously, with EMU banks investing hugely in bonds issued by troubled and deficit economies.

The market participants ignored these brewing troubles just as they ignored much of the American sub-prime crisis. In fact, till early 2010, Greece or Europe was not on most experts’ risk list. In its pre-formation years, economists doubted and criticized EMU, as it did not have a fiscal union to begin with. Robert Mundell, who won the Nobel Prize for his work on monetary union and on whose broad ideas the EMU was based, had mentioned that a fiscal union is critical to a successful monetary union. But this warning was ignored by EMU founders who, in their vision to build one Europe, took the easier route of first having a MU and then integrating other policy areas over a period of time. EMU also was quite successful despite some initial shocks like the dot-com crisis, 9/11 etc., and hence the above highlighted risks were ignored by markets.

And when realization dawned, towards March 2010, that Greece would be unable to fund its budget, and all hell broke loose. Greece also had been reporting lower fiscal deficit numbers than those which actually existed, making things all the more worse. Greece was followed by Ireland, which had a banking problem; Portugal, which had low productivity; Spain, which had a housing bubble; and Italy, which had been running debt at 100% plus levels for a long time. So far only Greece, Ireland and Portugal have needed funds, but Spain and Italy (even France at times) are continuously on the market radar. The EMU banks have large exposures to EMU sovereign debt and the debt problem has become a banking crisis as well. In US, the banking crisis turned into a debt crisis and in EMU it is the other way round.

The policies to ease the crisis were baffling. Political Scientist Henry Farrell of George Washington University rightly says the instinct of EMU policymakers is to come up with technocratic fudges that are incomprehensible to the outside world but get some minimum consensus among states. Initially, the world thinks that problems are resolved but as they figure out the details and realize it is inappropriate, and they again start shorting EMU markets. This has been a continuous process since May 2010 and there is no end in sight. The IMF-coordinated bailouts were followed by the ECB bond-buying program, with the latter being very reluctant to intervene, as its mandate is to deliver price stability and not bail out banks and countries. Then we had the European Financial Stability Facility (EFSF), which finances itself by issuing bonds backed by EMU economies, and it then lends to troubled economies, and was recently allowed to buy bonds in secondary markets as well. EFSF will be converted to European Stability Mechanism which will be a permanent crisis resolution body. On top of this, you have multiple proposals from the seventeen countries with stronger economies reluctant to provide funds to weaker countries. It is complete chaos out there.

One can write reams on the EMU crisis but given space constraints I have to conclude. The final thought is, it was a flawed idea to begin with and cannot continue in its current form. There are some major modifications required to make the union functional, without which the battering of the EMU is likely to continue.