By RAMESH GOPALKRISHNAN
In 1999, the European Union (EU), an economic and political community of 27 nations, established a monetary union, the ‘Eurozone’. All EU member nations who were part of this zone had the freedom to decide their individual fiscal policies. However, the European Central Bank (ECB) decided a common monetary policy. It dealt with establishing a common currency (the Euro) and the supply of money in the zone by targeting rate of interest to propel or control growth.
While this worked well during times of economic prosperity during the global financial crisis, the ECB’s one-size-fits-all policy looks suspect.
As a formal structure bridging the ECB’s monetary policy with the fiscal policy of individual nations is non-existent, there is a chasmic difference in how different nations handle their public finances. This has led to a chary Germany and a profligate Greece on the same side of the table, both bound by the same monetary policy.
Though a few riders exist to protect member nations from their wastrel neighbours, (EU Treaties have a ‘no bail out’ clause for member nations with financial difficulty) it is easier said than done. In an economy as intertwined as the EU, there is little choice but to bailout member nations, as in the case of Greece.
However, the bailout’s harsh provisos of slashing public spending and stabilizing national debt, will adversely affect an already recessionary Greek economy. Reduction in public spending reduces money in the economy and results in lesser money in the hands of the people. This shrinks investments and reduces demand; thereby stifling growth. Without growth, Greece cannot possibly earn any revenue to repay its loans. Increasing taxes, especially in the current scenario will lead to civil unrest and the kind of political instability that Greece cannot afford. In such a scenario, the Greeks have little choice but to default.
Hypothetically, the immediate effect of the $400 billion sovereign debt default will lead to global financial markets entering into a double-dip recession. Banks heavily exposed to toxic Greek debt will close down, à la American subprime crisis all over again. Investors will panic and short EU nations’ bonds, especially Italy and Spain as they seem to be heading the Greek way.
Another perspective could be that a Greek default is imminent. While no one discounts its cascading effect, what works for it is that the global financial markets and investors are anticipating a Greek default. They are already mitigating or hedging their losses. Moreover, the EU’s repeated bailouts seem to have little effect on the actual problem, Greece’s national debts.
Instead of squandering huge sums of money on Greece, the EU should shore up European banks most exposed to the toxic debt. Alternatively, it can bailout Italy and Spain, both bigger and more powerful economies than Greece which are on the periphery of a Greece style downward spiral.
Meanwhile Greece must use the crisis to cobble together political will to restructure its public finances and rewrite its policies. If necessary, it should leave the eurozone, give up the euro, and return to the Greek drachm. Only then, can it control its monetary policy, devalue its currency and kick start its exports, all of which will eventually in time lead to positive growth.
For Greece and the European Union, the only choices are; the two must work out a closely integrated and orchestrated default wherein everyone takes a hit or a complete collapse of the Union and with it the very idea of an integrated Europe. There is no third way.