February 7, 2010 6:30 pm

Greece and the eurozone: Halcyon no more

The single currency zone faces the biggest test of its 11-year life

Firefighters light smoke flares during a protest outside the Greek parliament in Athens

In the calm between wintry tempests Alcyone, daughter of Aeolos, ruler of the winds, is once said to have made a nest on a tranquil sea and, as a kingfisher, laid her eggs.

This winter, even as they enjoy the thin Aegean sunlight, Greeks have little sense of the “halcyon days” to which she mythically gave her name. Instead, their country’s parlous public finances have set forth a wave of storms that are now lashing other parts of southern Europe as well.

Last week brought emergency cross-party talks and a nationally televised address by George Papandreou, prime minister, announcing fresh steps to plug gaping holes in the budget. Athens won a respite when the European Commission endorsed its plans to reduce the fiscal deficit and imposed the strongest surveillance measures ever on a member of the 16-country eurozone. But with Greece still at risk of a default, the interest rate the markets demand on its government bonds ended on Friday near 10-year highs. (See chart below)

More alarming for European Union policymakers, investor nervousness has become contagious. Portugal and Spain, fellow eurozone members where public sector deficits have also spiralled, had their bond yields pushed up to levels last seen at the height of the global crisis in early 2009.

As a result, problems in one of the eurozone’s smallest countries – Greece’s gross domestic product accounts for only about 2.5 per cent of the total – have escalated into the biggest challenge facing Europe’s monetary union in its 11-year history, threatening economic instability across much of continental Europe even as the global crisis recedes.

“There had to be a point when we were testing the [eurozone] construct in difficult circumstances,” says George Papaconstantinou, Greece’s finance minister. “We happened to be at the forefront of this.”

But the drama is much bigger that that – with shortcomings exposed on many fronts. Why was an obvious lack of accountability in Greece for its finances ignored for so long? Why was more not done earlier to put its economy – pumped up by EU aid but riddled with inefficiencies and corruption – on a sounder footing? Why was the contagion allowed to spread so rapidly to other countries – and could the eurozone find a better way of dealing with crises?

“For the past 10 years we have had an abstract, theoretical debate about whether a monetary union can work without a fiscal union,” says Marco Annunziata, chief economist at Unicredit, based in Milan. “Now we have had it tested – and have found out that that it does not.”

For many, Greece’s downfall should have been easy to foresee. “Europe has been derelict in its duties,” says Stefanos Manos, who was finance minister in the early 1990s. “What happened in Greece is something that was bound to happen. But nobody bothered – inside or outside Greece.”

Signs of a country living beyond its means, with a bloated public sector and rapidly declining competitiveness, included a current account deficit that peaked at almost 15 per cent of GDP in 2007, the largest in the eurozone. Over the past decade, Greece has also had the lowest private savings rate. Government debt has soared above 110 per cent of GDP and is exceeded in the EU only by Italy. “Hardly any other country has drawn such great advantage from EU and eurozone membership, while at the same time flouting the rules so often as Greece,” observed Otmar Issing, the European Central Bank’s former chief economist, in the Frankfurter Allgemeine Zeitung last month.

Greece is famous for tax evasion – an estimated 30 per cent of VAT goes uncollected. Mr Manos also points to examples of waste in education, where there are four times as many state schoolteachers per student as in Finland – regarded as a model in the EU – with as many again in the private sector making up for poor quality in the public system. (The government disputes his calculations.)

Until late last year, the acuteness of Greece’s plight was partly hidden. Elected in October, Mr Papandreou’s socialist government angered EU policymakers by revealing that the 2009 public sector deficit would be nearly 13 per cent of GDP – double what had previously been feared. But the surprise was not large: official Greek statistics have long been suspect – and the country has considerable form as Europe’s miscreant.

Greece was nevertheless determined to join the eurozone, which in the 1990s moved towards realisation. A burst in growth and an apparent improvement in public finances allowed it to enter in 2001, two years after the start of the currency union.

Initially, the country benefited from falls in interest rates and the elimination of exchange rate risks that had previously discouraged foreign investors. A high-water mark was reached in 2004, when Greece won praise for its staging of the Olympic Games.

For groups such as Greek farmers, who in recent weeks have blocked main roads in a campaign to protect their subsidised lifestyle, the benefits of EU membership remain clear. “I’m fairly certain that we have more tractors per capita than any other part of the world,” says Mr Manos. “This is where the EU money is going. A lot look like they have just come out of the showroom.”

In retrospect, however, it is equally clear that much of Greece’s economic improvement was illusory. Even before the latest crisis, statistical revisions showed public finances had never improved sufficiently to meet eurozone entry criteria. More damaging – and overlooked by financial markets until recently – the era of lower interest rates had put the economy on an unsustainable trajectory.

In the US, the economic crisis followed a binge in private sector credit. “Here our problem was mainly publicly generated. It was politicians that were spending, much more than households,” says Loukas Tsoukalis of Eliamep, a foundation for European and foreign policy. The effects of public munificence spread, however. Spyros Papaspyrou, leader of the 420,000-strong Adedy civil service union, says the early years of eurozone membership “created a false sense of prosperity, a fake way of life – as has now been demonstrated”.

Just as with subprime mortgages in the US, official institutions proved powerless. Without a single political authority, eurozone countries are expected to adhere to rules set out in the “stability and growth pact”, which includes a limit of 3 per cent of GDP for public sector deficits. That rulebook proved “a lopsided, very post-modern construction,” says George Pagoulatos, associate professor at Athens University of Economics and Business. “The system is biased. If your deficit exceeds 3 per cent, there are procedures. But countries that have large debt levels and fast growth have not faced effective pressure to reduce that debt – and that was exactly the problem faced by Greece.”

At a summit this week, EU leaders will discuss ways a repeat of the Greek crisis might be prevented. The Commission last week belatedly vowed to monitor Athens’ deficit reduction plans closely – it also launched legal proceedings over Greece’s failure to provide reliable financial statistics.

But many say more is needed. Even the Greek government argues that future controls should look at a much broader picture than envisaged under the stability and growth pact. “There is a good case to be made ... for finding a way to broaden the economic policy surveillance to include structural issues, to which we have only a soft approach at the moment,” says Mr Papaconstantinou. Criteria could include competitiveness, tax and labour market policies and the openness of the economy.

A widening of surveillance procedures has a good chance of success, argues Mr Tsoukalis at Eliamep – if only because of the risks to the stability of the eurozone that Greece has exposed. “A result of the crisis will be a more effective governance system – more effective co-ordination of fiscal policies, greater surveillance and new forms of solidarity ... The alternative would be catastrophe. That is something [financial market] traders don’t understand – that the political commitment is so high because the stakes are so high.”

Still, others remain sceptical about such ideas. “They sound very good in theory but are just a rehash of what we have already,” says Mr Annunziata at Unicredit. “You need hard incentives for countries to act in a more responsible way. Why do International Monetary Fund programmes work? Because they only provide financial help, in tranches, when conditions are met. You should have something similar in Europe.”

Another urgent need identified by commentators – which would help not just Greece but other countries being pounded by financial markets – would be a formal reassurance that the EU had a fallback plan to avert, for instance, a default. To press eurozone governments to keep public finances in order, the architects of the monetary union wrote in a “no bail-out” clause – ruling out joint help for a struggling country. But that hardline approach may now be exacerbating Greece’s problems – by adding to financial market concerns and sending borrowing costs even higher.

Not helping investors’ nerves is the real threat that Greek government bonds, if downgraded further by rating agencies, might no longer be eligible for use as collateral by banks borrowing liquidity from the ECB.

Greece could seek help from the IMF. But such aid would be opposed elsewhere because of the signal it would send about the eurozone’s inability to solve its own problems.

An alternative would be an explicit understanding among eurozone politicians that help would always be provided in an extreme case. “Some kind of guarantees would be sufficient – I am sure they would not be tested and no money would actually flow,” says Yannis Stournaras of the IOBE business think-tank.

Without such reassurances, Athens faces at best a long, hard haul back to respectability. Trade unions plan noisy protests this week, which could damage the cross-party consensus and voter support that Mr Papandreou has enjoyed so far.

A worry of the Greek central bank is that the government has underestimated the scale of the expected contraction in the economy this year – put at just 0.3 per cent. George Provopoulos, central bank governor, says an economic overhaul is needed, boosting sectors where it has comparative advantages – for instance in tourism, shipping and as a retirement destination for Europe’s elderly. “The Greek economy cannot be revived without regaining the competitiveness we have lost,” he says.

But before Greece can turn itself into the Miami of Europe, more storms are likely. Unless market nervousness abates, the soaring cost of borrowing will stifle its economy; the government’s financing programme makes April and May particularly perilous. For the eurozone, the storm season is far from over; Greeks have little time to make their nests secure.

The credibility gap widens...

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