Greece loses a major incentive to stay within EMU

January 28, 2010

cr_mega_503_JaneFoley-150x150-Jane Foley is research director of The opinions expressed are her own.-

Germany’s Finance Ministry this week denied a report in Le Monde that Germany, France and other countries were working on a package to rescue Greece. It seems that for now the official line from the grandfathers of European Monetary Union is that Greece can sort out its own budget deficit. The official line from the Greek government is much the same; it continues to maintain that it doesn’t need a bailout.

The problem with this is that this lacks credibility. The blowing out of the yield spreads on Greek government bonds over bunds and the price of credit default swaps are evidence of that. In the months after EMU, the 5 year Greek-bund spread was less than 200 bps. This week it was over 400 bps. Unless the impact of bond yields can be contained Greece loses a major incentive to stay within EMU.

As with many of the less well fiscally managed countries in the approach EMU in 1999, Greece benefitted hugely from convergence trades. Technically, the spread between Greek bond yields and Germany’s should have closed only after budgetary reform led to a much smaller budget deficit.

In practice what happened with many countries is that the market pre-empted the convergence trade and the countries which had previously suffered from high debt maintenance costs saw the burden of financing their deficits decline markedly. In turn the savings made on financing the deficit hid the fact that true budgetary reform was in certain cases avoided. Years of strong growth allowed the government in Greece to get away with it. That the recession has uncovered the cracks is not really a surprise.

While EMU offers Greece many political advantages, the question now must be can it afford to stay within EMU? It is no longer benefitting from German-like bond yields and it is suffering the pressure of what is still a very strong exchange rate. It is not without precedent that a country can turn its fiscal situation around. Sweden’s experience in 1994 is a very good example of this. Canada also suffered years of austerity in the 1990s and transitioned its economy into one which was better positioned than most to cope with the latest recession.

Ireland also appears to be swallowing the bitter bill of budget reform. What makes Greece different is that it is highly questionable as to whether the electorate have the stamina to suffer reform. The farmers have this month been blockading roads; the risk of rising social discontent is high.

Worsening the hand of the Greek government is the fact that tax avoidance is high. If yields continue to rise, Greece may begin to see appeal in the re-establishment of a very weak drachma. It is exactly this risk that will force the authorities within Germany and France to work out a bail-out for Greece.

If it was just down to economics than the lack of budgetary rigour would probably have kept Greece out of EMU in the first place. The fact is that EMU was always more about politics than economics and it is this reason which will force the grandfathers of EMU to protect their system and bail out Greece.

They will of course make Greece squirm first; lessons have to be learnt and pledges have to be made. Greece may be given certain goals which will have to be achieved before rewards are made. But the fact is that if Greece exits EMU, the whole system could topple. German and French pride is not about to allow this to happen.


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