The Greek story is not over yet

March 12, 2010

Jane Foley– Jane Foley is research director at The opinions expressed are her own.-

By rushing extra austerity measures through parliament last week and finding very good support for its bond sale Greece last week pulled its way clear of the edge of the abyss.  This is not the end of the story, however, but rather just another chapter in the fledging system which is European Monetary Union.

The euro found support in the positive developments surrounding Greece at the end of last week, and on rumours that a key European institution was on the bid in EUR/USD.  But the Greek story is not over.  Not only does the country still have to prove that it can implement this year’s austerity measures but it will take years before it can build up a track record of budgetary prudence.

In the interim there will be risks that Greece’s problems will again rise to the fore and that strains on EMU will again emerge.   More significant than Greece itself it the fact that it has opened the market’s eyes to the inadequate fiscal controls of EMU.

Greece, Spain et al should not have been allowed to squander the opportunity for budget reform that the ‘fat’ years of growth presented to them.  In this respect their respective governments were as guilty of taking too much risk as were the bankers that fuelled the financial crisis.

If EMU is to prove it can be sustainable over the long term, than stricter adherence to fiscal controls is necessary.  In essence the development of a European Monetary Fund thus seems like a good idea.  Whether or not the legal framework of the EU can be negotiated to allow it to be set up is another matter entirely, but it is essential for the future of EMU that the process that has not been embarked upon by politicians aimed at strengthening fiscal controls does yield fruit of some sort.
In recognising that budget reform will involve a variety of measures likely to cut real (and in some cases nominal) wages, pensions, welfare benefits and (for a temporary period) employment it becomes clear firstly that there will be difficulties in adhering to it; particularly given the additional constrain of a strong and inflexible currency.

It also becomes obvious that reform will coincide with years of slow growth.  This is likely to be felt most acutely in Southern Europe.  However, insofar as Spain is Germany’s eighth largest export partner the drag is likely to feed back through the Eurozone.

Slower growth in the Eurozone relative to the US is likely at least through 2011 be and this can be expected to weigh on the ability of the ECB to raise interest rates perhaps until the latter stages of 2011.  Faced with the possibility of widening growth and interest rates differentials with the US, in addition to the risk that strains of EMU could yet re-emerge, EUR/USD could fall further over the medium-term; potentially back to its 1.18 long-term average.

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