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Greek Tragedy Could Have Multiple Acts

Thursday, May 6, 2010

In considering the timing of the Federal Reserve’s exit strategy, Chairman Bernanke should not underestimate the potential fallout of a Greek failure on the U.S. and global economies.

In a manner all too reminiscent of Federal Reserve Chairman Ben Bernanke’s initial dismissal in early 2007 of the subprime loan loss problem, President of the European Central Bank Jean-Claude Trichet keeps insisting that the Greek economy constitutes only 2 percent of the European economy. He does so to assure markets that Greece poses no real threat to the European economic recovery and to detract attention from the very large amount of Greek sovereign debt being held by European banks.

In deciding on the timing of an exit from the Federal Reserve’s extraordinary monetary policy easing, Bernanke would do well to ignore Trichet’s reassurances. The body blow that a Greek default would deliver to the European banking system—together with the contagion that it would unleash on Spain, Portugal, and Ireland—would have major reverberations throughout the global economy.

Greece’s threat to the global economy stems from the fact that it is both insolvent and in need of a markedly weaker currency to restore international competitiveness. Despite the International Monetary Fund (IMF) and European Union’s recently announced US$140 billion support package for Greece, any attempt by Greece to reduce its budget deficit from 14 percent of GDP at present to 3 percent of GDP (the target of the Growth and Stability Pact) without the benefit of a currency depreciation to boost exports will involve a major Greek economic recession.

The body blow that a Greek default would deliver to the European banking system—together with the contagion that it would unleash on Spain, Portugal, and Ireland—would have major reverberations throughout the global economy.

If the Greek authorities have any doubt on this score, all they need do is look at the sorry experience of Latvia and Ireland over the past two years, where output has collapsed by more than 20 and 10 percent, respectively. It has done so precisely as a result of IMF-style budget deficit reduction in the context of a fixed exchange rate system that closes the door to letting these countries export their way out of their budget deficit problems.

At the same time that Greece is being told to bring order to its public finances, the IMF and the Europeans are insisting that Greece aim at restoring the 30 percent that it has lost in international competitiveness over the past decade through an “internal devaluation.” Given the limitations on Greece’s ability to increase labor productivity through structural reform, Greece will need to tolerate price and wage deflation of the order of 20 percent over the next few years in order to restore competitiveness.

The basic flaw in the IMF-EU sponsored program to restore Greek fiscal sustainability through a program of draconian public expenditure cuts is that if successfully implemented it will have the unwanted effect of increasing rather than reducing Greece’s public-debt-to-GDP ratio. Since if Greece’s nominal GDP were to decline over the next few years by 30 percent as a result of a deep recession and price deflation, Greece’s public-debt-to-GDP ratio would arithmetically rise from its present level of around 120 percent towards 175 percent. It is calculations of this sort that have recently led Standard and Poor’s to warn Greek bond holders that they might eventually retrieve only 30 to 50 cents on the dollar on their bond holdings.

A further shock to the European banking system would likely be accompanied by a return in spades of risk aversion in global financial markets.

A major write-down of Greece’s $400 billion sovereign debt would deal a serious blow to an already enfeebled European banking system, which holds the majority of that debt. Indeed, if Greece’s debt does need to be written down by anywhere near the Standard and Poor’s estimate, one could see the IMF having to revise up by at least 20 percent its present estimate of the European banks’ likely loan losses from the 2008–2009 global economic crisis.

The even greater risk to the European banking system from a Greek failure is that it would bring very much into play Portugal, Spain, and Ireland. These countries, which between them have around US$1.5 trillion in sovereign debt, suffer from similar, albeit less acute, public finance and international competitiveness problems. And they too are stuck in a Euro-zone straightjacket that severely constrains their ability to deal with these problems in a credible manner.

In considering the timing of the Federal Reserve’s exit strategy, Bernanke would make the gravest of errors were he to underestimate the potential fallout of a Greek failure on the U.S. and global economies. For not only would a further shock to the European banking system diminish U.S. export prospects by tipping the European economy back into recession and by materially weakening the euro, it would also all too likely be accompanied by a return in spades of risk aversion in global financial markets.

One would think that Bernanke would certainly not want to minimize the importance of these risks at the very time when bank deposits continue to leave Greece and when markets are pricing Greek debt at distressed levels in spite of the very large IMF-EU bailout package.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

FURTHER READING: Lachman tracks global monetary policy, most recently suggesting, “Maybe Milton Was Right About the Euro,” and that we should “Expect a Steady Fed.” He has discussed Dubai as “A Warning from the Desert with More to Come” and said that the “IMF Can’t Bail Out Greece Without German Support.” Lachman has also explained “Greece’s Threat to the Euro” and “What China’s Currency Shift Could Mean.”

Image by Rob Green/Bergman Group.

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