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A bailout that hurts the Germans but doesn’t help the Greeks

Published on the Institute of Economics Affairs blog, 5 May 2010

After months of agonising discussions, European leaders have agreed on a “solution” for the Greek crisis. Unfortunately, the joint efforts of the EU and the International Monetary Fund to keep Greece financially afloat are not addressing the more pressing issue of Greece’s competitiveness.

The mistake most politicians make about the Greek situation is simple. They believe that Greece’s principal problem is its budget deficit of around 13 per cent of GDP (if the figures are to be trusted). If that were the case, plugging the hole in Greece’s public finances with international help could work. To be sure, it would still require huge amounts of money from the IMF and eurozone members. But it would buy the Greeks time to get their budget troubles under control.

This calculation will not work, though. It ignores the fact that apart from its fiscal crisis, Greece has more serious economic problems. The most pressing issue is Greece’s lack of cost competitiveness. To put it simply, as long as a cappuccino costs €4.50 in Athens, the country has no chance of economic recovery.

Given the Greeks’ poor productivity, Greek wages (and prices) are at least a quarter higher than they should be. This means that Greece will not be able to compete with Germany. It will also struggle to compete with its neighbours in the important tourism market. It will not be able to recover.

If Greece still had its old currency, there would be an easy way out of its current quagmire, namely to devalue. In fact, that’s precisely how countries like Greece had previously dealt with similar challenges. This would have made imports more expensive, thus correcting the trade imbalances that are currently troubling Europe.

The euro has made this course of action impossible. Greece is trapped in a monetary union that now forces it to slash its budget and cut its wages in the country’s most severe recession for decades. You don’t need to be a Keynesian to understand that this will cause enormous economic pain and risks political destabilisation.

So Greece’s problems are not solved by the billions of euros now flowing into the country for the next three years. At best, this will only postpone Greece’s eventual collapse. Greece would be much better served if it were allowed to default, leave the euro and devalue. It would be following the example of Argentina’s default from which the country bounced back at a remarkable speed.

European politicians are scared of such a scenario, of course. Having bailed out their banks in the financial crisis, they would have to do the same once again for all banks holding Greek bonds. However, why shouldn’t they bail out the banks directly instead of taking the detour via Athens?

Besides, it is not clear why Greek bondholders should not suffer some loss (i.e. a haircut). If interest rates on different types of government bonds reflect the risk of default, then default as an option should not be taken off the table. We are creating moral hazard if even the most risky government bonds would always be backed by an implicit EU/IMF guarantee.

On closer inspection, the EU/IMF rescue package does not provide the help the Greece really needs. But this non-solution will still cost taxpayers, not least in Germany, billions of euros. Years from now, the Germans will ask why they had to pay about €40bn to Greece when this substantial amount of money did not manage to cure the Greek patient. The answer is that it was the wrong medicine in the first place, but politicians were gullible enough to believe that there was no alternative.

We can only speculate how long the German taxpayers’ patience with the euro will last under these circumstances. If they are not going to wake up now, will they wake up when Portugal asks them for money? Or Spain? Or Italy? Or Belgium?

As long as countries such as Greece are joined with Germany in a monetary union, this monetary union will not work. Both of them cannot be members of workable monetary union at the same time. It is high time for one of them to leave.

Will the Germans finally realise that it’s not too late for them to bring back the Deutschmark?

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