Who Lost Greece?

Taking a Spring Break

A relatively insignificant southern European country threatens the very survival of the euro in its present form. How did we get here, and what lessons does Greece hold for the rest of the European periphery?

By Desmond Lachman

With Greece now literally in a state of economic and political collapse, and with the country on the cusp of an official debt default and an exit from the euro, it is not too early to pose some uncomfortable questions. Who lost Greece? How did we get to a situation in which a relatively insignificant southern European country threatens the very survival of the euro in its present form? And what lessons does Greece hold for the rest of the European periphery?

According to the narrative being spun in European capitals, the answer to these questions is both simple and unambiguous: It is all Greece’s fault. After many years of fiscal profligacy and living beyond its means, not to mention cheating on its budget reporting, Greece has brought its misfortunes upon itself. All that is now happening is that Greece’s day of reckoning has finally arrived and the Greeks are paying the price for their past sins.

To compound its difficulties, Greece has stubbornly resisted taking the strong corrective medicine that has been prescribed by those multilateral institutions charged with bailing it out—as Christine Lagarde, managing director of the International Monetary Fund, is wont to point out. In particular, Greece has stubbornly refused to get serious about tax collections and it has done everything within its power to avoid serious labor market reform.

Making Greece’s tragedy into a morality tale suits European policymakers well. It absolves them from any responsibility in the Greek fiasco. It also supports the story that European policymakers are now trying to sell to skeptical international bond markets that Greece was an exceptional case that has little applicability to the rest of the European periphery.

The trouble with this narrative is that it does not hold up to scrutiny. Could Greece really have sustained the excessive budget spending that it undertook over the past decade had the German and French banks, together with the international bond market, been more prudent in their lending to Greece? Or to put the matter more succinctly, could Greece have overspent if its creditors had not over-lent? In that context, it is well to recall that as late as the summer of 2009, at a time when its budget problems were apparent for all to see, Greece was able to raise as much long-term funding in the markets as it desired at a mere 20 basis points above the rates that Germany had to pay.

If the European banks were overly eager to make imprudent loans to Greece, they were aided and abetted in their folly by European policymakers. Did not Jean-Claude Trichet, former president of the European Central Bank (ECB), keep assuring bond markets that, with the introduction of the single currency, there was no longer any need to worry about the payment imbalances that might arise between the individual members of the European Monetary Union? And did not the European bank regulators encourage excessive bank lending to the European periphery by placing zero capital-requirements on bank sovereign lending? And was not the IMF conspicuously silent about the dangers of the large internal and external imbalances that had built up in the European periphery?

The signal failure of the ECB and IMF to anticipate the European debt crisis was more than matched by their egregious misdiagnosis of Greece’s economic problem once the crisis began. Rather than recognizing from the start that Greece had a solvency problem that needed to be addressed by a fundamental restructuring of its sovereign debt, the ECB and the IMF treated Greece as a liquidity problem that could be solved with the ample provision of liquidity. The IMF eventually found that by attempting to avoid in May 2010 what could have been a small, pre-emptive Greek debt restructuring, by March 2012 it had to back a 74 percent write-down of the net present value of Greece’s privately held sovereign debt.

A more serious policy failure of the IMF and the ECB was to think that massive fiscal austerity in Greece within the euro straitjacket would solve Greece’s public finance problems. The application of a hair-shirt fiscal policy has plunged the Greek economy into a depression that has substantially eroded Greece’s tax base. Over the past four years, Greece’s economy has contracted by a staggering 16 percent while its unemployment rate has risen to 22 percent. And there is every sign that the deterioration in the Greek economy is now occurring at an even faster pace, which is throwing its budget performance irremediably off-track.

A truly tragic aspect of the Greek debacle is how little European policymakers seem to have learnt from the crisis. Rather than admitting past policy mistakes and seeing parallels between Greece and the remaining countries in the European periphery, policymakers insist on painting Greece as an exceptional case that got into trouble by its own doing. This makes it all too likely that many of the same policy mistakes made by the IMF and ECB in Greece will be repeated in the rest of the European periphery.