To get back to health, Greece needs two things. First, a lower debt burden. Second, improved economic competitiveness. The new programme addresses both.
Bringing down the debt
Some countries have been able to work down heavy public debt burdens. Those that were successful did it through sustained high growth. But in Greece’s case, it had become clear that high growth – let alone sustained high growth – was not going to come soon enough. Debt had to be restructured.
The process was long and messy. After all, bargaining between creditors and debtors is rarely a love affair. In the process, foreign creditors were often vilified in Greece as bad guys – rich banks, who could and should be willing to take a hit. But in the end, banks belong to people, many of them saving for retirement, who saw the value of their bank shares go down in value.
All said, the PSI (private sector involvement) deal – the largest ever negotiated write-down of public debt – has reduced the debt burden of every man, woman, and child in Greece by close to €10,000 on average, a sizable contribution on the part of foreign savers.
Greece now has to do its part – with sustained political commitment to implement the difficult but necessary set of fiscal, financial, and structural reforms that have been agreed as part of the programme supported by Greece’s partners in the Eurozone and the IMF. It is a huge challenge, no doubt. But it is also an opportunity – to take advantage of the economic space opened up by private and official creditors. Will Greece seize it?
Fixing the public finances
First, it has to bring down its fiscal deficit further. Otherwise, this will simply negate the progress which was just made on the debt. The fiscal effort which has been accomplished already is truly impressive, with the primary deficit coming down from 10% to less than 3%. The reduction and the rescheduling of debt will help cut interest payments, but this will not be enough in itself to fix the hole in the public finances.
Greece is still running a primary deficit, and it will soon need to run a primary surplus. There is simply no alternative. Much spending will need to be cut. And, on the tax side, given the harsh measures that have to be taken, much of the focus of the programme is on fairness, on making sure that richer people do indeed pay their fair share.
Reducing the current account deficit
Equally, or perhaps more importantly, Greece has to reduce its current account deficit, for two separate reasons. First, no country can run a large current account deficit and borrow from the rest of the world forever. Second, as fiscal austerity cuts into domestic demand, the only way to return to growth is to rely more on foreign demand to reduce the current account deficit.
And Greece still has a very large current account deficit, at close to 10% of GDP, despite the depressed level of output. To reduce a current account deficit, there is no secret: a country has to become more competitive, sell more abroad, and buy less from abroad. At the moment, Greece’s exports amount to only about 14% of the goods it produces.
By how much does Greece need to improve its competitiveness? It is difficult to be sure, but an improvement in competitiveness – or a real depreciation – of about 20% seems to be what is required.
Strategy for improving competitiveness
There are two ways to become more competitive: become much more productive, or reduce wages and nonwage costs. The first way is much more appealing. But there is no magic wand. While many sectors in Greece show a large productivity gap, the reforms needed involve changes in regulation and behaviour, none of them easy to achieve. The programme designed with the Greek government tries hard to identify where and how progress can be made. The list is long, but implementation is hard, results uncertain and, in any case, will not come tomorrow.
This leaves decreases in relative wages, at least until higher productivity can kick in. In countries with flexible exchange rates, this can be achieved through currency depreciation. In a country which is part of a common currency area, it has to be achieved by decreasing nominal wages and prices. In Greece, wages have increased faster than productivity growth for years, compounding the problem. Unit labour costs – which is a key measure of competitiveness – increased by over 35% during 2000–10, compared to just under 20% in the Eurozone. This has to be undone.
The best way forward would have been a negotiation between social partners to reduce wages and prices, and avoid a long and painful process of adjustment. This did not happen. The programme tries to accelerate the process, while protecting the most vulnerable. The harsh reality is that the adjustment has to take place one way or the other; otherwise competitiveness will not improve, demand will not increase, the current account deficit will continue, and unemployment will remain very high. The faster it does take place, the less pain there will be.
No viable alternatives
Were there less painful alternatives? I do not believe there were, or are.
For example, the notion which is sometimes floated that large infrastructure projects might boost growth, increase productivity, and improve the fiscal and current accounts, is fanciful. Surely, structural funds from Brussels, and more generally fiscal transfers, would be helpful, at the very least in increasing demand. But the problem of Greece is not primarily a problem of physical infrastructure. Projects financed by state funds would do little to impact growth in the short term, would make the fiscal deficit worse, and would only delay the inevitable adjustment.
What about increasing rather than decreasing wages, as some have suggested? This might indeed increase demand, and thus growth in the short run. The increase in disposable income may lead consumers to spend more, although it is likely to be partly offset by a decrease in investment. But the wage increase would exacerbate the problem of competitiveness. Indeed, as imports increased and exports decreased, it would lead to a larger current account deficit. It would just delay and amplify the scope of the inevitable adjustment.
What about leaving the Eurozone? Euro exit followed by a sharp depreciation could achieve the relative wage and price decline that Greece needs, and achieve it faster. (Note: the relative price and wage decline would not be avoided; it would just happen faster). Indeed, if Greece had had its own currency to start with, this would surely have been part of the programme. But Greece is part of the Eurozone. And, leaving aside the large costs of no longer belonging to the Eurozone, the dislocations from a disorderly exit – from the collapse of the monetary and financial system, to the legal fights over the proper conversion rates for contracts – would be very, very large.
The bottom line: Will the programme work?
Greece will have to climb a mountain at least as high as the one it has just climbed and success will hinge crucially on the government’s sustained and strong implementation. In all programmes, unexpected events will happen, and the programme will no doubt have to be readjusted along the way. As Christine Lagarde has said, "the risks remain exceptionally high”.
All this is true. But it is also true that the programme deals squarely with the two most fundamental issues facing Greece – not only high debt but also low competitiveness. And it is fair, both in asking for shared sacrifices, not only within Greece, but also between Greece and its creditors.
Editor's Note: This column is reproduced with permission from the blog iMFdirect.