Greece has been a thorn in the side of the Eurozone for a very long time. Right from the start, other member states were dubious about its fiscal responsibility and commitment to EU rules: something never quite added up. But once it admitted that it had lied about the true state of its finances in order to gain admittance to the Euro, the gloves came off. Other Euro member states, angry that Greece had put at risk the financial stability of the whole bloc and scared of being on the hook for its debts, wanted to force it out of the Euro—brutally. Tim Geithner recalls in his memoirs that the Eurozone leadership wanted to ‘get out the [baseball] bats’.
Fortunately cooler heads prevailed, and Greece was allowed to remain in the Euro on condition that it complied with the fiscal rules set by the Troika—the European Commission, ECB and IMF—on behalf of Greece’s creditors. Its debts were restructured in 2012: private sector investors took large losses, but the official sector, nothing. Now, nearly all of Greece’s debt is owned by other European states and their banks, the ECB and the IMF. Any further debt restructuring would require some or all of these august bodies to accept losses.
Three years on, and we appear to be replaying the same scene. But this time, Greece is playing hardball. It has refused to comply with the terms and conditions of its previous bailout and is arguing for further debt restructuring and a new approach to restoring growth. The creditor nations are furious. The fact that Greece has now been in deep recession for over 5 years and shows little sign of recovery matters little to them. They say that since the Eurozone has been seriously threatened by breaches of rules and obligations by member states, its future cohesion now depends on everyone abiding by their agreements.
Creditor nations have a point. A union is only as strong as its weakest member, and Greece is definitely the weakest link. Other Eurozone countries may be poorer, but only Greece defies the authority of the European Commission and the ECB. Only Greece refuses to comply with fiscal rules designed to ensure that other countries are not forced to bear responsibility for its spending decisions. Only Greece risks being pushed out of the Euro, at who knows what cost not only to its own economy but to the financial stability of Europe. True, the banking systems of other states are less exposed to Greece than they were in 2010. But a Greek exit would mean losses for the ECB and other Eurozone governments, and the possibility of destabilising outflows of capital from other distressed periphery countries.
So is Greece made of sterner stuff than the other member states, or are its expectations simply unrealistic? Are other member states that are complying with the terms of their bailout programmes even at the cost of depression and high unemployment wimps, or do they have a stronger commitment to the aims of the European Union? To what extent can Euro members really determine their own fiscal policy?
The Eurozone has a single monetary policy. This is set by the ECB which looks at the bloc as a whole, not at the needs of individual members. Accusations that the ECB sets policy according to the needs of Germany are unfair: the performance of Germany, as the largest economy in the Eurozone, inevitably correlates closely with the performance of the bloc as a whole.
But the Eurozone is not a complete union. It is a collection of sovereign states that have chosen to use a currency that none of them uniquely issues. Monetary policy is common across the Eurozone, but fiscal policy is the responsibility of the individual states. And therein lies the problem.
In a complete union such as the United States, a single monetary authority is partnered by a single federal-level fiscal authority. Automatic stabilisers (pensions, important welfare benefits, income taxes) are set by the federal authority and apply to all states in the union equally, just as monetary policy does. Other functions such as education may also be administered at federal level to ensure that all citizens have equal opportunity. Individual states or cities may raise their own funds to administer local programmes, and if they act irresponsibly they can and do go bankrupt, as Detroit in the US has done recently. In a complete union, the broad base of taxation and benefits is not affected by city or state bankruptcies. People in Detroit didn’t lose their pensions because the city had run out of money. But in the Eurozone, if a state runs out of money it may be unable to pay its pensioners—and there is no federal-level backup.
The lack of a federal fiscal authority in the Eurozone would be less of a problem if there was an agreed framework for sharing risks and responsibilities. But that too is outlawed. Each state is on its own, lacking both the ability to use monetary policy to defend its economy from shocks and the fiscal transfers that offset loss of monetary independence in a complete union. Weaker states are therefore forced to use fiscal policy to depress wages and prices to prevent serious loss of competitiveness to stronger neighbours.
If stronger countries operate more generous fiscal policies than weaker ones, then there is room for weaker countries to tighten fiscal policy without causing serious damage to their economies. But when those stronger neighbours themselves tighten fiscal policy—as Germany has been doing persistently through most of the Euro’s existence—weaker states find their competitiveness squeezed even more. In theory, they should respond by driving their economies into recession to force down wages and prices. But since persistent recession damages the supply side of the economy, this is in reality no choice.
Unsurprisingly, prior to the Eurozone crisis weaker states accepted loss of competitiveness. Their deficits ballooned, both in the private and—after the 2008 financial crisis—in the public sector. Large imbalances grew between stronger and weaker states, sowing the seeds of the Eurozone crisis.
Post-crisis, in an attempt to prevent such imbalances building up again, the EU has put in place a strict fiscal framework, the so-called ‘fiscal compact’, which in effect forces states to harmonise fiscal policy. They are no longer free to determine their own approach.
To be sure, the Maastricht Treaty had already established a common fiscal framework which limited states to cyclical deficits of 3% of GDP and a maximum debt/gdp ratio of 60%. But few states complied with these limits: even Germany breached the debt/gdp ratio in the early 2000s because of its poor economic performance at that time and the cost of reintegrating the former East Germany. Germany’s debt/gdp still remains above the Maastricht limit, largely because it bailed out its own banks in 2007-8 and other Eurozone countries from 2010 onwards.
The new fiscal framework still uses the Maastricht limits, but enforces them far more strictly. The ‘fiscal compact’ requires Eurozone countries to balance their books and reduce debt/gdp to Maastricht limits. Countries persistently running deficits above the Maastricht limit may be fined, as may countries that fail to comply with “excessive deficit procedure” rules.
This puts weaker states in a far more difficult position. Previously, when stronger states were tightening fiscal policy in order to comply with the fiscal compact, weaker states were able to use counter-cyclical deficit spending to offset the effect on their economies. But now, if they respond by increasing deficit spending beyond 3% of gdp, they fall foul of the fiscal compact rules. If they do not, their economies are forced into recession by the fiscal tightening in larger states, and they may as a result find themselves with fiscal deficits in excess of 3% of gdp anyway, simply because of the falling denominator. They are ‘damned if they do and damned if they don’t’.
The single currency transmits the deflationary policies of stronger states to weaker ones, and the fiscal compact prevents anyone doing anything about it. No wonder large swathes of the Eurozone are depressed.
And no wonder Greece has called time on the entire arrangement. Greece has suffered a deeper and longer recession than anywhere else: its economy has shrunk by a quarter, over a quarter of its adult workforce are unemployed and more than half of its young people have no work and no prospects. The severe fiscal tightening of the last five years has resulted in the debt/gdp ratio rising from 130% in 2010 to nearly 180% today despite the 2012 restructuring. The primary surpluses (4.5% of gdp) required under the fiscal compact to reduce its debt/gdp to Maastricht limits are frankly unbelievable, since fiscal tightening of such severity in a fragile and damaged economy would drive it straight back into recession, causing gdp to fall and therefore—perversely—eliminating the primary surpluses. And above all, there is the psychological effect: if all output must go straight into debt repayments, why would anyone bother to put in the effort needed to restore the economy? Fiscal rules that are too tight cannot be enforced for any length of time. In the end, people rebel.
The Eurozone is slowly being forced towards fiscal union, because monetary union without fiscal union does not work. The current fiscal compact is clearly not fit for purpose: if there is one thing that the Greek rebellion could usefully achieve, it would be to force its redesign. The Greek finance minister says that his aim in forcing the Greek problem into the open is to deepen Eurozone integration. It remains to be seen if he will succeed, or whether Greece will be forced to leave the union, temporarily or permanently.
But there are also powerful forces that may ultimately tear the Eurozone apart. It is far from certain that the member states will accept the surrender of sovereignty that will be necessary for this union to work. In the end, it is not just monetary and fiscal policy that must be shared: it is politics, culture and identity. The Eurozone is built on competition rather than cooperation, and on the avoidance of war rather than a sense of shared destiny. Is this an adequate basis for a sustainable union? I have my doubts.
Frances Coppola is a writer and commentator on economics and finance. She is associate editor at Pieria and contributes to Forbes.
Front image: '2011 Greece Uprising' by Kotsolis at English Wikipedia. Licensed under CC BY-SA 3.0 via Wikimedia Commons.