Greece has come to the edge of the abyss – leaving the euro zone – and blinked, apparently choosing an orderly but painful adjustment within the euro zone over financial chaos outside it. How did we get here? As dispassionate North American economic observers, we have identified five fundamental errors over the past two decades that led to the latest Greek debt and banking crisis.
Error #1: The creation of the euro itself
The euro never made hard economic sense; it was created for political reasons to reinforce an increasingly integrated European political union. The European Union is not what economists call an "optimal currency area," where the same monetary conditions (including the exchange rate) can apply in many EU countries and regions. Sharp cultural differences among and between EU countries create barriers to forming a common economic philosophy and similar conditions, both of which are essential for sharing a common currency. The EU is also not a full federation with built-in mechanisms for transferring fiscal resources from rich to poor regions – again, essential to holding a currency union together.
Despite these evident shortcomings, the euro zone was launched in 1999. A few stronger EU members – the U.K., Denmark and Sweden – chose not to join, thereby preserving their own currencies and monetary policy.
Error #2: Letting Greece into the euro zone
Greece has a long history of substandard economic and debt management, having experienced multiple debt and banking crises. It never really met the supposedly strict entrance criteria, and it certainly never shared the same prudent fiscal and economic philosophy as a dominant euro zone economy like Germany – but it was admitted anyway in 2001.
Error #3: Private creditors extending significant credit to the Greek government
Once Greece entered the euro zone, EU and other banks were all too willing to buy its government bonds. Denominated in euros, these bonds financed ongoing fiscal deficits. The banks made the implicit assumption that Greece would either find the means to honour its debt obligations or someone else with financial means would bail Greece out if necessary.
However, that expectation was misplaced. After the Greek debt crisis erupted in 2010, private sector organizations holding Greek paper were required to write down much of the face value of their bonds and lower the interest rate, with the writeoff exceeding 70 per cent in net present value terms.
Possible error #4: Bailing Greece out in the first place in 2010 and 2012
In theory, the other euro zone members could have decided at the outset not to provide bailout financing, since Greece was unable to meet the performance standards of membership. Greece could have defaulted on its private sector credit at that point and left the euro zone.
In practice, however, there is a remarkably deep political commitment among euro zone member countries to hold the currency union together, even at a high financial cost. There was also significant risk to the stability of the European financial system in 2010 if the earlier Greek bailouts and other euro zone bailouts had not proceeded. So the Greek bailout cycle began, and continues today.
Error #5: That Greece had added negotiating leverage
The Syriza-led Greek government wrongly believed it had significant leverage in the negotiations with euro zone partners; it assumed governments and voters elsewhere in Europe would pay for Greece's excesses out of a sense of social solidarity.
Debtors seldom have more leverage than creditors. They can threaten to withhold payment (and thus impose a financial penalty) or accuse the creditors of being bullies or even "terrorists" – and Greece has recently done both. And after stringing out the debt negotiations for months, the Syriza-led government doubled-down on its bet by calling a referendum at the 11th hour in an effort to strengthen its hand.
But creditors ultimately have more leverage, because they can withhold the new credit that is essential to keep the debtor afloat until they are satisfied with the fiscal and policy conditions required in their view to rebuild confidence and creditworthiness. A debtor like Greece that overplays its hand can end up paying a high economic and financial price, in this case the imminent collapse of its banking system.
What next? We believe fear of the end of the euro zone is vastly overstated. For its members, the political reasons for creating the euro zone remain valid today; there is no scope for turning back the clock to reassess its economic merit. Euro zone members will need to prepare themselves for debt relief in Greece, which seems inevitable. They will also focus their energy on supporting the other heavily indebted euro zone members – Italy, Spain, Portugal and Cyprus – to keep them in the union.
Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada.