The Economic Consequences Of Greece

History, said Karl Marx, repeats itself twice, “the first time as tragedy, the second time as farce”. Bad economic policy, on the other hand, repeats itself forever – but the results are rarely funny.

Take Brussels’ current economic plans for Greece.

They are, in economic terms at least, akin to the Versailles Treaty of 1919. Germany (whose politicians have lobbied hardest for this type of deal) is attempting to impose the kind of austerity (and relative lack of debt forgiveness) that was imposed on it after the First World War – the reparations policy which contributed to the rise of Hitler and WWII*.

As John Maynard Keynes, who worked for the Britain delegation to Versailles, prophesied in his breakthrough work,The Economic Consequences of The Peace, the upshot was economic chaos, social unrest and, ultimately the rise of extremist politics in Germany, with hideous consequences.

But despite this lesson, as Ambrose Evans-Pritchard writes in the Daily Telegraph this morning, the latest set of austerity measures imposed on Greece are equally onerous. With Greece in its current spiral, every extra euro cut from public budgets further diminishes the country’s economic capacity to recover, and pay its way back out of debt.

Default is now inevitable – the only question is whether it’s a messy, unplanned one; and whether, under those circumstances, Greece could stay in the euro.

Why then, bearing all of this in mind, are the Germans still persisting with such disastrous policies? It can’t be due to economic ignorance: a country with its history knows better than most of us the implications of consigning a country to an economic agreement it has no reasonable hope of fulfilling. Which leaves us with three possibilities:

1. It is trying to make an example of Greece. Brussels is terrified of the so-called moral hazard that would ensue if it was seen as providing the country with bail-out cash without securing a guarantee that it wouldn’t misbehave again.

2. It doesn’t really expect the country to meet the bail-out conditions.

3. It wants Greece to leave the euro.

In fact, the answer is likely to be a combination of all three. But perhaps the most important is the final one. At present, there is still broad-based support for euro membership among the Greek people. As long as that perseveres, Brussels cannot reasonably eject the country from the euro area – both in that there are no legal levers allowing it to do so and that it would look politically appalling both within and outside Europe.

The best rational explanation for the extreme austerity policies Germany is inflicting on Greece is that it wants Greek support for remaining within the euro to plummet and for the country to decide to leave the single currency of its own accord. By imposing ever-more-impossible conditions on each successive bail-out, Germany/Brussels will eventually make euro life so intolerable for Greece that it will have little option but to pull the escape cord.

Greece’s departure could then be posited by Brussels as an example of what happens to those who flout its rules.
Which begs two immediate questions: (1) Does this leave Greece better off, and (2) will the rest of the euro be able to survive? Briefly:

1. Greece should be better off in the long-run, since it will be able to devalue its currency and finally improve its competitiveness. But leaving the euro will effectively exile it from capital markets for some months, if not years. At present, Greece is nursing a primary deficit, meaning that even if you ignored its existing interest servicing costs on its debt, it would still have to borrow to pay for its public sector. So there is no point in it leaving the euro (and defaulting or devaluing its debt) until later on in the year, when it moves back into primary surplus. Even then, the associated economic chaos of a euro departure would wreak chaos on domestic politics.

2. In theory, the European Central Bank and European Financial Stability Facility have created enough of a firewall to prevent Europe’s financial system from imploding in the event of a Greek departure, or messy default. However, as the collapse of investment bank Lehman Brothers showed in 2008, there is really no knowing how the financial system will react in an event of such significance. Moreover, the real risk is that other periphery countries, such as Portugal and Ireland, look at what happened to Greece and ask whether it might be worth their while leaving as well. And what about Italy? At the very least, investors will ask similar questions, which could trigger a big sell-off in government bond markets.

Whatever your expectations, the truth is that as every day passes, the likelihood of Greece leaving the euro looks more and more likely. So while the Greek parliament’s decision to pass the latest austerity plans may calm the European economy for a short while, don’t expect that to last.

* If we’re being strictly accurate, the current plan is rather more similar to the Young Plan of 1929, which modified the original Versailles Treaty and Dawes Plan, reducing the total debt Germany owed. After all, last July’s revised bail-out package included a 50% reduction in private sector holdings of Greek debt. But by most economic measures, this still isn’t enough to allow Greece to grow out of its current hole.

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