Is Greece eurozone's Iceland?

The Times - Friday, 11th December 2009

The financial crisis has taken many casualties. Aside from the impact that the recession has had on all countries across the world, two particular cases stand out. In 2008, Iceland's sudden prosperity built around its banking sector collapsed and the country effectively went bust. Last week, the collapse of the state-owned company Dubai World brought Dubai to its knees. Investors are starting to seriously worry about the possibility of more countries defaulting on their debts. In the euro-area, there is one country that everyone is talking about as the likeliest candidate: Greece. So, will Greece become the eurozone's Iceland and default on its debt? There is no doubt that Greece is in terrible economic trouble. Prices on credit default swaps tied to Greece, which are essentially used as insurance against bad government debt, are rising and its credit rating has already been downgraded from A to A-. Meanwhile, the difference in bond market spreads between Greek government bonds and German bonds has also increased rapidly despite the fact that Greece already paid significantly more on its government bond spreads than other EU countries. Their new Finance Minister, George Papaconstantinou, went as far as to write an article in last week's Wall Street Journal in a bid to reassure investors and commentators that, while the country was in recession and facing a grave fiscal situation, it would not go bankrupt. Of course, the "Greek problem" is not new. Greece has spent most of this decade living with spiralling government debt and high Budget deficits. On the latter point, the outgoing conservative government bequeathed to its socialist successor books that were cooked. This year's Budget deficit is now expected to be 12.7 per cent of GDP as opposed to the eight per cent stated by the outgoing Administration. Greece's government debt is projected to rise to 135 per cent by 2011. Greece, like Italy and several other member states, viewed the eurozone as a modern day "Noah's Ark" that would save them from financial turmoil. Like Malta, they took short-term measures to ensure that they joined the euro swiftly but did not make the deeper structural reforms to ensure greater labour market flexibility and productivity and the sustainability of their public sector programmes. However, the socialist government has demonstrated that it understands the gravity of the situation and is ready to act. Prime Minister George Papandreou, just a week after being elected in October, admitted that his country's economy was "in intensive care" adding that Greece was facing "the worst economic crisis since the restoration of democracy". Moreover, Mr Papandreou has the advantage that Greek public opinion know the mess that his government inherited and this should give him public support to make necessary but normally unpopular policy reforms. He has proposed a draft Budget for 2010 that includes a €3 billion fiscal stimulus programme and higher spending in education and health but stiff spending cuts elsewhere. These include a 25 per cent reduction in government consumption spending, a civil service hiring freeze in 2010, whereby only one new worker will be hired for every five who retire, and cuts to defence spending. They have also promised to grasp the nettle of pension reform and measures to tackle tax evasion. The Greek government expects these budgetary measures to reduce the deficit to 9.1 per cent by the end of next year. Still, these are fine words but they need to be matched by results. The response of financial markets indicates that they are far from convinced. One thing is for sure: they can expect few favours from the EU. The EU's Stability and Growth Pact, which stipulates that countries should keep government debt levels below 60 per cent and Budget deficits below three per cent, has taken a real battering during the crisis. Virtually all EU countries, including Malta, have breached the terms of the SGP and the Commission and the European Central Bank are desperate to ensure that their rules encouraging fiscal prudence are not completely abandoned. At the meeting of European finance ministers last week, Greece braced itself for stiff penalties. In other words, it is quite possible that a supplementary Budget, delivering further deficit cuts will be demanded. But I still think it is unlikely that Greece will go bust. As a member of the eurozone, it will not be allowed to and the ECB's president, Jean-Claude Trichet, continues to brush aside questions from journalists about the possibility of a eurozone country going bankrupt. For one thing, the eurozone is as much about political union as it is economic and monetary union. For a country to effectively drop out of the eurozone would be profoundly embarrassing for the EU. So, after all, can one say that being a euro member indeed offers a certain protection from sovereign debt default? Not so fast. The answer is in the affirmative but not for reasons implied by the "Noah's Ark" school. In fact, default is unlikely due to a combination of market discipline, peer pressure and the EU's SGP. It is through enormous sacrifices and painful policy measures "forced" on a eurozone country that will finally save it from bankruptcy. There will definitely be no soft bail-outs from the EU. Nonetheless, Greece's predicament should serve a salutary warning to others, including Malta. Running up huge government debts and Budget deficits, cooking the books with creative accounting and treating euro membership as though it provides you with a blank cheque, catches up with you eventually. Without credible public finances and fiscal and monetary discipline, a sustainable return to growth and normality is no more than a pipedream in or outside the eurozone. Prof. Scicluna is a Labour member of the European Parliament