When the gory euro zone debt crisis is dissected to determine what went wrong when, the "what" will, of course, be Greece and the "when" will be early 2010. By then, it should have been apparent to any sentient central banker or finance minister that Greece was insolvent and that propping it up, instead of letting it default, would be a hideously expensive – and ultimately futile – exercise.
More than a year and a half later, a country worth less than 3 per cent of the euro zone's economy has propelled the euro experiment to the brink of destruction. This is the equivalent of Nova Scotia shredding Canada.
Ireland and Portugal followed Greece into the bailout bog. Now Spain and Italy are on the edge. Even mighty Germany, the economic strongman that was supposed to keep the euro intact during the crisis, is running out of puff. Europe is on the verge of another recession and the banks, facing a financing squeeze, may need a second round of bailouts, assuming the financial magicians in Berlin, Frankfurt and Brussels can pull a few hundred billion euros out of a hat.
The fundamental mistake was believing that an austerity program in exchange for €110-billion ($153-billion Canadian) in bailout loans would steer Greece back to health before contagion set in. It didn't work that way.
Austerity programs are typically a blend of spending cuts and tax hikes – they yank stimulus out of the economy. The programs might work if the economy is growing (or at least not shrinking) and the private sector fills some or all of the void left by the government. That's what happened in Canada in the 1990s, when then-finance minister Paul Martin swung the meat cleaver at the federal budget. The effort was made less bloody by a rising economy and a healthy private sector, thanks to surging exports to the United States, where Americans were happily gorging on debt to buy "Made in Canada."
Guess what? Greece was no 1990s Canada. It was running current account and private sector deficits. When the 2008 financial crisis hit, followed by a deep recession, the private sector naturally tried to increase savings by reducing spending. This only intensified the recession. Then came a series of austerity programs, each more demanding than the last.
The result was economic freefall as both the public and private sectors went into reverse. Unemployment rose, triggering social unrest – the euphemism for protests, strikes and riots, some of them violent and deadly. In 2010, the Greek economy shrank by 4.5 per cent. It's expected to fall by 5 per cent or more this year. National debt, which was at an unsustainable level even during the boom years, is rising relentlessly.
Yet more austerity is demanded by the German and International Monetary Fund masochists. No, Greece should not have been allowed into the euro zone in the first place, and yes, it deserves punishment for having fudged its debt and deficit figures for years. But heaping austerity upon austerity is backfiring for both Greece and the euro zone. The soaring cost of insuring sovereign debt against default in most euro zone countries, Germany included, tells you as much.
The economic brain trusts in Brussels and Berlin should have realized in early 2010 that Greece could not endure a double retrenchment. At that point, allowing – indeed, insisting upon – a default would have been the sensible thing to do.
To be sure, a default would have been messy, with unpredictable results. Some banks would have failed and the Greek economy would have gone through hell, as Argentina's did a decade ago when it chose the default route.
But look at the result today: Falling growth rates and a probable European recession, a debt crisis in Italy, a country too big to save, ailing banks that might have to be bailed out, high unemployment, mass demonstrations, the threat of deflation and turmoil within the European Central Bank, the euro zone's last line of defence.
The market, which has always been several steps ahead of the politicians in the euro zone debacle, says Greece is on the verge of default (credit insurance prices imply a 90-per-cent-plus probability). The speculation is that the groundwork is being put in place for an "orderly" default – definition to come – within the next few months. It could come as early as December, when the clapped-out country faces the formidable task of rolling over more than €5-billion of bonds.
If a Greek default would have been a horror in 2010, it's going to be double horror this year or next, given the frailties throughout the euro zone. The default will probably have to come with a European version of TARP – the bank-saving $700-billion (U.S.) Troubled Asset Relief Program launched by Washington after the collapse of Lehman Bros. It may result in Greece abandoning the euro zone. Too bad the country's would-be saviours failed to realize that austerity and private-sector retrenchment are a deadly combination.
Eric Reguly