Could Greece Go Over the Cliff?

Let me consider the arguments put forward by those who regard a Greek default as unavoidable.

Their first argument is economic. The adjustment program is too harsh, given the level of the debt-to-GDP ratio reached in Greece. It will produce a debt spiral which will lead the country into a recession and deflation. The problem is made worse by the loss of competitiveness suffered by Greece over the last decade — and the impossibility of devaluing the currency.

Their reasoning is generally no more sophisticated than that. Some analysts have put together a few numbers to show that they are aware of the problem.

But I have not seen a serious analysis of the 120-page report produced by the IMF which looks at the various aspects of the program, including the impact of the structural measures on growth, the sustainability analysis or other features of the program. There has been not one review of the realism of the assessments made by the staff of the IMF and the European Commission.

In fact, I suspect most market analysts have not even looked at the adjustment path for the primary surplus which is embedded in the program, which aims to reach 6% of GDP in 2015 — a level no different from the ones that other countries in the past have implemented to consolidate their public finances.

It's a level that a number of other countries — including some outside the euro area — will have to achieve if they want to stabilize their debt. Most market analysts and other observers have probably not even looked at the structural measures that are embedded in the program, affecting for instance the labor market, or at several liberalizations and their impact on economic growth.

The inefficiencies in the tax collection system, which have been aggravated before the elections, have also been overlooked. The perception that the Greek program will not work looks more like an assumption than the result of a serious assessment.

To summarize, I wonder which analysis is more serious and credible: The many one-pagers — very well publicized, I must admit — which probably aim to influence the rest of the market, or the IMF's 120 pages of rather tedious analysis describing the contents of the program, together with its risks.

Let me add that I have not read a single page on what a (partial) default of an industrial country would mean for the country itself, for the euro area and for the global economy. It's often been stated — or I should say, assumed — that there is such a thing as an "organized" or "orderly" default.

Argentina is sometimes mentioned, as if anything orderly happened there since it defaulted. On top of this, several of those who propose an "orderly default" also favored letting Lehman fail, as a way to eliminate moral hazard and achieve better-functioning markets. We saw what happened.

The second argument of those who foresee a Greek default is political. The government of that country, they claim, will not have the political stamina to sustain the adjustment effort over time in the face of domestic protests and will sooner or later give up.

It's an argument that seems to ignore events and facts, at least from the Greek side. The Greek government was certainly slow in recognizing the problem, but as soon as it did, it reacted swiftly. On February 11, 2010, the European Council asked Greece to take measures to reduce its deficit by 4% of GDP. It did so in a few days and brought them to parliament.

The same happened for the IMF program, which was quickly negotiated and adopted by parliament in less than a week. The prime minister even expelled three members from his parliamentary group because they abstained from voting. So far, all the measures contained in the program have been approved. The fiscal adjustment has been frontloaded.

Budget data available for the first four months of the year show an improvement of over 40% of the deficit compared with last year, whereas the target was 35%. A schedule for privatization has just been approved by the government.

This is not to say that it's going to be an easy ride. But what's the alternative? Is it politically more palatable for a government to default? How would the millions of Greek savers react if suddenly they found out that part of their savings is worth substantially less? Would any government get away with it?

And what would be the political future of Greece in the European Union if it did not repay its debt to the German, French, Irish and all the other countries' taxpayers? What would happen to the millions of euros in structural and cohesion funds that Greece receives every year from the EU?

Maybe you need a bit more than one page to give proper consideration to these factors.

Let me now turn to the euro area and consider the third argument which is sometimes made by market participants, namely that euro area governance has substantial weaknesses that undermine the viability of the single currency.

Overall, the combination of monetary and budgetary policies in the euro area has brought price stability and budgetary results that on average are better than those of most other economies. The problem is that this is true on average, but not for all the members of the Union, as it should be.

What is needed is a more resilient system that avoids bad policies by the member states and the contagion they can cause for the area as a whole.

This requires working both on the numerator and on the denominator — i.e., on the budget and on economic growth. The way forward is two-fold. It requires changes in the member states' economic policies. And it requires a strengthening of the institutional framework for budgetary surveillance.

It is understandable to nurse doubts about the results of all these efforts. However, looking at the decisions which have been taken in recent weeks and months, one cannot doubt the determination of the 16 euro area countries to stick together and do what is necessary to defend what has been achieved over the past ten years and to improve upon it.

The 16 countries believe, as do we at the ECB, that sticking to commitments, in particular in the case of the Greek program, is essential for the credibility of the currency and the prosperity of its members, as would be the case for any other advanced economy or country.

This is why the governments of the member states and the representatives of EU institutions will do all that is needed to preserve that credibility and that prosperity. As I noted earlier, monetary union is de facto a political union. It has to function and it will function.

Let me conclude. What we are currently experiencing is a crisis of public finances in advanced economies. It started with Greece — and the euro — because of the specific institutional framework which prevents Greece and the other euro area countries from using the inflation tax to overcome their budgetary problems.

This will force euro area countries to address their fiscal positions earlier. It's not easy. But it will be done, because it can be done and it has to be done in any case. And, last but not least, because there are no alternatives.

Editor's Note: This piece is the second in a two-part essay adapted from Lorenzo Bini Smaghi's address at the 63rd Plenary Session of The Group of Thirty on May 28, 2010.

Read Part I here.