ILLUSTRATION BY AJAY MOHANTY
by the Greek imbroglio.
LESSONS FROM THE
GREEK EPISODE
An important one for all countries is the need to maintain
fiscal prudence, says C RANGARAJAN
he Greek tragedy has
T opened our eyes to many
things. No one can any
longer mock the critics of
high fiscal deficits. Not on-
ly was the fiscal deficit of Greece high
but that there were attempts to ma-
nipulate the numbers to hide the re-
ality. It took a long time before this
could be uncovered.
It is now estimated that the budget
deficit of Greece is in the range of 13.5
per cent of GDP. The stock of debt is
equivalent to 115 per cent of GDP.
Greece has reached a critical point
where it cannot meet its repayment ob-
ligations without outside help. The eu-
rozone and the IMF have put together
an ambitious package to help Greece.
It is not known at this stage how this
will be implemented. The package of
support will also require Greece to put
through a series of austerity measures.
Unfortunately, there is a strong re-
sistance to such measures.
The debt problem of Greece is com-
pounded by the fact that a good part of
the government debt is held by foreign
institutions, particularly foreign banks.
It is estimated that ¤106 billion of
government bonds may be held by for-
eign banks. A default by Greece will
have serious consequences for its econ-
omy. It will dry up all sources of ex-
ternal funding which will then weaken
the economy even more. Greece is
also having to deal with a huge debt
problem when it is hardly growing.
The 2008 financial crisis was trig-
gered by the excesses of financial in-
stitutions and financial markets. It
was thus the failure of the market
and the private sector. Driven by the
need to achieve higher profitabili-
ty in the face of acute competition,
private financial institutions, in-
cluding banks, resorted to innova-
tions which proved to be self-de-
structive of the financial system. On
the other hand, the current Greek
episode has been triggered by the
excess of a public entity, which is the
government of Greece itself. Thus,
it is a case of “government failure”
as opposed to “market failure”. How-
ever, the reactions of private finan-
cial markets and financial institu-
tions have aggravated the crisis. It
is also not clear what role investment
banks have played in misleading in-
vestors into investing in government
bonds of Greece.
n both cases, rating agencies played
Iternational
a dubious role. In the case of the in-
financial crisis, the rat-
ing agencies were irresponsible in cre-
ating a booming market in suspect de-
rivative products. In the current
episode, it was an error of omission.
The rating agencies took a long time
to discover the correct fiscal posi-
tion of Greece.
There are several lessons to be learnt
from the Greek episode. The first re-
lates to the level of fiscal deficit and
the second to the manner of financing
the deficit. In substance, the US situ-
ation is in many ways similar to the
Greek situation. The US was having a
high fiscal deficit even before the cri-
sis. It has now exploded and is close
to 10 per cent of its GDP. The fiscal
deficit is also being financed by for-
eign institutions, including central
banks holding US government bonds.
Of course, the saving grace for the US
is that the US dollar serves as a reserve
currency. Unlike Greece, the US may
still be a desired destination of investors.
But the inherent dangers should not
be overlooked.
The US needs to correct the serious
imbalance it faces on the fiscal and bal-
ance of payments fronts. At least with
respect to balance of payments, the
process of correction has started. It
is now estimated that the current ac-
count deficit of the US might have come
down to 3 per cent of GDP in 2009 from
the peak of 6 per cent. The US is not
Greece and it has many strengths. Nev-
ertheless, the similarities should not
be overlooked.
The impact of the Greek crisis per
se may be minimal on India. However,
India has to watch out as to how the
eurozone will handle the situation. If
there is turmoil in Europe as a con-
sequence of the crisis, it may adversely
affect India’s trade and capital flows.
The world may come in for another
shock if the eurozone countries fail to
come to grips with the problems forced
The European Union (EU) was a
conglomerate of nations with differ-
ent levels of development and pro-
ductivity. However, they decided to go
in for a common currency in the be-
lief that all these factors would soon
converge, which, however, did not
happen. For the last decade or more,
since the economies of most of the
countries were booming, the con-
tradictions did not come to the sur-
face. Of course, there were occasions
when individual countries felt that the
monetary policy being pursued at the
EU-level was hurting them.
The pursuit of a single monetary
policy for the EU as a whole is making
the life of some other smaller countries
with lower productivity uncomfortable.
In a situation like the one faced by
Greece, if Greece had its own cur-
rency, it would have devalued but that
option is not available now. No doubt,
these small countries benefited earli-
er being under the umbrella of the EU.
Given this situation, it may seem
incumbent on the richer countries with-
in the EU to come to the help of small-
er countries. The question that will be
raised is for how long and whether
such assistance will be an open-end-
ed one. The euro would perhaps sur-
vive as a common currency of the EU.
But for it to continue as a common cur-
rency, several fundamental changes
may have to be introduced.
The EU must have an overarching
mechanism to monitor the fiscal per-
formance of member countries. A sim-
ple Maastricht rule regarding fiscal
deficit is not enough. Countries have
found it possible to get around it
through various mechanisms. The EU
must also think in terms of creating
a fund which can come to the aid of
the member countries at the time
of any crisis.
The one lesson from the Greek
episode for all countries is the need to
maintain fiscal prudence. There is mer-
it in containing the fiscal deficit to a
level that is consistent with a country’s
ability to meet the debt service pay-
ments. It is wrong to assume that by
running high fiscal deficits, a coun-
try can grow faster and ride out of the
problems. The situation becomes even
more complicated if a substantial part
of the debt is held by foreigners. On
the whole, there is wisdom in countries
working towards maintaining an ap-
propriate ratio of stock of public debt
to GDP. To be prudent is to be wise.
This is plain “old” economics.
The author is chairman,
Prime Minister’s Economic
Advisory Council