Greece and the Euro: Recession With No Exit

Pity the poor Greeks and beware of getting what you wish for.

When after earlier failure Greece was finally allowed into the euro zone in 2001, people cheered. Two thirds of the ten million Greeks enthusiastically welcomed the end of the drachma and the arrival of euro notes and coins. The finance minister at the time said the euro meant stability and symbolized Greece's full acceptance into the European club.

Now the Greeks don't know what hit them and they're already wishing they still had their tattered drachmas. Why? Because if this debt crisis had happened in the 1990s, they could have devalued the drachma and even boosted their major industry--tourism--because with devaluation a vacation in the Greek islands would be made cheaper. A deep recession could have been avoided.

But by having the euro the devaluation option is unavailable. The only remedy today is for Greeks to swallow the bitter medicine of austerity. That means wage and pension cuts plus new taxes, measures creditors insist upon as the price of the bailout.

As recently as last month the Greek economy was expected to decline by 2% in 2010. But with the austerity measures, forecasts have been revised sharply downwards. Now a 4% decline is expected and some economists, like former chief economist at the International Monetary Fund Simon Johnson, believe that number is overly optimistic. Johnson argues, persuasively I think, that the stiff cutbacks in government spending and the subsequent removal of purchasing power from the economy will produce a deep recession. He predicts the Greek economy will contract by 12% over the next 18 months.

Months ago, Desmond Lachman of the American Enterprise Institute accurately foresaw what the Greeks were up against. He said Greece faced twin problems of solvency and competitiveness. Short-term, the solvency issue was addressed May 9th, kicked down the road by the I.M.F. and European Union bailout. But to regain competitiveness--absent devaluation-- Lachman says cuts of up to 20% in wages and prices are needed. This, he argues, the Greek government will be unable to deliver.

Latvia, the former Soviet republic on the Baltic Sea, provides something of a case study for what the Greeks are trying to accomplish. Latvia in 2008 was hit by a financial crisis in which its currency came under speculative attack. But since Latvia--like Greece in 2001--was determined to hold its exchange rate steady in order to be admitted to the euro zone, policy makers rejected the advice that they devalue. Instead, the Latvians slashed wages and government spending by 10 to 20% and deliberately engineered a deep recession in the hopes of getting their budget deficit down to the prescribed levels for euro zone entry. While Latvia has succeeded in holding its exchange rate steady, the ensuing recession has been the deepest in the European Union. In 2009 the Latvian economy contracted by 18% and unemployment rose to 20%. This is the kind of calamity that may be awaiting the Greeks, where unemployment is already 11.3%, a six-year high.

Looking back, Greeks didn't realize back in 2001 that their politicians had cheated to meet the euro's membership requirements. In a country where tax evasion is a national pastime, citizens assumed that if the bureaucrats in Brussels accepted the official fiscal deficit numbers, they must be correct. Never in their wildest dreams did Greeks imagine that just nine years later they would discover that a financial crisis was the true price of euro zone membership.

For Greeks to endure the kind of austerity that the Latvians have experienced, there must be some perceived reward for the hard times and sacrifice. For Latvians that is still the hope of membership in the euro zone. But for Greeks who already have the euro, what's the payoff?