Greece must step out of the danger zone

Global financial institutions are in denial over the inevitable Greek default

Greece faces a triple challenge of cutting its government debt and; reducing prices and keeping future wage growth below the euro-zone average.
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The Greek government, the European Commission (EC) and the IMF are all denying what markets perceive clearly: Greece will eventually default on its debts to its private and public creditors.

The politicians prefer to postpone the inevitable by putting public money where private money will no longer go, because this allows creditors to maintain the fiction that the accounting value of the Greek bonds they hold need not be reduced.

That, in turn, avoids triggering requirements of more bank capital.

But even though the additional loans that Greece will soon receive from the EU and the IMF carry low interest rates, the level of Greek debt will rise rapidly to unsustainable levels. That is why market interest rates on privately held Greek bonds and prices for credit default swaps indicate that a massive default is coming.

And a massive default, together with a large sustained cut in the annual budget deficit, is needed to restore Greek fiscal sustainability.

More specifically, even if a default brings the country's debt down to 60 per cent of GDP, Greece would still have to reduce its annual budget deficit from the current 10 per cent of GDP to about 3 per cent if it is to prevent the debt ratio from rising again. In that case, Greece should be able to finance its future annual government deficits from domestic sources alone.

But fiscal sustainability is no cure for Greece's chronically large trade deficit. Its imports now exceed its exports by more than 4 per cent of its GDP, the largest trade deficit among euro-zone member countries.If that trade gap persists, Greece will have to borrow the full amount from foreign lenders every year, even if the post-default budget deficits could be financed by borrowing at home.

Eliminating or reducing this gap without depressing economic activity and employment in Greece requires that the country export more and import less.

That, in turn, requires making Greek goods and services more competitive relative to those of the country's trading partners. A country with a flexiblw currency can achieve that by allowing the exchange rate to depreciate. But Greece's membership in the euro zone makes that impossible.

So Greece faces the difficult task of lowering the prices of its goods and services relative to those in other countries by other means, namely a large cut in the wages and salaries of private-sector employees.

But even if that could be achieved, it would close the trade gap only for as long as Greek prices remained competitive.

To maintain price competitiveness, the gap between Greek wage growth and the rise in Greek productivity - ie, output per employee hour - must not be greater than the gap in other euro-zone countries.

That will not be easy. Greece's trade deficit developed over the past decade because Greek prices have been rising faster than those of its trading partners. And that has happened precisely because wages have been rising faster in Greece, relative to productivity growth, than in other euro-zone countries.

To see why it will be difficult for Greece to remain competitive, assume that the rest of the euro zone experiences annual productivity gains of 2 per cent, while monetary policy limits annual price inflation to 2 per cent. In that case, wages in the rest of the euro zone can rise by 4 per cent a year.

But if productivity in Greece rises at just 1 per cent, wages can increase at only 3 per cent. Any higher rate would cause Greek prices to rise more rapidly than those of its euro-zone trading partners.

So Greece faces a triple challenge: cutting its government debt and future deficits; reducing its prices enough to wipe out the current trade gap; and keeping future wage growth below the euro-zone average or raising its productivity growth rate.

Since the Greek crisis began, the country has shown it cannot solve its problems as the IMF and the EC had hoped. Countries that faced similar problems in other parts of the world always combined fiscal contractions with currency devaluations, which membership in a monetary union rules out.

A leave of absence from the euro zone would allow Greece to achieve a price-level decline relative to other euro-zone countries, and would make it easier to adjust the relative price level if Greek wages cannot be limited.

The Maastricht treaty explicitly prohibits a euro-zone country from leaving the euro, but says nothing about a temporary absence (and therefore does not prohibit one).

It is time for Greece, other euro-zone members and the EC to start thinking seriously about that option.

Martin Feldstein, professor of economics at Harvard, was the chairman of the former US president Ronald Reagan's council of economic advisers and is the former president of the National Bureau for Economic Research