Lessons for Europe from the Greek Crisis

In this article I argue that the pre-Euro decade of buoyant growth in Greece was not entrenched in solid economic fundamentals, but rather exemplified a” bubble economy” that eventually burst. Many observers have noticed that fiscal consolidation was excessive and too much front-loaded; at least as important, however, is the fact the macroeconomic adjustment would have required a major expenditure switch in production from non-tradable to tradable goods, which did not materialize. In the paper I argue that something went wrong with the Troika’s timing of structural reforms. While labor market reforms were swiftly and radically implemented, pro-competitiveness product market reforms lagged. As a result, nominal wages collapsed but prices remained stable, aggravating the fall in households disposable income and domestic demand, while generating an insufficient improvement in price competitiveness , foreign demand and trade. What went wrong in Greece? Fundamentally, the years of rapid growth which largely coincided with the adoption of the Euro were entirely demand-led and financed by domestic and foreign, private and public debt. The economy was on a sort of “bubble” and output growth was not supported by fundamental long-run productivity growth . When the bubble burst, the economy faced a classical sudden stop, with lack of access to capital markets leading to a credit squeeze, and a sharp fall in investment, consumption, real GDP and employment. Real wages and labor costs fell back to pre-Euro levels. The adjustment, however, was harsher and more painful than necessary. On the one hand the fiscal consolidation was too much front loaded and hastened (which is the other side of a late and insufficient debt restructuring); on the other, structural reforms did not help in the short run. By focusing mostly on the labor market, rather than on the product market, the Troika got the reform sequence wrong. The resulting sharp fall in nominal wages was not paralleled by a fall in prices, so that real wages fell, domestic demand was depressed, foreign demand did not pick up, inequality soared undermining the support for reforms This analysis has clear implications for the ongoing relations negotiations between Greece and its creditors: • the required fiscal adjustment should be smoothed over time, possibly not exceeding 1.5% primary surplus, and debt payment should be restructured accordingly; • structural reforms should concentrate on reducing barriers to entry in product and export markets, bureaucracy, tax administration and on the task of recapitalizing banks’ balance-sheets, a pre-condition for removing credit constraints on small and medium enterprises; • The reform of the pension system, while inevitable, should be implemented only gradually with a view on not further depressing households’ consumption by raising uncertainty on future incomes.