Q. With world markets in tumult last week, there was a lot of talk of “contagion” stemming from fears about the situation in Greece and Europe. Your research has indicated multiple reasons why markets react this way, so in this case, what accounted for the phenomenon?
A. Contagion from the situation in Greece should not have come as a surprise. There are a number of mechanisms that transmit crises from one country to another, i.e., that cause contagion. One form of contagion that has been particularly powerful in this crisis is a “wake-up call” effect. The main idea is that events in one country can provide information about risks in other countries. If a country with certain macroeconomic characteristics is discovered to be susceptible to a crisis, then investors “wake up” and reassess other countries as having similar risks. Investors now realize that even though Greece is in the euro area, its large budget deficit, high debt levels, and uncompetitive cost structure will mean a prolonged period of slow (or even negative) growth and probably a debt default. This has made investors more aware that being in the eurozone does not guarantee economic stability, and that other countries with large deficits and debt and uncompetitive cost structures could also be in store for prolonged recessions and even debt restructuring.
Q. In that case, to what extent do other EU countries still face these dangers?
A. Greece’s problems are certainly not unique — although they are more severe than in the other EU nations. Greece has run large budget deficits and seen wages and costs increase rapidly for years. This has eroded Greece’s competitiveness and led to a huge government debt burden of about 115 percent of GDP (and external debt burden of about 75 percent of GDP) at the end of 2009. Other countries, such as Portugal, Ireland, Italy and Spain (commonly referred to as the PIIGS when Greece is included) share many of these characteristics. All of these countries have high costs relative to other major members of the EU such as Germany. This means that their exports are not competitive, and they import more than they export, which they fund by borrowing from abroad. The most recent global crisis aggravated total government borrowing, and it has become increasingly difficult for these countries to keep finding people willing to finance their debts.
But on a more positive note, Portugal, Ireland, Italy and Spain are not yet in nearly the predicament of Greece. For example, Portugal, which is probably the most vulnerable of the group outside of Greece, still had a government debt burden of only 77 percent of GDP at the end of 2009 (although its external debt was slightly higher than Greece’s at about 95 percent of GDP). Ireland started with lower government and external debt ratios and has already made a series of very difficult spending cuts and tax increases — a sharp contrast to Greece’s slow response and violent protests, which suggest Greece may have more difficulty implementing its fiscal consolidation. Italy’s budget deficit is less than half that of Greece. Hopefully these other nations will use this period to reduce their budget deficits and regain competitiveness so that they can avoid being in as difficult a situation as Greece is today.
Q. The Economist recently said that Europe’s leaders have “three years to save the euro.” What is the future of the euro, since countries like Greece and Germany are in such different fiscal situations? And does it make sense for Greece to stick with the euro?
A. Although staying within the euro will force Greece to make a number of difficult adjustments, this is the “least bad” of a number of very bad options. If Greece left the euro, borrowing costs would spike even further, Greece could no longer finance its deficits, investors would likely panic and sell Greek stocks and bonds, and the Greek banking system could easily collapse. Greece has no option except to stay in the euro. Another question is whether the countries with sounder fiscal positions — such as Germany — will want to remain in the euro if it involves paying for the past profligacy of Greece. Will German taxpayers — who have been more responsible savers and seen low wage growth for years — be willing to write a series of checks to Greece? The German government realizes that keeping the Euro together is important for economic and political stability in Europe — as well as to support key markets that buy German exports. But if this situation continues for years, it will be interesting to see how long German taxpayers will continue to support this arrangement.