The European Union said Thursday it will rescue Greece from its debt crisis, but the extent of the aid will not be known for a few days. In the meantime, economists and the markets are left to speculate on how the crisis will impact eurozone countries and the currency itself.
Greece has quickly become the focus of the current European fiscal crisis despite its small size in part due to investor wariness. “Investors have been presented with many unpleasant surprises in the last couple of years,” said professor of finance Sergio Rebelo. “Some are worried that the Greece debacle is the beginning of a more general fiscal crisis.”
To head off a wider crisis, Greece and the E.U. have handful options to choose from. First, Greece will have to significantly cut a number of government programs to get its current budget under control. The mere mention of any cuts has upset many Greeks, leading to government employee protests Wednesday. Second, wealthy eurozone nations like Germany and France (but mostly Germany) may have to throw some money at Greece in the form of loans, bond purchases, or some other aid. The thought of this has upset many Germans.
As a last resort, Greece could leave the eurozone and revert to the drachma. “Leaving the eurozone is a path fraught with financial problems,” Rebelo said. “Greece could depreciate its currency and gain competitiveness. But the Greek debt, which is denominated in euros, would be even more difficult to pay with a devalued Greek currency.” So what’s the likelihood of Greece ditching the euro? Slim to none. And given the repercussions such a move would have on the 15 other eurozone countries, most experts are expecting a German-backed bailout.
Unfortunately, Greece is not all alone in its corner of shame. Italy will probably be the next domino to wobble. Though Italy does not have a high current deficit like Greece, “the debt is extremely high,” said Paola Sapienza, professor of finance.
Mediterranean countries like Greece and Italy “have a problem of credibility in implementing the cuts that will be necessary,” Sapienza said. Rather than make tough decisions, the Greek and Italian governments have preferred to search for creative—but ultimately ineffective—ways out (think Italy’s infamous tax amnesties). “These countries want to tie their hands by going to Europe because they think this will force some virtuous kind of policies,” Sapienza said.
“The E.U. will have to balance two considerations,” Rebelo said. “The first is the desire to show that it can solve problems within the euro area without external help. The second is to avoid writing blank checks to the countries in trouble, since that will only encourage future profligacy.”
Rebelo and Sapienza think any bailouts will be accompanied by imposed structural reforms. Though both the bailouts and the reforms are sure to be unpopular, European leaders seem to understand the consequences of inaction.
“If the eurozone members were to leave Greece to its own devices and Greece defaults on its debt, the impact on the single currency would be disastrous,” Sapienza said.
Photo by caribb.