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Analysis/Comment Last Updated: May 24, 2011 - 5:16 PM

Dr. Peter Morici: Greece should restructure debt and abandon the euro + Video interview; France's Christine Lagarde
By Professor Peter Morici
May 24, 2011 - 1:11 AM

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Spanish Prime Minister José Luis Rodríguez Zapatero, looking glum after his socialist party, the PSOE, had the worst regional election results in 30 years, Madrid, May 23, 2011
On Monday, the euro dipped to record lows against the Swiss franc and two-month lows against the US dollar on a day when yields on Spain’s 10-year sovereign debt jumped to highs not seen since September 2000. Italian 10-year bond yields also rose. Investors dumped Spanish bonds after a very poor performance by the ruling Socialists in regional elections. Miguel Angel Fernández Ordóñez, the central bank governor, said Spain should not accept the high cost of debt and must forge ahead with its economic reforms.

Markets also reacted on Monday to a Friday night announcement from Standard & Poor’s about Italy's credit rating when it cut the outlook on the sovereign A-plus rating to negative because of concerns about the economy.

Dr. Peter Morici: Greece is in crisis again. Athens should restructure its debt and abandon the euro to reassert control over its finances and economy - - Video interview with France's Christine Lagarde at the bottom of page.

Just one year after wealthier EU governments and International Monetary Fund extended €110 billion in emergency financing, Greece is unable to meet the aid plan’s deficit reduction targets and grow fast enough to make its debt payments more manageable.

The European Central Bank and IMF insist that Athens can meet these targets, but raising taxes or cutting spending further would only slow growth even more, and likely cast Greece into a deep recession from which it could not recover.

Now, Greece is slipping from a liquidity crisis into downright insolvency. Bond investors are demanding yields 20 percentage points higher on Greek debt than on comparable German debt. Rolling over existing bonds, as those come due, will be prohibitively expensive, and the collapse of Athens’ finances seems inevitable.

Unless Greece gets significant concessions and loans at preferential rates from the EU and IMF, it will be impelled to ask private creditors to accept bonds with longer maturities and paying lower interest rates than the bonds they currently hold. As the market value of those securities would be much lower than the face value of Greece’s current outstanding debt, such a restructuring would constitute a “soft default.”

Exacerbating the crisis, the ECB has threatened to cut off support for Greece’s private banks if Athens restructures its debt. The ECB reasons that the banks’ holdings of Greek debt would make them a bad risk, but it does not extend such thinking to German and other European banks holding Greek government paper.

The European Central Bank and IMF remain firm that no such restructuring is necessary, but cutting government spending or raising taxes enough to pay higher interest rates as debt rolls over would be self defeating. The recession that would result would reduce debt servicing capacity, not improve it, and endanger political stability as social services were slashed and unemployment skyrocketed in tandem.

The alpha and the omega of Greece’s debt crisis—and those that could follow in Portugal, Ireland and other distressed states—are the anomalies in EU institutions that make difficult financing pensions and other social benefits in Greece and other poorer EU economies.

The 1992 Maastricht Treaty significantly harmonized product and safety standards and methods of taxation across the continent and was supposed to remove untold barriers to growth. It didn’t, because European strict labor laws and business regulations discourage individual initiative and investment, and the EU’s much advertised single market raised expectations among voters in poorer countries that pension and social benefits would be on a par with Germany and other rich states.

The single currency, the euro, introduced in 1999, was heralded the next great elixir but it too failed to rev up growth, because it addressed a problem that didn’t exist and created a new major barrier to the effective management of macroeconomic policy.

Prior to the euro, the European Currency Unit linked at fixed rates the national currencies of many of today’s euro zone countries. The ECU was accepted as payment in international commercial transactions—the primary void the euro was supposed to fill.

However, each country could print its domestic currency and occasionally devalue against the group as its circumstances might require. With the euro that flexibility was taken away from poorer countries like Portugal, Spain, Greece, and Ireland.

Germany, like New York, greatly prospers by participating in a huge single continental market, but Brussels cannot tax Germany to subsidize Greece’s welfare state in the same way Washington taxes New York to subsidize Mississippi’s Medicaid.

With all that wealth to itself, Germany provides generous pensions, gold plated employment security and jobless benefits, short work weeks, and the like. Meanwhile governments in Greece and other poorer EU states struggle to keep up, pile up lots of debt and can’t scale back too much without risking political upheaval, because their populations won’t accept they cannot enjoy the same perks as the Germans.

If Greece still had its own currency, it would still have had to cut spending and increase taxes—but not by nearly as much as the EU aid pact requires—because Greece could also devalue its currency against those of richer EU economies to make exports more competitive, accelerate growth, and increase debt servicing capacity.

Now things have gone too far. Greece’s debts are too large and are denominated in euro, not the Greek drachma.

The only real solutions are for Greece to restructure its debt—both sovereign and private creditors should take haircuts; abandon the euro and reinstate the drachma; and rethink its welfare state. Like Americans, the Greeks will have to work longer to retire and accept other less generous social benefits, but they could reassert control over their economy.

The alternatives are endless EU bailouts—something the German and French voters are doubtful to allow—loss of Greek sovereignty, and economic collapse.

Greece Must Deliver: Lagarde:"Greece has to deliver," French Finance Minister Christine Lagarde told CNBC when discussing the euro zone debt crisis and measures Greece has promised to take to tackle the crisis:

Peter Morici,

Professor, Robert H. Smith School of Business, University of Maryland,

College Park, MD 20742-1815,

703 549 4338 Phone

703 618 4338 Cell Phone




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