Vanessa Rossi
(Former Chatham House Expert)

The centre of the current debt storm is Europe, with Greece in the spotlight. Debt crises are always brutal, especially if they involve massive twin deficits (both government profligacy and external imbalance) and heavy reliance on borrowing from abroad. There has to be an unpleasant period of belt tightening to get figures back into shape, whether it is financial markets or the IMF that impose the tough measures needed.

The problem currently faced by Greece is no different from that of a number of other countries, such as Hungary, Romania, the Baltic states and Ukraine, which all received IMF assistance between late 2008 and spring 2009. But the implications for the euro area are far more challenging when there is a crisis in one of its member states, calling into question the ability of policy-makers in Brussels to take care of their own backyard whether or not Greece fails to refinance its debt and needs a bailout.

This has also raised the question of exit from the euro, although such a move looks not only politically unattractive but practically impossible. Announcing an exit strategy would leave Greece in financial limbo and facing a host of complications, including the urgent need to refinance a substantial portion of debt this year.

Is devaluation really as important as some claim? Notably, EU states outside EMU such as the Czech Republic, Hungary, Poland as well as the UK were free to devalue, but actual outcomes have been mixed. Countries with euro pegs such as Bulgaria, the Baltics and Romania had the option to break away and devalue but few did (Romania saw a modest devaluation but has since stabilized). But outside the EU, some of Greece's 'Club Med' tourism competitors such as Turkey let their currencies weaken, stirring up opinion in favour of Greece also devaluing.

It is important to examine possible outcomes carefully before jumping to conclusions: devaluation may help some economies more than others. Holiday-makers would clearly gain from Greek devaluation, buying their holidays for less, but would this benefit Greece? For example, a 20% discount on the price of holidays would have to be matched by a surge of more than 20% in the number of tourists for total revenues to be higher after devaluation and it is not obvious that this outcome would be feasible or even desirable. In the long run, for small countries already inundated by the surge in population in the holiday season, it will become increasingly difficult to absorb yet more tourist numbers. The long-term focus has to be on quality of services and boosting the average sum spent per tourist, not reducing it.

It must also be remembered that devaluations did not help Greece in the past but led to instability and low growth. Exit from the euro would not resolve Greece's underlying tensions, which are chiefly related to inconsistent and unsustainable aspirations for higher rates of growth, fed by over-generous fiscal policy and foreign loans. Unrealistic expectations simply foster persistent instability, not economic progress, whatever exchange system is adopted.

While the macroeconomics of EMU have proved difficult, as many expected, the reality is that the currency has made exchange and business easier to conduct across the euro area, from a financial market stand point, the euro has been successful and politically it also has strong support. Perhaps the European debt crisis will finally force macroeconomic policies into shape as well: instead of being a breaking point, might this prove a making point for the euro area?

Can Greece avoid a recession? If Greece's debt level had been lower in 2008 (like the UK's), it might have been able to fund a short run of high deficits. If most of the debt had been held domestically rather than abroad, then high local savings and domestic support might have been able to fund the increase (as in Japan). Or Greece could have maintained fiscal prudence and undergone recession in 2008-2009, bringing down the trade deficit and curbing foreign debt. But with little credibility and substantial demands for external financing, Greece is now in no position to survive without sharp adjustment - inevitably implying a recession.

If this new austerity programme fails, the next stop will be the IMF or, possibly, a debt workout plan along the lines of the 'Brady bond' escape route used by Latin America in the 1980s. But this was also far from a painless solution.

Further resources

No Painless Solution to Greece's Debt Crisis
Programme Paper
Vanessa Rossi and Rodrigo Delgado Aguilera, February 2010