Caught in the Drachma dilemma?

YEARS of profligate living by deficit spending has pushed Greece towards default, threatening a cascade of financial crises in other EU problem economies such as Spain, Portugal, Italy, and Ireland.
The Economist, citing research, recently noted: "It has spent half of the last two centuries in default." With its solemn belief in a united Europe and the reciprocity of Europe's commitment to Greece -- the country embraced the euro nine years ago -- it surrendered its sovereignty in monetary policy to the European Central Bank (ECB). When it adopted the euro, its public debt was in excess of 100 percent of its GDP. With discretionary fiscal expenditure uncompromised Greece kept borrowing, and its spending grew at an average of 4 percent a year until 2008.
In 2009, budget deficits jumped to 12.7 percent of GDP. In January, interest rate on 10 year Greek bonds hit 7.1 percent compared to 3 percent on comparable German bonds. Greek bonds were degraded to BBB+ from A rating. A sovereign default is brewing, a crisis for the euro is looming -- forcing EU leaders to pledge "determined and coordinated action" to defend the euro if necessary.
Suspecting that Athens may have engaged in accounting tricks to cover up its growing deficit, the European Commission has instituted an investigation. Discovery of any such malpractice will put Greece's bailout process in jeopardy. In fact, a recent poll revealed that 70 percent of Germans are averse to financial support for Greece.
Officially, the EU treaty has a "no bailout" clause pledged by all member states. But can the EU afford a default by Greece? That may induce contagion effects -- threaten the viability of the euro, damage the prospects of the entire European project, and cause defaults elsewhere outside the euro zone -- raising the spectre of a second global financial crisis.
While the EU bosses debate the moral implications of a bailout, a falling euro is already providing some relief. The moral hazard is that other problem economies could unleash their deficit spending habit, believing that the rest of the euro zone would ultimately come to their rescue anyway.
So far, the euro has depreciated nearly 15 percent against the dollar and continues to slide -- albeit slowly. The falling euro boosts Greece's exports and provides the desired means to increase tax revenues, restoring some order in fiscal operations and the much needed fiscal consolidation. Until the crisis emerged, the euro was believed to be overvalued and the correction came as a blessing, as if to rescue Greece, and was welcome in all the euro zone capitals.
Professor Melvyn Krauss (New York University) in his February 12 NYT piece wrote: "So long as inflationary expectations in the euro zone remain subdued, a 'bailout by the euro' will not pit European against European. But what the falling euro does do is pit Europeans against Americans."
It is anticipated that the euro may keep falling as fiscal consolidation continues in EU countries and the dollar will continue gaining strength against the euro. Fiscal consolidation is an unpopular measure that holds back public programs and brings hardships to many stakeholders. However, if the euro keeps falling, that hardship will be less severe.
Some observers blame Greece's crisis partly on the unsustainable appreciation of the euro, brought about by the US policy makers' deliberate move of letting the dollar fall in order to boost US export sector jobs. If the US unemployment continues at its current rate of around 10 percent, the policy makers will surely move to put the dollar in reverse gear, eliminating EU zones gains in export advantage by the falling euro.
Although there is no provision for bailout of members of the euro zone, letting Greece default may have dire consequences for others. Athens owes its neighbours billions. According to estimates from the Bank of International Settlements, Greece owes foreign financial institutions a total of $303 billion -- $75.5 billion to French banks, $64 billion to Swiss banks, $43.2 billion to German banks.
Among the possible measures being discussed are direct EU aid, a European bond issue, bilateral loans, help from the IMF, as a way to help the highly indebted country get back on its feet. There is speculation that even expulsion from the euro zone was also raised.
As a prudent step though, the Greek government is required to make significant spending cuts -- a deficit reduction of 8.7 percent of GDP this year. Higher fuel taxes and a freeze on salaries paid to some civil servants are already being enforced. The European Commission and the ECB are set to monitor the implementations of these measures.
Greece's share of the European Union's gross domestic product is a mere 2.6 percent. However, its fiscal deficit, which now threatens the viability of the euro, is evidence that a currency union comprising sovereign member states with separate fiscal policies is conflicting and unsustainable.
Economist Nouriel Roubini, one of the foremost predictors of the 2008 global financial crisis, observed: "No currency union has survived without a fiscal and political union." An economic government or a political union is unlikely at this stage. However, some form of fiscal discipline is being contemplated by the leaders of the stronger EU economies.
Since its inception, EU has always been aspiring to become a superpower to counterbalance the US. With the present crisis on the table that goal has been pushed back. As Greece's crisis is affecting the weaker economies, each country is poised for inward looking management while the block as a whole has become somewhat weakened. Saving Greece from bankruptcy and keeping the euro and the monetary union afloat have become the immediate exigencies of the EU leaders.

Dr. Abdullah A. Dewan, founder of politiconomy.com, is a Professor of Economics at Eastern Michigan University.