The Greek Predicament

Typically when the economy starts to veer towards an undesired direction, policy makers have the ability to intervene either through the use of fiscal policy, or through the use of monetary policy.

Side bar: The government is in charge of fiscal policy, while the Central Bank working with the Finance minister is in charge of monetary policy. Under the monetary policy the Central Bank tries to move the economy in the desired direction using the money supply mechanism or by affecting interest rates. Under fiscal policy government spends or cuts taxes in order to affect the economy.

However, as part of the European Union, Greece does not have the ability to use monetary policy as it does not have a monetary system independent of that of the European Union. This means that Greece is unable to affect growth through the use of monetary policy since the European Central Bank oversees all monetary operations.

To make matters worse, the EU has mandated the Greek government to implement austerity measures! The EU refuses to lend Greece any more money until they agree to raise VAT, reverse their promise to raise minimum wage, and privatize the energy and transport sectors. In a period of recession and impending economic doom, this is the opposite of the action that should be taken (consumption and government spending will shrink at a time when the economy is already not performing well). What this will cause is a serious contraction of output in the Greek economy. Notwithstanding that, the EU has mandated Greece to sign a reform before they would consider pouring more loans into the Greek economy. What is of major concern is the fact that Greece is indebted to its neck as the total debt owed to the EU as well as other monetary institutions comes to about 176% of GDP- so the total debt of Greece is more than the county's national income. The thing is, when you are in this situation as a small country, you will probably have to keep rolling over your debt, and seeing as you are very indebted, the cost of borrowing will continue to rise for you, it is going to be an endless cycle of debt taking.

Right now Greece has two options. The first option is to default on its debt (if they don't give in to the austerity demand, they would simply be unable to pay back their debt), the second option is to give in to the austerity demand.

What will happen if Greece defaults on its debt? Well let's just say life will become very hard. If Greece has managed to borrow almost twice its GDP, it is evident that they are quite used to living above their means. Defaulting would mean not being able to borrow internationally or having to borrow at extremely high interest rates. That means the government will have to make do with internally generated money while forging through a recession. This is all while still living up to its promise to pay its citizens their pension. It seems to me that the government of Greece is building castles in the sky, because if they default on their debt as they are threatening to, they will have to raise taxes in order to perform and they will ultimately renege on their promise to raise minimum wage. Either that or they slide down to the bottom of the Economic ladder and become just a former developed country. It is difficult to imagine that the European Union will let this happen if it comes to that, and that is probably what Greece is counting on, that no man will be left behind. The Greece government has until May 6th to pay back the 200 million euros it owes the IMF.

The other option for Greece is to take austerity measures. If they would cut their spending and raise taxes, the credit crunch that will be experienced will be dire. I mean the Greek government will be increasing VAT during a time of economic crisis, how is that even an option? The economy is already not performing well, so this is a difficult ask. Increasing the minimum wage seems like a promise that should and will be reneged on regardless of what decision Greece makes. Why? Because Greece is not in a position where they can squeeze money out of an economy that is not performing well. Interest rates at commercial banks in Greece will drop severely (people are already pulling out bank deposits!), and ultimately, the recession will deepen.

Final Note: There is talk of Greece leaving the EU, but I don't think that is a viable option for Greece or the EU right now, but especially for Greece. The only reason Greece has maintained its developed country status for so long is because it had the backing of the European Union, and that is more obvious now than ever. On the part of the EU, a Greece exit would be detrimental as it would set a precedent for countries to withdraw from the union, a union that has been strong so far (there is currently talk of a Britain exit too!).