Up Front

Web Chat: The Greek Crisis and Europe’s Reaction

Domenico Lombardi

The recent debt crisis in Greece threatened the stability of the European financial system and resulted in the first bailout in the history of the euro. In order to shore up its economy, Greece was forced to take drastic austerity measures that have triggered violent protests throughout Athens and encouraged other nations, like Spain and Portugal, to follow suit as a method of stemming further contagion. Questions still remain whether these changes will be enough to restore confidence in the euro, however.

On Wednesday, May 26, Domenico Lombardi answered your questions about the Greek crisis and its implications for the eurozone and globally. David Mark, senior editor at POLITICO, moderated the discussion.

The transcript of this chat follows.

12:29 David Mark: Welcome, Domenico. Many in the U.S. are looking at the Greek debt crisis as a cautionary tale of what happens with an imbalanced economy. We look forward to your thoughts.

12:29 [Comment From Jen: ] How did Greece get into such financial trouble?

12:29 Domenico Lombardi: The Greek crisis was triggered, but by no means originated, by the recent global financial crisis. Over-consumption, that is living beyond one’s own means, is the root cause. While this is a feature that is currently shared by other countries, Greece’s membership of a currency union left the country with no monetary and exchange rate policies to maneuver, which further escalated concerns among market participants. Dubious fiscal accounting practices also played a role as well as the inability of euro area countries to conduct, and enforce, the existing EU surveillance framework.

12:30 [Comment From Rachel: ] How will the bailout work?

12:31 Domenico Lombardi: As of now, the agreed-upon rescue package is not technically a bailout. Greece will be paying an interest rate to the IMF and the other euro area countries for the EUR 110 bn (that is, about $145 bn) package that will be disbursed in a three-year period starting from this month of May. While the charged interest rate does reflect evolving market conditions, it is less than Greece would normally pay under the circumstances due to the nature of “preferred creditor” of the IMF and, I would argue, of the other euro area countries.

12:31 [Comment From Danielle: ] How has the crisis impacted the euro? And other currencies?

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12:32 Domenico Lombardi: Greece is a very small economy within Europe, accounting for about 2 percent of the euro area GDP. The fact that the crisis has spread to the euro area and to other currencies can be attributed to the lack of timely action which has underscored early European reactions, including Greece itself. Market participants have started to wonder what the consequences can be if other countries in the euro area may find themselves in a similar situation and, like Greece, delay corrective measures while their euro area partners show little willingness to come forward with help. This is a manifestation of what economists call “contagion.” By doing so, however, financial markets have eventually precipitated a situation (or “equilibrium”) they feared it could materialize.

12:34 Domenico Lombardi: As for the impact on other currencies, there are some direct effects as well as indirect effects. As for the former, markets are pricing a weak euro because they are discounting the monetization of public finances that the European Central Bank is de facto conducting. Essentially, this means that inflation may be higher. Markets, however, are also pricing a somewhat higher probability that the euro area may break up if the “northern” countries fail to reach a credible understanding with the “southern” ones (which also include Ireland) on how to run the euro. There are then some indirect effects. The Chinese currency has appreciated against the euro and policymakers in Beijing expect less exports to Europe. An appreciation of the yuan against the dollar along the lines expected in Washington sounds unlikely at the present time.

12:35 [Comment From Leandro: ] What is Greece doing to turn things around?

12:37 Domenico Lombardi: The Greek government has agreed on a very ambitious program of adjustment with the IMF and the EU. In theory, it can be fulfilled but two conditions ought to materialize: first, it assumes that the government has the political capital for selling the program to the Greek citizens, which recent events in Athens and elsewhere have casted doubts on; secondly, it’ll need assurances by the Europeans that there may be a follow-up program. Even if, and I underline “if,” the Greeks carry this program forward, Greece will be unable to return to solvency in a relatively short time window, as the current three-year program implicitly assumes. It is a bit like if someone is hit by a car, he is unlikely to run again without an adequate rehab program.

12:37 [Comment From Benjamin Minor: ] Why is this having such an effect on the U.S. markets? What’s the relationship?

12:39 Domenico Lombardi: US banks are not directly exposed to Greece but they are to other European banks which, in turn, are exposed to Greece and other euro area countries that may be hit by the crisis. Fearing this connection, there is a chilling effect in the financial markets of other countries, including the US.

12:40 [Comment From Yan: ] Are there any parallels between this crisis and the crisis that started in the US last year?

12:42 Domenico Lombardi: The Greek crisis originated as a budget crisis, the US as a financial one. They both spread to other sectors of the economy quickly. In the case of the US, however, there was prompt intervention by the authorities, that is, the US Treasury and the Fed. The Greeks did not intervene promptly and, in any case, they could have not used the European Central Bank on which they don’t have full sovereignty.

12:42 [Comment From Nick: ] What impact will this crisis have on future countries who want to join the EMU?

12:45 Domenico Lombardi: The Greek crisis has highlighted that entry in the euro area should have been more selective and more checks should have been conducted on the fiscal accounts submitted by applicant countries. New applicants (like Latvia and Romania, for instance) will get more careful checks and, most likely, their entry will be delayed.

12:45 [Comment From Henry: ] Do you think this crisis is partly the result of admitting inferior economies into a union with more advanced and mature ones (ie Germany)?

12:47 Domenico Lombardi: I don’t think it is a matter of “superior” vs. “inferior” countries. But to share a currency, each country needs to harmonize its overall policy framework. What the euro area countries have done is to share the monetary policy but maintain full national discretion on their fiscal and structural policies. This hasn’t worked out.

12:47 [Comment From Marcus: ] DO you think a crisis like this could break apart the EMU?

12:48 Domenico Lombardi: Much depends on whether the Europeans are able to avoid contagion to “systemic” countries of the area like Italy and Spain. If they don’t succeed, a break up of the euro area then becomes a serious possibility.

12:49 [Comment From Mark, Greenbelt: ] Is it possible for the Europeans to simply dump Greece out of the eurozone? or would that just be a different kind of disaster?

12:50 Domenico Lombardi:With hindsight, the Europeans should have prevented Greece entry in the first place. Now that it is in, it is just nonsense to say that it should be expelled. The resulting chaos would negatively affect each country of the euro area.

12:50 [Comment From Jennifer S., Staunton, VA: ] Are there other European countries out there in similar straits? Isn’t Spain having something of a crisis? Is there potential for a domino effect?

12:52 Domenico Lombardi: Spain, Portugal, Italy, Ireland…and who knows which other countries…have their own vulnerabilities which are somewhat different from those that triggered the crisis in Greece but that, nonetheless, can drive their economies in the same mess.

12:52 [Comment From Pia: ] What is your opinion about the comparison between Greece and California? Wednesday May 26, 2010 12:52 Pia

12:54 Domenico Lombardi: They both share a budget crisis but California is in the US where there is a central fiscal authority, a true functioning single market and is part of an economy with an extraordinary potential for thriving and generating new resources.

12:55 [Comment From RichY: ] Is there conclusive evidence to say that one of the causes was deceptive financial engineering involved in masking the country’s over spending? If so, what can be done to stop such practice?

12:57 Domenico Lombardi: Dubious practices like the ones you mention have been reported in the case of Greece but my sense is that the crisis has been primarily driven by lack of policy coordination at the European level. We may have avoided the sub-prime crisis without the deceptive financial engineering but the crisis in Europe would have come regardless.

12:57 [Comment From Teresa: ] What kind of role has the IMF played in this?

12:58 Domenico Lombardi: The IMF is playing an important role largely filling the vacuum generated by the lack of European leadership in handling the crisis. It provides credibility to the agreed-upon measures and offers an important source of technical expertise.

12:58 [Comment From Tom: ] What do you mean when you say financial markets have “precipitated” the situation – that they are causing contagion? How much do you expect such contagion to spread?

1:00 Domenico Lombardi: Simply that their reaction may get things worse. That said, responsibilities lie policymakers not with “speculators.”

1:00 [Comment From Brianne: ] Why didn’t other EU countries step in before this was truly a crisis? There had to be signs that this was coming.

1:01 Domenico Lombardi: Indeed. They assumed that things could get better just by “announcing” that they would do something. But if you don’t put your money where your mouth is, markets will not believe you.

1:01 [Comment From Mike: ] Does this crisis suggest at all that a monetary union with so many diverse countries is impractical?

1:04 Domenico Lombardi: The euro area is a unique experiment in history where countries that were used to going to war against each other until a few decades ago have decided to voluntarily surrender their sovereignty in a number of areas. They are at a very critical juncture: either they move forward or the union will break up. As it stands, the current equilibrium is precarious.

1:04 [Comment From Linda: ] Turkey’s been trying to get into the EU for years. Will the situation with Greece make Turkey’s accession more unlikely?

1:05 Domenico Lombardi: This is likely, but not because of Greece. The current situation will require a lot of soul-searching which will make the EU more inward-looking and less open to new applicants.

1:06 [Comment From Leo: ] Could the austerity measures being enacted by Spain, Italy, Portugal, etc. lead to a “double dip” recession within the Eurozone?

1:06 Domenico Lombardi: It is very likely.

1:06 [Comment From Troy: ] Can you talk a little about what’s going on with the protests and unrest in Greece related to this crisis? How much of a concern is this?

1:08 Domenico Lombardi: Whenever there is a crisis like this there is distributional fight over who should bear the costs. Civil servants and fixed income earners are easy to target but Greece needs to do more to tackle its well-known problems with tax evasion and compliance.

1:08 [Comment From Jay C. Streit Council: ] Following on Jennifer S.’s question and your corresponding answer, Spain, Portugal, Ireland, and now Italy, have all announced austerity plans that should reduce budget deficits and encourage growth? Do you view these austerity plans as being effective in stemming the prevailing trend of running unbridled debt?

1:09 Domenico Lombardi: They have announced additional fiscal measures. As important as they are, the key is how to lift the potential growth in the euro area. On this, still no answers.

1:09 [Comment From Randy: ] What’s Papandreu’s popularity like these days?

1:10 Domenico Lombardi: He is confronting an unprecedented situation. However, he has, in many ways, inherited the problems he is trying to mend right now.

1:11 [Comment From Tom: ] Do you believe the $1 trillion EU/IMF fund will be enough to ward off contagion, and is it reasonable to expect the IMF to be able to provide 1/3 of whatever support is given?

1:12 Domenico Lombardi: Much of the money is not there yet. Moreover, the IMF does not precommit but assesses country funding needs on a case by case basis. This is why markets have reacted unfavorably to the news.

1:12 [Comment From Carol: ] do you think the amounts allotted for the rescue are enough? or do you expect there might be a need for a second round of rescue funds later?

1:13 Domenico Lombardi: Besides any amount pledged so far, euro area political leaders need to show they stand by the single currency “whatever it takes.” Otherwise, no amount will ever be enough.

1:14 [Comment From Francis: ] Won’t the fall in the value of the euro vis-a-vis the U.S. dollar make U.S. exports less competitive in the global market? How can the U.S. manage to decrease unemployment and create more jobs in this climate?

1:15 Domenico Lombardi: This is an issue, indeed. The US competes with Europe in the international trade markets. Thus a cheaper euro will benefit European manufacturers. This is why Washington is pressing the Europeans to show resolute action in containing the crisis.

1:15 [Comment From Dave: ] Do you expect an influx of immigrants out of Greece during this crisis?

1:17 Domenico Lombardi: This is possible to some extent. But Europe, albeit a single market in theory, is not like the US where there is one language spoken and common professional standards across states.

1:17 [Comment From Michael Barry: ] I just don’t understand how you can maintain a democracy and defy the expressed will of the people. How can German leaders bailout Greece, given widespread opposition, expect to remain in office?

1:18 Domenico Lombardi: Well, they only decided to support Greece when they realized their economy would face worse consequences by not doing so.

1:18 [Comment From Will: ] Is there anything the US should be doing at this point to either help out Europe or protect itself?

1:18 Domenico Lombardi: The US is talking a lot to the Europeans but, in the end, this is an issue that the Europeans themselves will have to address.

1:19 [Comment From Patrick: ] You rightly point out that the key to recovery will be growth, but aren’t all the austerity measures likely to have a deflationary impact, which is exactly the opposite of promoting growth? And what will the Greeks be able to export even if they regain internal competitiveness? Isn’t that another fundamental difference with California?

1:20 Domenico Lombardi:That’s why any rescue package should have two legs: short-run fiscal adjustment and medium-term growth strategy. So far, I see the first but not the second leg. Markets do the same.

1:20 [Comment From Nate: ] Do you think there’s a feeling of resentment among other countries that they have to now bail Greece out after it didn’t even belong in the union in the first place? If so, what does that mean for intra-EU relations?

1:22 Domenico Lombardi: This is a problem for everyone in Europe. The Greeks feel terribly humiliated, the Germans disillusioned about the euro. However, this is nothing in comparison to the feelings that European leaders had to overcome at the end of WWII when they lay down the foundations of an unprecedented historical enterprize.

1:22 [Comment From Leo: ] Does the debt situation imperil the type of social services that Western EU nations provide? For example, pensions?

1:23 Domenico Lombardi: Indeed. But the cost of the European welfare is an issue that the Europeans should tackle anyhow regardless of the crisis. If anything, the crisis may help to implement politically-sensitive decisions.

1:23 [Comment From Erica: ] How’s China weathering all these financial storms. It seems like the country stands to benefit when the economies of the US and EU are both in the toilet simultaneously.

1:25 Domenico Lombardi: If Europe does badly, this is a problem for China, the US and the rest of world economy. It is the largest economic bloc. Less exports to Europe imply less growth and job creation at home. For mature economies like the US this is a greater problem that in emerging-market ones which enjoy still untapped sources of domestic growth.

1:27 [Comment From Chris: ] Maybe this crisis is a chance as well? European integration is a pattern of crisis and reform. Monetary Union was a project driven mainly by political considerations – in a nutshell it was the price Germany had to pay for France’s consent to Unification. But at that time the political will was not going as far as to transfer the necessary sovereignty to the Unions level when it comes fiscal policy. The national policies are being coordinated but with no much effect. When the Lisbon Treaty was negotiated nobody dared to touch the articles concerning EMU. Perhaps now there is a chance to get it right.

1:27 Domenico Lombardi: This is a sensible point. But national policies have not been fully coordinated as they should have.

1:27 [Comment From Jake: ] You mentioned before that it would be “nonsense’ for the EU to kick Greece out of the euro zone. But is there any chance Greece might leave voluntarily? Has that ever happened before?

1:28 Domenico Lombardi: Even Greece were to leave, its debt would remain denominated in euro. Against a devalued national currency, the debt would just balloon.

1:29 David Mark: Thanks for joining us, everybody.

1:30 Domenico Lombardi: Thanks to all for joining this chat and to you, David, for moderating it.

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