Last month saw the first eurozone default. Greece defaulted on its debt, but this event, contrary to popular belief in the final quarter of 2011, did not cause an abrupt panic. It did not force Greece out of the euro, and the crisis did not bring down Portugal, Italy or Spain.
And it was indeed a default. In March, Greece experienced the largest sovereign-debt restructuring in history. Current debt holders (primarily EU banks) exchanged their existing debt for new bonds, which pay a lower interest rate and have a lower face value. Since lenders were forced into accepting the terms, this fulfilled the necessary conditions for a default.
As a result, Greece pledged to continue with its reforms. It is expected to decrease its debt-to-GDP ratio from 160% to 120% in 2020. Furthermore, the current set of enforced policy measures will mean that Greece is unlikely to experience any growth or recovery until 2020. It is a lost decade and potentially a lost generation for Greece.
There are two possible remedies. The first involves an immediate exit from the eurozone followed by currency depreciation and capital controls in order to stop capital flight out of the country and quickly restore competitiveness (without the need to renegotiate wages down). The second focuses on reducing debt and the current account deficit while trying to restore competitiveness.
The depreciation argument assumes that the central issues are relative prices not productivity, implying that depreciation is the quickest possible solution - as experienced recently in Iceland. But Greece is not Iceland – Greece does not have the productive capacity for its problems to be solved simply by currency depreciation. Its culture is consumption (as is shown by the structure of its current account deficit), its labour markets are corrosive and state dependent, its government is inefficient (even in basic tasks of collecting revenue), and its banking and business sectors are hampered by lack of confidence and uncertainty. To address all this Greece does not need a fiscal stimulus or fake austerity with no institutional support; rather it needs structural reforms and to develop the strong pro-market institutions that it presently lacks.
Institutional reform starts with political stability. Greeks have little confidence in their government. In order to address this, the politicians need to restore belief in the system and the rule of law. The government must act as an enforcer of contracts to signal greater stability to both domestic businesses and foreign investors. After this, it has to continue with public sector reforms and liberalisation of the labour market (both are closely tied since the public sector unions are the ones with the highest level of rigidity). It must show strength in the bargaining process and create favourable incentives for businesses. Signals for new specialisation, trade and productionshould be left to the market - to bring about the necessary restructuring process supported by the new institutional setting. This is the only way to enable an efficient allocation of resources, removed from any distorting signals and able to attract capital. The banking system will benefit from positive signs of confidence and stability in the economy, which will reduce capital flight and slowly but gradually improve balance sheets. A euro exit could threaten this process by making it harder to achieve political stability. It would take Greece much longer to consolidate.
Greece should turn to pro-market institutional reforms that will reduce distorting signals in the economy and create space for market led specialisation and investment. And these institutional reforms should not be limited to Greece. They are applicable to a series of countries which find themselves constrained by their unsustainable welfare state models of debt accumulation, high current account deficits, fiscal profligacy, corruption and high levels of state intervention.