Salvaging European economic governance from Greek ruins


The euro zone crisis has highlighted the need for a consolidation of European institutions

GREECE IS battling to regain market confidence and escape financial disaster. The conventional wisdom is that the government should take the tough decisions and come up with a credible austerity plan.

Many observers have even suggested that Greece’s best course would be to follow Ireland with a fiscal plan heavy on spending cuts and structural reforms. The underlying assumption is that doing the hard thing is the good thing.

Policy credibility is at the heart of the debate, and rightly so. Greece should come up with a “credible” fiscal consolidation strategy. Yet two critical issues are too often neglected. Firstly, trying to achieve credibility by making “tough choices” is not always a good solution. When economic fundamentals are seriously misaligned, signalling toughness may harm rather than enhance credibility.

Secondly, credibility-building is not only about pleasing international markets by restoring macroeconomic discipline; it is also about constructing political legitimacy at home.

The first issue relates to the viability of the underlying political economy. It remains to be seen whether Greece can balance its budget and improve competitiveness without devaluation. This is not a minor issue.

Devaluation was a key condition facilitating fiscal consolidation strategies in the past, including in Ireland’s successful adjustment from the late 1980s. The second, and more important, issue is that achieving market credibility is a highly political process. Both Brussels and the markets are urging Greece to introduce even further cuts in public spending.

EU commissioner Joaquín Almunia has argued that “the markets are putting on pressure. This pressure cannot be ignored.” But the state of political and social fundamentals cannot be ignored either. This is the old lesson from the famous political economist Karl Polanyi: markets cannot work without political stability and social peace. Is Ireland the right model for Greece? Political constraints are the main issue. Ireland is a flexible liberal-market economy with a non-ideological political system and a contemporary tradition of social partnership.

Greece is a country with militant union movements, high ideological polarisation and a confrontational political culture.

In this context, pursuing an internal devaluation a la Ireland in Greece is a risky strategy.

Argentina’s crash in 2001 shows that enforcing austerity at all costs can end in social default.

The Greek government cannot afford to be complacent. Only a couple of years ago the country experienced Europe’s worst riots in modern times. Greece is already facing a latent legitimacy crisis that could easily evolve into further political turmoil. The solution to Greece’s credibility dilemmas is mainly political. Market credibility can hardly be achieved without political legitimacy.

Prime minister George Papandreou is so far enjoying a crisis-mandate honeymoon. But this support can vanish quickly, mainly if the proposed policies do not pull the economy out of recession. In addition, history suggests that Greek society will not acquiesce to austerity without a big fight.

The Papandreou administration needs to strike the right balance between macroeconomic discipline and political support, not least by ensuring adjustment costs are fairly distributed. The Greek government should also understand that the power of external commitments to impose domestic discipline is limited. The exit-costs of abandoning the euro are prohibitive; but the political costs of enforcing an internal adjustment can also become unbearable.

The EU is part of the problem and the solution of Greek debt crisis. EMU is hardly an optimum currency area and lacks monetary and fiscal co-ordination.

Moreover, the absence of a European citizen identity and party system poses a serious challenge to its political sustainability.

In this context, EU leaders should not contribute to the consolidation of a divisive north-south narrative (hard-working northerners against profligate southerners) which is undermining Greece’s efforts to rebuild reputation.

Restoring the credibility of European economic governance is not only about tying countries to the mast of Maastricht; it is also about rebuilding the ship in the middle of the storm.

Economist Martin Feldstein’s proposal of a temporary exchange rate reset for Greece might not be a good idea. Yet preventing the unthinkable (the collapse of the single currency) requires not converting institutions into a sacred dogma.

Institutional stability sometimes implies a dose of institutional adaptation. This critical juncture should be seen as an opportunity for consolidating Europe’s great institution-building credentials.

Sebastian Dellepiane-Avellaneda is a research fellow at the UCD School of Politics and International Relations