VoxEU Column Europe's nations and regions

How to rescue the EMU

Unlike Southeast Asia, Greece cannot devalue its currency in a bid to kick start an export-led recovery. Instead this column argues that, while it will be politically difficult, Greece needs a combination of debt reschedulement and consolidated, coordinated wage cuts – and fast.

The Asian financial crisis of 1997-98 happened in emerging market economies. Little did we think that the next sovereign debt crisis would be in an advanced country, or even in Europe. But these earlier crises have taught us four crucial things, the understanding of which is vital if we are to deal with the Greek crisis.

  • First, the Asian financial crisis showed that the way for a country to recover from a financial crisis is to devalue its currency – to a very large extent – and then to pursue export-led growth.
  • Second, we learned from the Asian crisis that an IMF rescue is not a bailout for the citizens of the country. They were loans not gifts – they did not involve the obligations of the citizens being written down. In the end, the IMF and other creditors were repaid by the countries’ governments, and these countries then collected the money from their own taxpayers. The IMF simply acted as a debt collector for Wall Street. Such action does not encourage moral hazard on the part of the countries involved.
  • Third, we learned from the Asian crisis that an IMF rescue is a bailout for the banks and other financial institutions that lend to a country. Such a set-up does lead to moral hazard on the part of lenders.
  • Finally, we learned from Asia that default and debt write-downs may not be a good idea after a financial crisis. Dealing with a debt overhang poisons recovery, since the need to repay large loans leads to tax increases and cuts in government services that dampen the return to growth. Asia recovered rapidly without debt write-downs.
The Greek situation

How to apply these four ideas to thinking about Greece? The huge rescue of Greece by the IMF and the EU last month means that Greece will not need to borrow again from private financial markets for three years. During this time, bankers and other financiers who lent to Greece will get their money back. The IMF, and even more importantly, European taxpayers, will end up holding European debt. And Greece will get a three-year period to put its house in order and consolidate the necessary austerity.

But this will not work. An export-led recovery strategy, like that described above for Asia, is denied to Greece. Countries within the Eurozone cannot devalue their currency (see for example Cavallo and Cottani 2010). Even if there is a willingness to accept extreme austerity in Greece, the recovery process will be blocked by a lack of competitiveness. Severe cuts to public expenditure programmes and increases in taxes are a central part of the rescue package. These cuts should be replaced by a growing export sector but without a more competitive export position, these cuts will instead drag Greek economic activity down with them. Standard and Poor’s, the ratings agency, has estimated that Greece will not return to its 2009 level of nominal GDP until 2017.

As this happens, tax revenues will chase the economy downwards. Thus, even if austerity is accepted, it is projected that the deficit will continue to be large for some years, causing Greece’s debt-to-GDP ratio to rise from 125% to up to 150% during the adjustment period. The Greek economy will end up crippled by its debt. Severe cuts will begin to look like look savage cuts – and pointless ones. Austerity may well be resisted politically – this is not the kind of circumstance in which strong retrenchment policies can survive. The political will to carry on may evaporate and be replaced by a rise in anti-European and anti-German sentiment.

It thus looks inevitable that recovery in Greece will require a very large restructuring of Greece’s debts. This means that the rescue package, negotiated last month, will not fix Greece's debt problems. At some point in the next few years, before the Greek government needs to return to international markets, there will need to be a debt restructuring. It is true that it might be best to delay this restructuring until the primary deficit has been reduced and the debt level is no longer rising. But delay or not, such a restructuring does seem inevitable.

Sharing the pain – a political solution for Greece

The idea that Greece can undergo long-lasting austerity to pay the interest on its debt and in the longer term repay the debt itself is, in my view, unlikely. And policymakers need to plan for this.

But debt write-downs will not be enough. Debt write-downs do not restore competitiveness. The period from 2005 – 2008 saw a very rapid reduction in Greece’s competitiveness. Greece now needs the equivalent of a substantial currency depreciation. And the numbers are big. Competitiveness in Greece may need to increase by up to 30% if Greece is to be able to do what Asia did. I do not believe that it will be possible to achieve a large enough reduction in wages, costs, and prices without some sort of central administrative intervention in the process.

How to bring this about? The politically courageous thing to do is to seek to achieve a very large overall wage-cut, coordinated across the whole economy. To make this politically possible, such a move for a general wage cut should be coupled with a move towards a write-down of Greece’s international debt. That way it will be possible to present the wage reductions to the Greek population as part of a burden-sharing approach.

Of course, a general wage cut would need to be accompanied by some legal surveillance that ensures that prices fall in the same way. It is also difficult – nay, impossible – to impose price controls as a continuing system. But some oversight of a one-off cut in prices might be possible. Some will gain and some will lose out considerably. Such an approach would provide serious implementation challenges and would require serious thought.

Further, it is essential that the wage cut happen fast. A slow and gradual reduction of wages would bring about the worst possible outcome. With falling costs and prices, but no fall in interest rates to match, very few people can be persuaded to invest (see Allsopp and Vines 2007 and 2010 and Kirsanova et al. 2008). But investment and growth are what Greece needs. An environment of gradual deflation is not an environment in which to bring this about.

Learning the lessons for the Eurozone

What has happened in the last in few months poses steep political challenges for Europe as a whole, not just for Greece.

The Greek crisis has revealed a weakness in the whole Eurozone policymaking system. There should have been intervention from Brussels to prevent what has actually happened. What was happening to fiscal policy in Greece was in fact obvious from Brussels. The Stability and Growth Pact should have acted as a barrier to this kind of behaviour.

But in fact the Pact turned out to be completely unhelpful. Because Germany and France had breached it, the possibility of Brussels exerting discipline was completely compromised. The Pact drew its lines in the sand in places it could not defend and was overwhelmed. In retrospect, it appears obvious that this was likely to happen. The Stability and Growth Pact must be reformed.

The countries next in the line are Portugal and Spain – with wider and deeper economic and political ramifications. Many commentators now believe that the Economic and Monetary Union will break up unless there is much greater political and fiscal integration within Europe to prevent the kind of fiscal laxity that has driven Greece to the edge of this financial precipice (see for example Münchau 2010). But the political obstacles in the face of achieving this within Europe look very large.

Moreover, the conceptual difficulties are large. The misguided Stability and Growth Pact must be replaced by a new approach to fiscal policy (see Allsopp and Vines 2007 and 2010 and Kirsanova et al. 2008). This approach must be comprehensive enough to guard against difficulties like those in Spain, in which fiscal indiscipline was not the cause and for which mere fiscal discipline will not be a remedy.

But crisis has revealed an even deeper difficulty, one which has been slow to reveal itself. For all of the ten years since the euro was formed, Germany has determinedly cut its cost and wage levels. The result has been a super-competitive Germany that has taken demand away from other countries within the Eurozone – including not just Greece, Portugal, and Spain, but also others such as Italy.

German policymakers have, at the same time, insisted that German domestic demand be held down to make room for this foreign demand. This unilateral policy has led to a growing German surplus within Europe. The result is that demand, which has been taken away from other countries by Germany, has not been replaced. If Germany is to remain the hegemonic leader within the Eurozone, it must step up to the responsibilities that are required of it and stop holding down domestic demand.


Naturally policymakers will find it difficult to think about the two-fold radical moves that I have proposed for Greece – a move of debt reduction and a move of consolidated, coordinated wage cuts. But if my analysis is right, such moves may be needed and needed fast.


Allsopp, C and DVines (2007), “Fiscal Policy, Labour Markets, and the Difficulties of Intercountry Adjustment Within EMU”, in David Cobham (ed.), The Travails of the Eurozone, Palgrave Macmillan, London

Allsopp C and D Vines (2010), “Fiscal policy, intercountry adjustment, and the real exchange rate within Europe”, in , M Buti, S Deroose, V Gaspar, and J Nogueira Martins (eds.), The Euro: The First Decade, Cambridge University Press

Cavallo, Domingo and Joaquín Cottani (2010), “For Greece, a “fiscal devaluation” is a better solution than a “temporary holiday” from the Eurozone”, VoxEU.org, 22 February.

Kirsanova, T, M Satchi, D Vines, and S Wren Lewis (2007), “Optimal Fiscal Policy Rules in a Monetary Union”, Journal of Money Credit and Banking.

Münchau, Wolfgang (2010), “Europe’s choice is to integrate or disintegrate”, Financial Times, 3 May.