“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough,” Mario Draghi, President of the European Central Bank (ECB), stated on July 26, 2012. What was once a question of Greece leaving the European Union (EU), commonly known as “Grexit,” has now evolved into the question of breaking up the entire EU. The ramifications of multiple countries leaving the EU, or even one country leaving, would be felt in economies around the world. But, as Draghi states, European leaders are looking beyond this possibility to continue to work towards healing the crises in Europe.
The common belief thus far, shared by economists, leaders, and the public, has been that Greece would be the first to leave. Greece, the first EU country to suffer drastic economic setbacks, had accumulated large government debts prior to the economic downturn in 2008. The weak fiscal policies could not generate enough revenue to cover the high rate of borrowing. In 2009, its debt was 113% of Gross Domestic Product (GDP), putting it in a weak position to overcome the hit to its markets.
Elsewhere in the EU, Spain is trying to avoid becoming a second Greece by announcing harsher austerity measures that will increase taxes and cut spending at the local levels. Spain is in a risky position—the interest rate for its 10 year government bonds is passing 7%, signaling investor hesitation and long term instability. If investors are reluctant to put money into bonds, Spain will not get the money it needs to bail out banks. While some options are still on the table for countries like Spain, the actions taken in Greece will set an important precedent.
The idea of Greece potentially leaving the EU raises three questions: (1) Will Greece leave the EU? (2) Should Greece leave the EU? (3) If Greece leaves the EU, does it pave the way for progress?
The Greek elections on June 18, 2012 indicated a positive sign for Greece with the victory of the New Democracy. The party is in support of bailouts and implementing austerity measures to ensure that a “Grexit” does not take place. Even though the win represents a positive political shift in Greece, strong fiscal measures will be needed to lift Greece out of the economic depression. The two bailouts Greece has received amounted to more than 250 billion euros and aid continues to flow in the form of loans. Thus, in the short term, Greece is safe. The new government and new measures put into place will test how much longer Greece can sustain its EU membership.
Although some economists and analysts believe that Greece leaving the EU could be beneficial, an exit will be costly for Greece and its neighboring countries. If Greece leaves the EU, the first hurdle it will face is a drastic devaluation of its currency. With the euro, the currency valuation rests on the economic well being of 17 countries—out of which a few still show signs of economic growth. Without this buffer, the Greek currency will be extremely weak and vulnerable to hyperinflation. Greece’s primary industries of tourism and shipping are insufficient to support Greece on their own. Second, as seen in the past, drastic devaluation of currencies results in shortages, inflation, and eventually, political fallout. Economic instability has historically been a cause of political shifts and unrest. This will only lead to rebellion and violence, endangering Greek citizens and citizens of neighboring countries.
What really lies at the core of the crises? A more basic change that needs to occur in order to prevent these economic problems. Amongst the countries using the euro, we see many fiscal divisions that will not be solved by Greece leaving the EU. The fundamental problem lies in the way fiscal policies are implemented. A central bank, like the European Central Bank (ECB), has two main responsibilities: monetary policy and fiscal policy. The ECB carries out monetary policy but it lacks consistent fiscal policy—taxing and spending. The root cause of the Greek crisis was the increasing debt due to a small influx of taxes that was not enough to cover the excessive spending attributed to Greek wage and pension requirement. Thus, the ECB should maintain greater oversight over the types of tax policies and spending policies put into place by individual governments. If multiple countries are employing the same currency and some countries are undermining its value through ineffective fiscal policy, it can create a harmful domino effect.
The answer to all three questions stated earlier seems to be a “No.” Furthermore, an exit from the EU would set a bad precedent for other countries. An exit does not guarantee economic progress or serve as hope of calm in the midst of chaos. Economic recovery due to large budget deficits and extensive borrowing requires intensive reform that imposes strict consequences for excessive deficit spending. Draghi establishing his stance on this issue is an important step in not only giving investors hope that Europe has not given up in its fight, but also hope for the people of Greece and the EU that their government and the ECB will continue to support their needs in a time of crisis.
Figures obtained from BBC News, Forbes, and the Wall Street Journal.
Trisha Parikh is an undergraduate student at UCLA majoring in Economics and Political Science. She is a co-editor with The Generation.