Knowledge@Wharton - Fear is growing that Greece --
one of 16 countries that use the euro as currency -- may default on a massive
pile of debt, creating a ripple effect of problems throughout Europe and beyond.
Following pressure from the European Union and the European Central Bank, the
Greek government on March 3 announced a new round of austerity measures -- the
third such package in the last six months. It includes a freeze on pensions and
additional wage cuts for government workers. In addition, the top rate of the
country's value-added tax will be raised from 19% to 21%, and excise taxes on
alcohol, cigarettes and fuel will be hiked for the second time in two months.
Leaders of public-sector labor unions reacted with outrage to the measures,
saying they will harm Greece's economy; some unions vowed to stage strikes later
this month.
Meanwhile, Wall Street banks are again facing scrutiny -- this time, for
the complex financial instruments they used to allegedly disguise the country's
real debt. What caused Greece's debt problem to spin out of control? And what
steps should it take to remedy the situation? Wharton finance professors Richard
Herring and Itay Goldstein weigh in.
A transcript of the conversation appears below.
Knowledge@Wharton: Let's discuss some background first before we get
into the measures that Greece should take to help itself. How did Greece get
into this predicament? Was it a long time coming or not?
Richard J. Herring: Yes. And it's really a very old-fashioned kind of
crisis. It is a throwback to the kinds of crises we had in the 1960s when we had
a fixed exchange rate system in the world, and the countries we were bailing out
then were the U.K. and Italy, but we didn't worry so much about the less
developed countries because they couldn't borrow it all. In the case of Greece,
Goldman is getting a lot of publicity they would rather not have for this.
Knowledge@Wharton: Goldman Sachs, that is.
Herring: Yes, Goldman Sachs. There was a little help in aiding the
Greeks in achieving the entry requirements into the eurozone. The Maastricht
Treaty set out some very strict requirements for convergence. You were supposed
to have a budget deficit no more than 3% of GDP, and I think outstanding debt no
more than 50% of GDP. The Greeks didn't quite have that situation. But with a
little help from Goldman they could reclassify debt as a forward exchange
contract and they looked okay. Now, this was a wink-wink, nod-nod sort of
agreement with the Europeans. I don't think anybody was fooled at the time
because the Europeans were desperate to get Greece into the Union so that it
wouldn't fall back into the hands of a military dictatorship. They thought it
was an affront to Greece and to the world that the cradle of democracy should
have been controlled by a military dictatorship. So there were lots of reasons
to make it a little easier for Greece to get in.
The irony is that the ruse that was used is something that was invented in
Europe at the very beginning of modern banking. At the beginning of modern
banking it was not only illegal, but a mortal sin to lend money for interest.
And so everybody wanted to disguise debt, but there was a need for debt, just as
there is today. So they disguised it in foreign exchange transactions. It was
not illegal to charge for moving currency from one place to another or from one
currency into another. And that is essentially what the swap does. It is not a
new technique. It has just got some additional bells and whistles on it.
And what Greece has done is sort of run into the iron law of international
finance, which is that everybody would like to have an independent exchange rate
policy and an independent monetary policy, and an independent fiscal policy. But
it just doesn't work. You can only pick two of the three. And by joining the
euro, they have picked two. They have pegged their exchange rate and they are
stuck with European central bank monetary policy. That means they really have to
use their fiscal policy to stay within the parameters that will keep them in the
euro system. It is a lesson that has rung true for centuries, actually. But some
countries can actually do it. And Ireland is maybe an interesting example.
Knowledge@Wharton: I'm going to ask you about Ireland shortly, so
let's hold off on that.
Herring: Another one is Latvia, which actually reduced prices
internally. An exchange rate really is a mechanism for equating internal and
external prices so they are once again competitive, and Greece is really
overvalued relative to the rest of the euro community right now. So if they
could run austerity long enough to take the crisis down, they could make the
adjustment. But there's a real question about whether they have the political
will, the political support, or even the tools to do it.
Knowledge@Wharton: Itay, do you have anything to say in response to
what Dick just discussed?
Itay Goldstein: In general, I agree. I think what happened was a
simple debt swap around the time that they wanted to join the European Union.
Artificially, it looked like the debt was lower than what it is. It is kind of
similar to the off-balance sheet debt that we saw in some of the corporate
crises in the U.S.
Herring: We should remember that this happened in 2001, and it was
before the Enron explosion.
Goldstein: It was before that, right.
Herring: It was before that. And it was really sort of considered the
mission of banks and investment banks to help corporations and sovereigns fool
their creditors?. It was just an accepted fact -- "that's part of what we
do."
Goldstein: And I think that other countries did that, too, around that
time.
Herring: Yes, they were not unique.
Knowledge@Wharton: Is there also something more fundamental at work?
Was the government of Greece simply, over a period of years, spending way too
much money, whether it was in the form of wages to workers or pension benefits,
or other government expenditures? Were they living beyond their means?
Herring: Yes, because they were incurring account deficits
consistently throughout and that is the measure of whether you are living beyond
your means. As are we, I might add. And there comes a day -- and I'm not sure
when ours is coming -- but that can't go on indefinitely.
Knowledge@Wharton: Let's talk a little bit now about the aus | 
