European crisis validates old Indian wisdom
by Virendra Parekh on 25 Feb 2012 2 Comments

There is one aspect of the current economic crisis in Europe and America which is completely glossed over: the present plight of these mighty economies validates the traditional Indian wisdom on economic and financial matters and puts a question mark on economic models (and lifestyles) centred on debt. Consider the likely scenarios in Greece and the European Union, and this will become clear as daylight.


After marathon negotiations, European leaders, private lenders and the IMF have managed to produce the second bailout package for Greece, which is deemed to be politically acceptable to creditors and provides Greece with something it reckons to be sustainable. Greece will be given €130 billion ($173 billion) in additional finance in the coming two years. Private banks have accepted a reduction of 53.5 per cent of the nominal value of Greek bonds they hold, plus a reduction in the interest rate on new bonds, starting at 2 per cent and rising to 4.3 per cent from 2020. This amounts to a loss of net present value of about 75 per cent (up from the 21 per cent originally agreed in July last year. Besides, interest rate charged by eurozone members on their bailout loans to Greece will be cut by 0.50 per cent. The deal is expected to bring down Greece’s debt ratio to 120.5 per cent of GDP in 2020.


However, the largesse is conditional on Greece completing certain actions by the end of the month—for example, reducing minimum wage to make labour markets more flexible—and submitting to an “enhanced and permanent” monitoring of European Commission officials in Greece. Greece will have to deposit a quarter’s worth of debt-service payments into a “segregated account” that will be monitored by the troika of the European Commission, the European Central Bank and the IMF. Over the next two months, Greece will pass a law “ensuring that priority is granted to debt-servicing payments” and enshrine this in its constitution “as soon as possible”.


The package, if implemented (it is a big if), will enable Greece to avoid a disorderly default next month on €14.5 billion ($19 billion) of maturing bonds. However, the respite is bound to be temporary and unlikely to offer any solution to the basic problems facing Greece or, more importantly, eurozone economies. That is because patience and trust is running out on all sides. The lenders are tightening screws by demanding greater austerity and stronger commitments, the borrowers are becoming more and more resentful of the conditions sought to be imposed on them, and people in the lending countries are bristling at the prospects of making sacrifices to bail out their profligate neighbours.


There have been violent protests and demonstrations in the capital city of Athens and elsewhere against the austerity package. For the Greeks, who have long had it easy as part of the wider eurozone, the sacrifices sought, particularly the reduction in pensions, are a bitter pill to swallow. The feeling that they are being made to suffer deprivation at the insistence of foreigners, especially Germans, makes them all the more resentful. With unemployment running at near 20 per cent for the fourth year running, public anger against the political class has resulted in weeks of protests.


Almost as a counterfoil, anger is bristling in other countries of the eurozone against having to bail out the Greeks rather than letting them stew in their own juice. Pessimists point out that Greece is notorious for making promises it does not implement. Despite pledges over a year ago to privatise massively and slim down the civil service, not a single significant Greek asset has been privatised, nor a civil servant sacked. Having spent billions over a decade on the integration of Germany, Germans do not want to spend vast additional sums on those whom they view as the lazy, spendthrift bums of southern Europe. Other creditor states like Finland and The Netherlands are equally fed up with handing out money and have even fewer hang-ups than Germany about playing the part of good Europeans.


So, Greece’s agonies are by no means over. For one, the relentless rhythm of regular troika assessments and poisonous rows over disbursements will continue. And if Italy and Spain are able to make decent progress in dealing with their own public finances, the rest of the eurozone will feel more confident about turning off the Greek tap. Thus, Greece can delay a messy default, but it will happen eventually.


In more ways than one, Greece symbolizes the weakness of the European Union. As Martin Wolf pointed out in Financial Times, the fact that this small, economically weak and chronically mismanaged country has been able to cause such difficulty indicates the fragility of the EU’s structure. Greece’s failings are extreme, not unique. Its plight shows that the eurozone still needs a more workable mixture of flexibility, discipline and solidarity.


Politically, the eurozone is a halfway house. It has monetary union without fiscal unification. It is neither so deeply integrated that breakup is inconceivable, nor so lightly integrated that breakup is tolerable. Political pundits say that if eurozone is to survive, it must become a fiscal union like India that routinely ensures transfers from surplus to deficit states (as happens between Gujarat and Orissa). But Germans and other northern European voters chaff at the prospect. Indeed, today the most powerful guarantee of its survival is the cost of breaking it up. That is not enough. In the long run, European unity has to be built on something vastly more positive than that. But that is a Herculean task, given the economic divergences and political frictions revealed so starkly by this crisis.


Economically, eurozone is a marriage of unequals. High-productivity members (Germany, Holland and Finland) and low-productivity southerners (Portugal, Ireland, Italy, Greece and Spain—PIIGS) are locked into a common currency, the euro. The euro is highly undervalued for productive Germany, which, therefore, has booming exports. But the same currency is too strong for the PIIGS, who have worsening trade deficits. So, the eurozone crisis is fundamentally a balance of payments crisis. Since all members use the euro, trade imbalances among them do not get highlighted. But they are massive, totaling about 500 billion euros. An uncompetitive exchange rate has saddled the PIIGS with very slow or negative GDP growth, creating revenue shortfalls and, hence, rising fiscal deficits. Thus the trade problem has translated into a fiscal problem.


Resolving these issues is not easy. In addition, there is concern about the deteriorating euro-zone economy, which is probably in recession. The austerity plans undertaken by some governments would only retard economic growth, reduce government revenues and aggravate fiscal imbalance. That, in turn, will further reduce confidence, calling into question the ability of many different sovereigns to pay their bills. It is a vicious circle.


European banks are under great pressure. They have massive holdings of bonds, not only of Greece but also other countries which are believed to be susceptible to the trouble. The Greek bailout package will entail heavy losses for them. If the Greek contagion spreads to other countries, the whole financial system may be in danger. No wonder, most of the banks are borrowing from ECB to meet their maturing obligations rather than for releasing funds into the economy through commercial lending.


Asian countries and companies are specially affected by this credit squeeze by European banks, which have been their big financiers. Deleveraging by these banks in tandem with a slowing economy in Europe may be showing up in weak export performance in Asia.


What do these developments imply for India? EU is India’s largest trading partner, accounting for around one-fifth of India’s total exports. With exports set to moderate on the back of slowing demand from EU, aggravated by government budget cuts and bank deleveraging, India’s current account deficit could widen. As over three quarters of India's exports to EU emanates from the manufacturing sector, this likely dip in export demand could put pressures on domestic industrial production. Finally, markets world-wide remain edgy and future trade and investment flows will depend on how the Eurozone debt crisis gets resolved. Capital inflows into India could be affected as European banks continue to borrow to meet their maturing obligations rather than expand lending for fresh investment.


There is no certainty how, when and in which shape will eurozone emerge from the present morass. As eurozone struggles to find its way out of the multi-faceted crisis, India cannot expect to remain unaffected. It needs a comprehensive strategy to deal with all eventualities and scenarios. All that we see at present is knee-jerk market reaction to specific developments. That is clearly not enough.


The plight of European countries as also US holds some basic lessons for India. Their lunge from crisis to crisis brings home the perils of economic models based on debt. Following Keynesian economics, governments of these countries relied on heavy public spending to create additional demand and foster growth. Individuals and families in these countries piled debt upon debt to live what they thought was Good Life. A culture of credit cards and sub-prime lending created an illusion of opulence.


They are now rediscovering virtues of good old prudence. Their extravagance has come to haunt them. Their governments are ‘stretched’. Their social security systems are becoming increasingly unsustainable and inadequate. This is a necessary outcome in a society in which the sole specialization of the highest paid people is devising newer and more complex financial products. They are learning the hard way that you cannot leverage your way to prosperity.  


Earn first, spend later, our ancestors taught us. Always spend less than what you earn, they said. Our shastras and sages frowned on kings who indulged in profligacy and squandered taxes paid by their subjects. Under the influence of western economics, governments in independent India jettisoned those lessons, resorted to deficit financing on a massive scale and drove up prices of everything hundreds of times over the years.


Today, that habit of living beyond one’s means, reflected in gigantic fiscal deficits, has become a millstone around the economy’s neck. Printing of notes, borrowing from whoever is willing to lend, is a road to distress, not development. Nations are built on hard work, diligence and honesty. That is the lesson we should learn from the current crisis in West.


The author is Executive Editor, Corporate India, and lives in Mumbai

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