The ignored part of the problem

Greece?s sovereign debt crisis is usually associated with the huge general government budget deficits and many tend to ignore another important factor which is also at the root of the problem. That is the country?s chronic large current account deficit and associated external imbalances.

There is no doubt that running a large current account deficit is not necessarily wrong if the country does so to improve its future export capacity and boost labor productivity. Many developing countries have pursued this policy in the past either for the right reasons just mentioned or the wrong ones, namely to increase consumption.

Unfortunately, Greece has run large current account deficits for a long time for the wrong reasons, therefore becoming a net debtor nation. In the past, when the drachma was around, this situation gave rise to a foreign exchange crisis and a speculative attack on the currency, prompting corrective domestic economic policy action.

After Greece entered the European Monetary Union (EMU) at the beginning of 2001, the specter of a currency attack and an ensuing devaluation disappeared. The current account deficit, which occurs when total imports of goods, services and transfers exceed the country?s total export of goods, services and transfers, kept on widening, with very few people taking notice and even fewer sounding the alarm.

Of course, this would not have happened if the markets were not happy providing the necessary financing on the assumption that EMU participation meant Greek risk was almost as good as Germany?s or that of other member countries.

A good deal of the gap was financed by banks in the form of purchases of state bonds. The latter could be funded cheaply and required no capital to be set aside since government bonds were considered risk-free assets by the prevailing regulatory rules. So, the credit institutions are not alone to blame for this development.

In addition, a good number of the banks, which provided the inexpensive financing to Greece and other net importers, were from other eurozone countries which are net exporters and unintentionally facilitated the exports of their countries in pursuit of profit.

Needless to say, this was not just a Greek phenomenon. Other eurozone countries experienced a similar situation after joining EMU. Shielded from currency risk, they ended up with inflated wages at the same time gains in productivity were not enough to prevent a significant increase in unit labor costs compared to Germany and other core EMU countries. The ensuing loss of competitiveness showed up on their current account balances, where a string of large deficits aggravated their external position.

For some countries like Ireland with a large export sector amounting to 100 percent of gross domestic product, it may be easier to get out of the economic slump as they continue to pursue fiscal consolidation in a bid to gain access to financial markets. For Greece, whose export sector is much smaller, it is and will be more difficult.

This is evident in the current account balance data. According to the Bank of Greece, the country?s central bank, the current account deficit fell by 1.4 billion euros or 8.6 percent year-on-year, to 15 billion in the first nine months of the year. This reflects a sharp decline in the non-oil trade deficit and a rise of 0.8 billion euros in the surplus of the services balance, which more than offset a large increase in the net oil import bill and a widening of the income account deficit.

This means the Greek current account deficit may exceed 20 billion euros for the entire year, meaning it will end up at around 9 percent of GDP which is still quite large. This requires a greater national effort to boost exports and further cuts in imports of goods and services, particularly those associated with consumption expenditure.

Taking measures and steps to increase productivity is definitely the best way and the least costly from a social and economic point of view. However, the current tax policies and the existing institutional framework in many sectors do not serve this purpose. Of course, steps to deregulate certain input and output markets will help along with the more efficient use of resources brought about by privatizations. However, important privatizations are planned for later on and it is known their impact will be felt more in the medium term rather than in the short term.

So, reducing the wage and non-wage costs of businesses, known as internal devaluation, takes center stage as a means to bring down unit labor costs faster.

However, this also helps inflate the discussion of whether a currency devaluation may be a better alternative to internal devaluation. Still, anybody who has taken a close look at the effects of past drachma devaluations on the Greek current account deficit and the international competitiveness of the economy, knows the answer. The benefits were generally speaking short-lived and resulted in lower standards of living for the population.

All in all, Greece has to tackle its current account deficit problem to better cope with its sovereign crisis. This requires laying out a national export strategy supported by measures and steps to boost productivity and reduce unit labor costs.