Can Europe march towards economic prosperity with a common currency but without a common government?

As markets show signs of recovery, potential sovereign debt defaults have started to needle investor confidence. It all started with the collapse of Dubai World further exacerbated by the debt crisis in Greece (also in Portugal and Spain). According to Mr. George Papandreou, the embattled premier of Greece, the economy requires saving from “falling over a cliff” and is the “weakest link in the Euro zone”. These are harsher terms of course, particularly during bad times. So what is in store for Greece and for heavily indebted other European nations? Is there a risk of en-masse sovereign debt default in store?

It is highly unlikely that there will be a sovereign debt default by Greece or any other ailing European Union (EU) economy. The EU has already made several statements indicating their willingness to bail out Greece. Speedy manoeuvres are also currently underway to get the Greek economy back on track. The stability and development plan of the EU is aiming to cut the budget deficit from the current 12.7% of GDP to below 3% in 2012. That however is a lofty target and is unlikely to be achieved.

Mr. Papandreou is expected to implement a series of measures such as tax hikes and a freeze in public sector wages. While these measures may indeed help narrow the budget deficit, they are unlikely to help Greece reach the target 3% by 2012. In fact, some of them will be extremely difficult to implement. Meanwhile Greece is expected to face stricter surveillance by the EU in view of Greece’s less than reliable national accounts. Given the extent of its public debt, Greece is unlikely to be able to finance its budget deficit on its own.

Even though a sovereign debt default by Greece is unlikely to happen, Greece’s economic woes confirm the extent of financial crisis in western economies. It is therefore logical to expect similar bad news from other Euro zone countries seeking bailout packages. If the market response to the collapse of Dubai World and the debt crisis in Greece is anything to go by, bad news on sovereign debt is certain to cause jitters in financial markets. As such, it is important to identify other countries which are at similar risk.

Debt profligacy is not limited to Greece. Other European countries such as Italy, Iceland and Portugal are also sporting gaping fiscal deficits. They have amassed considerable debt over the last five years with some reaching record high debt to GDP ratios. Outside the EU, the US and Japan also have large fiscal deficits with growing government debt. 

Clearly, many European countries are at considerable risk with Italy, Iceland and Greece at the forefront. Outside the EU, Japan has the highest government debt as a percentage of GDP, but is in no danger of a debt default. Government debt in the US has also been on the rise due to stimulus packages. The US Federal Reserve has reiterated their commitment to continue stimulus packages, and therefore, their fiscal deficits are set to remain high.

While rising government debt may not lead to wide spread sovereign debt defaults, it remains a concern nevertheless. Governments will have to curtail public borrowings at some stage thus dampening growth. Similar to Greece, other governments may also be forced to curb public spending in response to rising government debt. It may also prompt a premature end to government stimulus programmes. Finally, and more worryingly, central banks may be compelled to raise interest rates in competition with private and corporate borrowings.

Given the political costs involved, is unlikely that Greece will be able to cut spending or raise taxes adequately and narrow the budget deficit to 3% GDP by 2012. It is the awareness of this stark reality that prompted wide spread scepticism as the government’s inability to finance the budget deficit will leave Greece with no option but to default. The EU’s financial muscle therefore becomes particularly important against this backdrop.

Such financial help however does not appear to be forthcoming, at least not in the form Greece wanted. EU finance ministers do not appear to have decided upon the nature of a potential bail-out package at their meeting on March 15. According to Luxembourg Prime Minister Jean-Claude Juncker, any financial aid to Greece is likely to be bilateral loans from several member countries rather than a carte blanche bail out or the widely anticipated loan guarantee arrangement. Jean-Claude Juncker chairs the monthly meetings of EU finance ministers.

An apparently disappointed Mr. Papandreou has stated that he may turn to the International Monetary Fund (IMF) for an emergency loan should the EU fail to provide adequate financial support. This is likely to be met with stiff resistance from other EU member countries as they have previously expressed opposition to IMF loans. In the absence of support from the EU Mr. Papandreou however is left with little choice.

While massive sovereign debt default is unlikely, it is important to bear in mind that there are other countries in the EU with high public debt and large fiscal deficits. Further bad news on Greece or any other European economy is sure to dent investor confidence. As individual member states in the EU struggle with their own economic issues, the question arises whether the EU can march towards economic prosperity with a common currency but without a common government!