Greece's Monetary Trap

The Greek government has just unveiled a new fiscal austerity plan. With a combination of tax increases and spending cuts, it aims to get budget deficits down to about 3% of GDP--10 percentage points lower than where it is now.

Everyone is expressing optimism.  But while this sort of belt-tightening is necessary for Greece to stay in the EU, it's going to come at a huge cost.  Greece is already in recession--that's why its budget problems loom so large--and the fiscal contraction will only make them deeper.  Meanwhile, the EU will be setting its interest rates to meet the needs of larger, healthier members (and inflation-hawk bondholders).  Tight fiscal and monetary policy means a long, painful period ahead for the Greeks.

This is the dilemma that faced Argentina with its monetary peg to the dollar; ultimately, it led to devaluation and default.  We will see if Greece can whether it better.