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.