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Finding the euro crisis’s “original sin”

More than five years after the International Monetary Fund’s failed bailout of Greece caused an economic crisis in the euro area, debate continues about whether either the IMF or the European Union has learned from its mistakes.

In recent weeks, The Economist and Vox EU have argued that the crisis has entered a chronic phase and won’t end until European leaders agree about what caused it in the first place.

Athanasios Orphanides, SB ’85, PhD ’90, a professor of the practice of global economics and management at MIT Sloan, agrees with this assessment — but his  recent  research cautions against viewing the “original sin” of the Greek bailout and the subsequent euro area crisis as a purely economic problem.

“Economics can help us understand why, but economics does not and cannot explain why [the crisis] was so mismanaged,” says Orphanides, adding that the response to the Greek crisis “poses a threat to the European project.”

Saving the euro area, not Greece Enough countries seek IMF relief from high public debt — triggered by overspending, increased consumption, rapid price growth, and an overvalued exchange rate — that the IMF has a standard program in place for restoring economic competitiveness. The short-term hardship — often in the form of debt restructuring and a correction of unsustainable populist policies — brings long-term recovery.However, in joining the euro area, Greece had ceded control of monetary and exchange rate policy. That meant the euro area had to coordinate a unanimous solution. But the European Union hadn’t created a framework for solving such a problem.

This opened the door for France and Germany, the euro area’s dominant economies, to take over the conversation, Orphanides says. “What we have is an example of Animal Farm, where all animals are equal but some are more equal than others,” he says.

At the time, French and German banks held €80 billion in Greek debt and would have suffered if the IMF restructured Greek debt — a common step in IMF intervention when debt is very high. Thanks to French and German influence, the IMF program imposed strict austerity on Greece but didn’t restructure debt. Instead, the IMF introduced a so-called “systemic exemption,” with which the IMF protected the interests of the euro area instead of Greece, Orphanides says.

The Greek economy collapsed; unemployment reached 25 percent, 10 points higher than the IMF projected, and the government defaulted on its debt in 2012 — only after French and German banks had sold off their Greek debt. Meanwhile, the crisis spread, with Ireland and Portugal also requiring IMF bailouts. In 2013, the IMF admitted that it would have acted differently had Greece not been in the currency union.

A bad idea from the beginning? Economists have questioned the feasibility of the economic and monetary union for more than two decades. “If there was ever a bad idea, EMU is it,” German economist and MIT professor Rudi Dornbusch said in 1996, a quote Orphanides cites in his work. And European Commission economist Bernard Connelly predicted this decade’s euro crisis in his 1995 book, "The Rotten Heart of Europe." (The book cost Connelly his job.)With no corrective mechanisms in place to prevent countries from exploiting the common market for shortsighted, domestic political interests, Orphanides says it’s “difficult to be optimistic” about the future of the European project.

“This sets a precedent that’s hard to reverse,” he says. “I don’t think the current setup is sustainable.”

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