Recession leads to deficits lead to austerity leads to worse growth and bigger deficits:
With economic conditions weaker than expected, tax revenue is coming up short of projections in parts of Europe. As a result, countries struggling with high deficits are now confronting the prospect that they will miss the budget deficit targets forced upon them this year by impatient bond investors.
Greece, for one, looks as if it will run a budget deficit for 2010 greater than the 8.1 percent of gross domestic product it agreed to as part of a rescue package from the International Monetary Fund and the European Union that amounted to more than $150 billion, according to a person briefed on the matter but not authorized to speak about it.
Again, what would normally happen to a Greece-sized country with Greek-sized problems is that the value of its currency would decline. Everyone would, consequently, become quite a lot poorer in “real” terms but the pain would be spread and unemployment wouldn’t necessarily skyrocket. The newly poor country would be cheap to visit, its exports would be priced competitively, and import-competing industries would remain in great shape. Things might either stabilize like that, or else structural reforms could be undertaken that lay the groundwork for growth.
Thanks to the Euro, none of that’s possible and it’s not at all clear to me what the endgame here really is. For understandable reasons, German (and Austrian, Dutch, etc.) taxpayers don’t want to bail out the government of Greece. And also for understandable reasons, German policymakers prefer the European Central Bank to run a monetary policy that’s appropriate for Germany rather than one that’s appropriate for Greece. So Greece is stuck on a path to default.