26/09/2011 07:23 BST | Updated 25/11/2011 05:12 GMT

Greek Debt Crisis and 'Great' Expectations

The economic paralysis of the Eurozone is not only threatening the currency union but also the very foundations of European unity.

One of the building blocks of modern economic thinking is the theory of rational expectations. The theory suggests that people develop expectations about future occurrences. However, in doing so, economic agents shape the actual outcomes by behaving according to their expectations. Hence, the economic outcomes we observe do not differ systematically from what people expect them to be.

Take for example the case of stock prices. If investors believe that the price of a stock will go down they will rush to sell their shares. Yet, their rationale response to these expectations results in the drop of the stock price as supply outweighs demand. Another example is the price of gold. If people believe that the price of gold will increase they will rush to buy gold, thereby contributing to its increase in value. There is a strong, co-evolutionary link then between speculation and outcomes in the economic realm.

This simple observation can help explain why the efforts to tackle the sovereign debt crisis in Greece have produced no real benefit (in fact, they have made things worse) and, in addition, why any future efforts based on the same macroeconomic policy witchcraftry are bound to fail.

Let's start from the basics. There's no person in her right mind believing that Greece can avoid some form of default. A mounting public debt coupled with ever-deepening recession leaves no room for disagreement. Well, in case there was, the Greek government removes any doubt with its insistence on fiscal austerity at a time when restoring growth should have been the priority. At this rate, the Greek public debt will soon exceed 200 per cent of gross domestic product.

Given the impossibility of a default-free future for Greece, economic agents act on the expectation of a Greek default. Quite simply, people realize that sooner or later there will be a credit episode so they adjust their behavior accordingly now. That is, they behave as if Greece has already defaulted on its debt.

On the one hand, lenders are actively trying to take Greek bonds of their balance sheets because they fear a drop in their value. In addition, prospective bond buyers demand excruciating interest rates given the perceived risk involved. This puts ever-increasing pressure on Greece's financial outlook that further reinforces the inevitability of bankruptcy.

Of course, outsiders are only part of the problem here. Greeks are equally responsive to the threat of bankruptcy. Consumers slash spending in anticipation of harsher times ahead. Producers have no appetite to invest given the uncertainty with regards to public finance, eurozone membership etc. As a result, the already anemic tax intake keeps falling and growth remains negative. More importantly, Greeks transfer billions of savings abroad, further weakening the fragile Greek banking system.

The real issue here is that the increased uncertainty surrounding Greece's financial woes, which is primarily of Greece and Eurozone's making, renders a default not only more likely, but also more costly. Evangelos Venizelos, the Greek finance minister, can try to convince Greeks and the world that default is avoidable through his eloquent, albeit meaningless, speeches. Yet, he's bound to fail unless he provides a convincing alternative. Similarly, investors will not take note of the German chancellor's assertions that Greece is an integral part of the Eurozone unless she fully commits to underwriting the Greek debt. Only decisive action can adjust expectations and behavior alike.

Nevertheless, a blanket guarantee of the Greek debt is the equivalent of political suicide in the North of Europe. Hence, the frustrating inaction we are witnessing. Yet, it's time Europe's leaders made up their minds. The economic paralysis of the Eurozone is not only threatening the currency union but also the very foundations of European unity.