When will the Greeks be made to suffer?

IN A column at Vox, Aaron Tornell and Frank Westermann point out that despite net private capital outflows, Greece has managed to continue running a current-account deficit. This is a rare occurrence, which can be chalked up to European Central Bank lending to the Bank of Greece, which has in turn expanded domestic credit. That's a terrible shame, write Mr Tornell and Mr Westermann:

This lack of expenditure adjustment contrasts with Mexico in the wake of the Tequila Crisis: From a current-account deficit of 7% of GDP in the year prior to the crisis, Mexico was forced to practically balance its current account during the crisis year (-0.5% in 1995 and -0.7% in 1996). Yes, in 1995 Mexico experienced a sharp real depreciation and a deep recession. By 1996, however, net exports rebounded and economic growth resumed. At the time it was argued that Mexico could have avoided the severe crisis by adjusting in early 1994. Unfortunately, like Greece today, the authorities chose to increase domestic credit to delay a recession. The difference between Mexico and Greece is that while Mexico had to run down its international reserves, Greece has been able to keep them practically unchanged. Instead Greece has used the EU rescue package and the Eurosystem loans to increase domestic credit. Had Greece been like a typical small economy with no access to rescue packages, it would have had to close its massive current-account deficit by now. Its ability to maintain such massive current-account deficit in the face of a sharp reversal in private capital inflows will be recorded in the annals of financial crises as a remarkably rare feat.
It is time to address Greece‘s economic policy options in a holistic manner, and stop the emergency measures that only provide Greece with another lifeline.

The Mexican experience is instructive. Faced with a similarly impossible economic situation, Mexico massively devalued the peso against the dollar. This obviously made repayment of its accumulated dollar debts difficult, but America stepped in to provide financial support. In 1995, the Mexican economy shrank by just over 6%, but it quickly returned to rapid growth in the years after.
Greece, by contrast, could and almost certainly will default on its loans. It is determined not to devalue, however, which would involve an exit from the euro zone. That makes the business of current-account adjustment very, very painful. When Mexico floated the peso, it quickly depreciated. This swiftly increase the cost and reduced purchases of foreign goods and boosted the competitiveness of Mexican goods in foreign markets. That, in turn, allowed for a fast resolution of the current-account imbalance without too much pain; external demand prevented a major collapse in Mexican output.
A country like Greece, stuck within a single-currency area, can't devalue via its exchange rate. Instead, internal prices must adjust to achieve the same effect. That requires a deep and painful recession. A gutting recession reduces domestic demand for goods and labour. As unemployment rises, prices and wages are bid down, until the needed depreciation is attained. This is a much slower and more painful process. The Greek economy shrank 2.3% in 2009, and 4.4% in 2010, and 7.3% in the year to the second quarter of 2011. The IMF forecasts that Greek output will also decline in 2012; indeed it is likely to if more austerity measures are adopted at the same time the euro-zone economy drifts into recession.
Of course, Greece's adjustment has been delayed by the expanded credit offered by the Bank of Greece. That credit has kept domestic demand above the level to which it might otherwise have fallen. That, in turn, has slowed deflation and the process of adjustment.
In the authors' view, this seems like a bad thing. Yet it's hard to imagine a better alternative. To achieve the crash decline in prices needed to facilitate an adjustment in the current account equivalent to 12% of GDP, the Greek economy would be plunged into a deep depression. Unemployment might well rise to 30% or more, and the political environment, already touchy, would be downright poisonous. To prevent the dissolution of the state, the Greek government would probably need to eject itself from the euro zone, thereby touching off a nasty round of financial fall-out.
The pressure of adjustment will find an outlet. If that pressure is not vented through emergency lending to the Greek central bank, it will burst out, perhaps violently, in some other way. It's easy enough for economists to talk about the need to rip off band-aids and deal with adjustments promptly. But societies have their limits; they can only be pushed so far before they break down. And it is a very good thing that, so far, Europe has not pushed Greece very much farther
http://www.economist.com/blogs/freeexchange/2011/09/adjustments?fsrc=scn%2Ftw%2Fte%2Fbl%2Fwhenwillthegreeksbemadetosuffer