Greek demonstrators gather in Athens’ Syntagma Square on July 5 as voters overwhelmingly reject creditors’ demands for more austerity in return for rescue loans. (Image credit: AP/Emilio Morenatti)

Greece’s best strategy to its crisis would be to overhaul its economic policy to favor growth-oriented, business-friendly measures, according to Stanford economist John B. Taylor.

Taylor, the George P. Shultz Senior Fellow in Economics at the Hoover Institution and a senior fellow at the Stanford Institute for Economic Policy Research, said that the origins of the Greek debt crisis can be found in economic and political mistakes by that country as well as by the European financial community. 

On Sunday (July 5,) Greek voters rejected the terms of an international bailout. The Stanford News Service interviewed Taylor on the Greek crisis.

What is your analysis of the economic situation in Greece? How did we get to this point?

The Greek economy is performing terribly by any measure.  Looking back in time, there are three key factors that have led to this situation.

First, Greece’s economic policies – regulatory, rule of law, budget, tax – have been very poor. In fact, their policies are the worst in Europe, according to the Heritage Foundation index, and on a par with many poor sub-Saharan African countries. This factor alone explains much of Greece’s poor economic growth.

Second, the interest rate set by the European Central Bank (the ECB) a decade ago was too low for Greece, and it encouraged excess borrowing and a housing boom, and eventually a bust and a huge debt overhang by 2010. The higher nominal wages and prices in Greece in the boom years also negatively affected Greece’s competitiveness due to the single currency.

Third, in 2010 the International Monetary Fund (IMF) started making loans to Greece without first insisting on the Greek debt being sustainable. The IMF broke its own lending rules in doing so. This bailed out the private sector, and has left public institutions (the IMF and other European countries and their taxpayers) holding the bag. The resulting acrimonious policy and debt negotiations have created political instability and confusion in Greece – a deterioration of economic policy and growth being the result.

The Greek prime minister’s (Alexis Tsipras) surprise pullout of the talks with the IMF, Eurogroup and the ECB and his call for a referendum are examples of the ongoing political instability.

What did Sunday’s referendum tell you about the mood of the voters in Greece?

They do not like being told what to do by their creditor governments and the International Monetary Fund. They want to get a better deal on the debt forgiveness, but they do not want to do what will help Greece grow because they have been told that would be harmful. There is of course an inconsistency in this view.  It represents a mood of political confusion and is a sign of more instability to come.

In your view, what is the best plan forward for Greece? And what’s the likely reality?

Best would be for them to change radically economic policy in a pro-growth direction. For example, this would include making it easier to start up businesses, ruling out tax rate increases, gradually reducing the size and number of government interventions in the economy. With a strong commitment to such policies (these are not austerity policies,) there could be further debt restructuring. With the current government, however, this is highly unlikely. So, until there is a change in policy the current mess will continue, including a possible exit of Greece from the eurozone.

What responsibility do Greece and the European Union have in this crisis?

Greece, through its government, is largely responsible for its economic policy and thereby for its own economy. Its neighbors in the eurozone common currency area have a role since the euro is the currency and the European Central Bank sets monetary policy. Also, when there is a run on the banks the lender of last resort in the European Central Bank.

Is defaulting and leaving the euro even a least-bad option for Greece?

Greece has already defaulted on its IMF loans, and the bank closures and capital controls are already doing great harm to many. Greece may decide to leave the euro, but the process will be difficult.