Wednesday, November 23, 2011

FIXING THE GREEK DEBT CRISIS: A CASE OF OVER OPTIMISM AND OVERDOSE?


George J. Papaioannou
Zarb School of Business, Hofstra University
http://people.hofstra.edu/George_J_Papaioannou/


When in May 2010, the Greek government agreed to a bailout plan drawn by the International Monetary Fund (IMF), the European Central Bank (ECB) and the European Union (EU) – also nicknamed Troika – it was expected that by 2012 the government budget would show a small positive primary surplus, the GDP would start to grow again and Greece would have returned to the public debt markets.  With the year 2012 almost upon us, none of these expectations seem realizable.  GDP is expected to decline in 2012 and Greece is not expected to return to the debt markets before 2020.  The government’s recent projections show a small primary surplus but its realization is precarious.  Debt has risen from 127% of GDP in 2009 to over 160% at the end of 2011 and is projected to stay way above the original projections in the Medium Term Fiscal Strategy (MTFS) unless there is a severe restructuring plan. 

So the question is: what went wrong?  A case can be made that the expectations were overoptimistic and the medicine prescribed to Greece was too strong.  Common to both explanations was the reliance on a set of assumptions that were not present in the case of the Greek economy and, more critically, the case of Greek politics and socio-economic culture. 


The original bailout plan provided loans up to EU110 bn. to refinance Greece’s debt up to 2013 under strict conditions aiming at repairing the fiscal imbalances.  The conditions included significant reduction of public sector expenditures, additional revenues through direct and indirect taxes, and liberalization of the labor and professional markets.  Keeping with the accepted view about the efficacy of fiscal measures, the plan was slightly tilted toward greater cuts in public sector expenditures than revenue increases through taxes.  Furthermore, restoring external competitiveness had to come from internal devaluation since currency devaluation was precluded.  The plan’s prescriptions and its anticipation of recovery within a few years betray a diagnosis of the debt crisis as being a liquidity rather than an insolvency problem. 

The success of the plan was dependent on three conditions.  The first condition was that the pro-growth effects of the fiscal consolidation and market reforms would more than offset the contractionary effects of the public sector cuts and tax increases.  The second condition was that the Greek government would seek to shrink its budget deficits by downsizing and streamlining the public sector as well as curbing tax evasion than by overly taxing the private sector.  The third, and most difficult to meet, condition was that the market reforms and the improved competitiveness would contribute materially and relatively fast to a climate conducive to economic growth through investments and rise in exports.

Two years into the crisis, we can see now that the expectations of the original plan has not come to pass.  For example, recent statistics show that Greek nominal GDP in 2011 will be EU218 bn. compared to EU225 bn. projected in the MTFS.  Similarly, in 2012, the nominal GDP is expected to be EU213 bn. compared to EU228 bn. in the MTFS projections.  It is clear that the negative effects of public sector cuts and new taxes have hit the economy with potency and immediacy that has not been matched by any pro-growth effects expected from market reforms and a more positive sentiment about the soundness of future public finances.  The plan’s designers and advocates could plausibly argue that had the plan been executed with clinical precision it would have succeeded.  Nonetheless, in the implementation of any business or economic plan, the designer must count on the ability of those responsible to execute the plan as well as the disposition of those affected by the plan and the capacity of the organizational – in this case socio-economic - culture to adjust to the dictates of the plan. 

It seems that the plan itself did not account for certain idiosyncracies of the Greek economy.  One of them was the makeup of the GDP, which was heavy in consumption and light in savings and capital formation.  Thus, while the fiscal adjustment took a heavy toll on consumption it got little support from the other two components.  The statistics show that consumption had grown through the last ten years and by 2010 it represented 75% of GDP compared to an average of about 58% in the rest of the Euro zone.  Accordingly, a major hit in the consumption component was destined to have a critical impact on GDP.  Indeed consumption has significantly declined through 2010 and 2011.  This echoes the U.S. case where the loss of purchasing power following the debacle of the housing market has had a persistent negative impact on consumption and in turn on US GDP growth rates.  To offset this loss of aggregate demand, investments and/or exports would have to increase significantly.  Although investments in Greece had achieved a respectable level in the eight-year period after the entry to euro in 2001, the slowdown of an extensive infrastructure improvement program due to the Olympic Games had returned investments to more modest levels.  Moreover, most of the investment in recent years was in construction (allegedly fueled by rampant tax evasion) than in productive capital formation.  Finally, exports of goods have historically been a small part of the GDP.  Thus, they could not make up for the loss of domestic demand, despite the notable increases in tourist services and exports in 2010 and 2011. 

The political cycle did not help the realization of the plan’s objectives either.  In the fall of 2009, the socialist party PASOK returned to power following the decisive defeat of the center-right New Democracy party that stood accused of fiscal profligacy during the last few years of its reign and of false representation of the budget deficit.  The political significance in the coincidence of a socialist party being in government and the need for unprecedented fiscal retrenchment lies in the plan’s demand for extensive dismantling of the statist economic model PASOK had espoused and practiced during its many years as the ruling party of Greece.  Apart from any accusation of patronage, favoritism, and crony capitalism, which after all could be also levied against the center-right New Democracy party, PASOK’ philosophy was embedded in the intellectual and political belief that the state’s presence in the economy was a beneficial force and as such it should be sustained.  Thus, it was an historical irony that PASOK had the unenviable task to go back on a fundamental principle of its economic policy. 

A hypothesis can be made that PASOK’s economic policy as a response to the crisis was perhaps unintentionally abetted by the optimistic forecasts of the Troika’s plan, and especially the anticipation that a return to near normalcy was possible in a few years.  Although the PASOK government ascended to the plan’s austerity measures, it is plausible to conjecture that, based on the plan’s relatively short horizon, the government concluded that it would be possible to ride the crisis without a serious downsizing and transformation of the public sector.  If relief was attainable within a few years, this logic would suggest that the statist economic model could persevere despite some unavoidable cuts in salaries and retirement incomes as well as pension reform.   The important objective from this standpoint was to avoid extensive layoffs of public employees and the privatization of state-controlled enterprises. 

Reluctance on the part of the PASOK government to downsize the public sector and its payroll meant that the brunt of the revenue enhancements would come from the private sector through various business and personal taxes, including value-added tax rate hikes.  Indeed the record shows that although government expenditures (apart from interest payments) come close to the MTFS targets, they have not declined between 2010 and 2011.  The reason is that the government has eschewed the termination of government related entities and public employee contracts and instead has preferred to reduce public expenditures through cuts in salaries and pensions.  Failure to curtail public expenditures and inadequate tax revenues, due to the recession, continue to generate primary budget deficits that push the public debt upwards.   As a result, interest payments have increased putting additional pressure on the budget.  More critically, the inability to curb tax evasion means that the brunt of new taxes falls on the “visible” economy which has continued to decline due to the recession.  Indeed the government practice is to resort to new ad hoc tax increases to close the budget gaps and satisfy the conditions of the agreement with the Troika. The result has been diminished purchasing power, declining consumption, and difficulty on part of businesses to retain their work force as revenues drop.  Indeed, by August of 2011, unemployment had soared to 18% (seasonally unadjusted) most of it afflicting the private sector work force.

In addition, the government has been painfully slow in organizing and initiating the privatization program due to both its partisan philosophy and the power of the labor unions of the state-owned enterprises.  From a resource allocation standpoint, the result of this distribution of the austerity measures has been a still bloated public sector and a weakened private sector.  In other words, human and capital resources have not been released from the less productive sector of the Greek economy (that being the general government and the assets under its control) but instead resources have been sidelined in the more productive private sector.  Thus one of the major beneficial consequences of a forced restructuring of the Greek economy was thwarted, sacrificed to political imperatives.  Eventually, at the behest of Troika in June 2011, the Greek government agreed to embark on a serious effort to cleanse its payroll of low-value agencies and personnel by placing public servants in a labor reserve that pays reduced benefits.  It also promised to accelerate the privatization program.  It must be noted, in this connection, that the success of the privatization program has also lost part of its original efficacy because the severe austerity measures and the down-spiraling economy have naturally reduced the economic value of the state-owned assets.

The third pillar of the debt crisis resolution plan was reforms that would liberalize the labor and professional markets, simplify bureaucratic red tape in the case of new business formation and operations, and in general lead to a more hospitable climate for inward foreign investments.  Notwithstanding the necessity and high degree of urgency of these policy prescriptions for future economic growth, a more careful reading of Greece’s politics and socio-economic culture would suggest that the anticipated benefits would materialize slowly over a longer time framework than it was needed for debt relief.  Nonetheless, there were some immediate benefits from the liberalization of labor laws and regulations, which allowed Greek firms to gain greater flexibility in structuring their work force in terms of size and flexibility of working conditions.  This has led to a substantial reduction of labor costs and is most likely responsible for the growth of exports. 

On the other hand, liberalization of the professional markets could not seriously contribute to growth, at least in the short-run.  First, the laws were enacted with significant tardiness due to political resistance.  Second, it was unlikely that the reforms would attract new entrants amidst a climate of worsening economy and dropping demand.  Similarly, improving the conditions for the creation of new business and inward foreign investments will take time before they produce tangible results for several reasons.  A case can be made that the entrepreneurial and risk-taking spirits have suffered considerable suppression in Greece following a long period of over-reliance on the state to provide well-paid jobs and financial security.  It has not helped either that politicians of the left and the right are not used to talking in favor of private resourcefulness, initiative, and profit seeking.  Whether it is a majority view or not, the ostensible sense is one of distrust of entrepreneurial efforts, especially those of large scale, and the underlying belief that the firm should operate at the benefit of its labor force irrespective of its viability or capacity to generate a minimum and acceptable reward to capital and risk-taking.   Furthermore, crony capitalism has established a culture where firms rely on business with the state to support their growth and viability.  With the economic retrenchment of the state, it will take some time for Greek firms to get accustomed to the idea of operating within a more arms-length business environment.  The contraction and precariousness of the banking sector places additional hurdles to the growth of – especially new – businesses as market liberalization takes hold.

Turning Greece into a more hospitable venue for foreign investments and capital is a venture still in the making.  Unfortunately, the future prospects have to overcome the bad record of the past.  Greece has a worse than mediocre record in attracting foreign direct investments (FDI) and usually occupies one of the last places among EU states.  (A study shows that FDI accounted for no more than 1% of GDP in the period 1970-2010!)  The last 20 years, foreign capital has been invested in already existed firms rather than creating large new enterprises.  In addition to uncertainty relating to tax policies, regulation, and labor union unrest, the setting up costs are of legendary proportions.  There is a story of a tourist resort in the southern Peloponnese that took 20 years to put together.  A foreign gold extraction investment in Macedonia (North Greece) was delayed over eight years.  Recently, a billion plus investment by a Gulf Arab state near Messologi (Western Greece) was scrapped for dubious environmental reasons.  Still two years into the debt crisis, press reports suggest that the relevant rules and arrangements to facilitate foreign investments are being worked out.  Not surprisingly, Greece perennially ranks very low in the Doing Business tables of the World Bank.  Overall, it will take time and a very determined effort on part of Greek governments and local authorities to convince foreign investors to establish green field operations in Greece.

Looking back it is clearer now that the Troika plan to resolve the Greek debt crisis was ill-designed and poorly executed.  Its design flaw was the excessive reliance on fiscal austerity which had an unanticipated contractionary effect on the economy.  The reason for this design was most likely the misdiagnosis of the Greek debt crisis as a liquidity than an insolvency problem.  The plan’s design also suffered from the unrealistic expectation that market and regulatory reforms would generate adequate growth through new investments and exports to offset the impact of austerity on aggregate demand.  The plan was further poorly executed by the Greek government which opted to close the gap by across-the-board taxation that hurt businesses and households.  The ad hoc nature of the revenue enhancement measures also accentuated the degree of uncertainty, thus damaging the investment climate.  The reluctance to reduce faster and more drastically the size of the public sector and proceed with a reliable and fast-track privatization program intensified the misallocation of resources and stymied the private sector’s growth.   As a result, the general view has finally arrived to the conclusion that the Greek debt is insolvent and only its reduction to a size that is compatible with the medium-run potential and capacity of the Greek economy to service it will extricate Greece from the vicious circle of austerity measures followed by more debt.   

Acknowledgements


In writing this short paper I have benefited from the following sources:1.  Various releases of Eurobank Research.2.  Boomerang by Michael Lewis, Norton, 2011.3.  “Can Greece Jumpstart Growth without Bank Credit Expansion?” (in Greek) by
     D.   Malliaropoulos, Eurobank Research, September 2011.
4.  “The Growth of the Greek Economy: Sources, Prospects, and the Role Investments and 
     Exports,” by N. Karamouzis and T. Anastasatos, Eurobank Research, October 2011.
5.  “Economic Crisis and Fiscal Policy:The Case of Greece,” by V. Rapanos and G.  Kaplanoglou, in 
     From the International Crisis to the Crisis of the Eurozone and Greece (in Greek), edited by
     N. Karamouzis and G. Hardouvelis, Livani, 2011.
6.  “Greece and the Fiscal Crisis in the Economic and Monetary Union,” by W. Buiter and E.
     Rahbari, in From the International Crisis to the Crisis of the Eurozone and Greece (in Greek)
     edited by N. Karamouzis and G. Hardouvelis, Livani, 2011.  7.  Greece’s ‘Odious’ Debt by J. Manolopoulos, Anthem Press, 2011.

1 comment:

  1. Anonymous7:29 PM

    Excellent analysis - it will be interesting to see how the balance of the EU members react to the impact of these policies both on Greece and, as they will certainly be needed for many of them, their own economies.

    ReplyDelete