The Greek Fiscal Crisis - Silver Lining?

December 2009, Update May 2010

Just two months ago the Greek Socialists led by George Papandreou won a land slide victory over the conservatives. "Five years of Conservative rule and nothing to show for it" thought the people of Greece. But was that because the conservatives were too conservative, or not conservative enough?

In Greece corruption is not limited to the business world, it even infects government statistics. Each incoming government unpicks the accounting tricks employed by the last administration, revealing ever deteriorating public finances, before concealing further rot behind new lies. Perhaps still proud of their ancient past, the Greeks are compelled to blinkered self flattery. Wake up people of Greece, its time to face the music.

This year the budget deficit is projected to rise to 12.7% of GDP, although the gap between truth and reality in Greece makes this number far more likely a floor than a ceiling. Some other Eurozone member states are running deficits of this size, but none of them combine it with a government debt-to-GDP ratio of 120 per cent. Greece, therefore, is clearly the Eurozone's economic basket case, and creditors are right to be scared. Add to this an uncertain world outlook, a credibility issue brought on by dishonest economic statistics, a new socialist government; and that fear is in danger of turning to panic.

Normally governments depreciate their currency and inflate their way out of debt, a trick Greece has regularly employed in the past, but inside the Eurozone such action is impossible. Years ago government bond traders used to marvel at a story which crossed their Reuters Terminal, day in, day out, for several years running: "Greek Bond Yields Narrow vs German Bonds". Now the same old story is playing in reverse - and 10 year Greek Bonds are already trading around 2.5% higher than their German counterparts (higher in yield, lower in price). As the yield creditors demand on Greek Bonds increases, the cost to the Greek Government of financing new debt increases, making default more likely, further increasing the yield in a vicious spiral toward default.

It is hard to overstate the degree of this crisis, this is economic history in the making. “It’s five minutes to midnight for Greece,” Former Bank of England policy maker Willem Buiter said in a Bloomberg Television interview recently. “We could see our first EU 15 sovereign default since Germany in 1948.” On the back of these sentiments the Greek ASE General Stock Index has fallen 38% in the last month.

Will the EU rescue the Greeks by lending them a great deal of cheap money? Aware of the horrendous moral hazard and the vast cost such a rescue could entail, the founders of the Eurozone created a rule which expressly forbids any member state providing loans to another member state to cover budget shortfalls or bridge deficits. Of course the rules can be changed - but only very very reluctantly. What about abandoning the Euro? Defaulting on its Euro debt and launching a toilet paper currency is the worst possible outcome for Greece and to be avoided at all costs. Will the Greek government implement draconian spending cuts to head off default? This would be the very opposite of what the new Socialist government promised at the election - in fact campaign pledges include real wage increases and extra social benefits for low-income households. Of course there is vast pressure being applied to Greece both by the market and by the EU to achieve credible cuts, but can democracy really deliver?

Explaining the fall of democratic Athens, which occurred in spite of its vast wealth during the 430BC Peloponnesian War with authoritarian Sparta, the historian Thucydides wrote:

Pericles indeed, by his rank, ability, and known integrity, was enabled to exercise an independent control over the multitude--in short, to lead them instead of being led by them; for as he never sought power by improper means, he was never compelled to flatter them, but, on the contrary, enjoyed so high an estimation that he could afford to anger them by contradiction. Whenever he saw them unseasonably and insolently elated, he would with a word reduce them to alarm; on the other hand, if they fell victims to a panic, he could at once restore them to confidence. In short, what was nominally a democracy became in his hands government by the first citizen. With his successors it was different. More on a level with one another, and each grasping at supremacy, they ended by committing even the conduct of state affairs to the whims of the multitude... [many blunders then led to total military defeat]

Today democracy is in trouble again, and, by bizarre coincidence, Athens again leads the fray. Nevertheless, Greece is hardly alone. California's radical experiment in direct democracy has left it in dire financial straights, yet the Californian economy represents 14% of US GDP, far more than Greece's insignificant 3% share of Eurozone GDP. Inside the Eurozone Greece is the worst offender, but many other countries are facing impending debt crises too. In fact almost the entire developed democratic world faces considerable difficulty, especially as the proportion of retirees increases over the next few decades.

Yet Greece's membership of the Eurozone is bringing her addiction to unsustainable government borrowing to a more rapid climax. The Dollar has strengthened recently, but I see in this crisis a silver lining that could in the long term vastly enhance the reputation of the Eurozone. With most rich democracies facing spiralling government debt I see Eurozone membership as a purging medicine which is forcing early resolution of an illness which could otherwise turn terminal; which is forcing a proper cure not just pain numbing devaluation; and which is treating individual member state cases before a pandemic develops. Countries like Greece and Italy have been rotting under incompetent economic policy making for generations. With China, with climate change, the challenges are only getting that much harder. The cruel disciple of Eurozone membership is the only hope of turning these dieing states around. If the Eurozone members get this right it will put them head and shoulders above the Americans who have no such mechanism to cure them of the modern democratic disease.

Nevertheless, I am not playing down the frightening challenges failing member states will be subjected to. Within the US, if unemployment is higher in Californian than New York, people can move to relive the pressure. Spanish unemployment in the eurzone now runs at twice the average level, but the average Spanish person can not move to Germany due to the differing languages. Ultimately wages and asset prices in Spain will probably need to decline relative to Germany, but wages are sticky and such deflation is notoriously difficulty to accomplish, usually requiring an extreme recession. The problem has its roots in poor economic policy making, yet the danger is that democracy responds to this painful adjustment by piling on yet more manure. The low rate of Eurozone inflation exacerbates the problem because a wage freeze takes years to make a difference.

Yet I still believe this violent medicine can be beneficial. Monetary union without political union is not impossible, it just requires exceptional economic discipline (in all areas of economic policy including fiscal and supply side policy). Asked to list the key benefits of monetary union most people begin by listing the absence of foreign exchange transaction fees, exchange rate stability and low interest rates (as a consequence of the deeper capital market). Then people explain how these factors increase economic efficiency. Yet there is more, the absence of devaluation and the intensification of free trade turns the Eurozone into a vicious economic pressure cooker, an ultra competitive environment which raises game play, the perfect organ of creative destruction. But this Darwinian challenge won’t work if we keep bankrolling failing strategies, instead the Greeks must now swallow the medicine of Economic discipline. This medicine is so powerful, supporters such as myself claim, that combined with the other Eurozone benefits, flexible monetary policy and exchange rates can be discarded. 

So Eurozone membership is forcing the Greeks to adopt better economic policy making. Either democracy will take a more responsible course, or, more likely, certain constraints will have to be put upon democracy. Angela Merkel alluded to this when she was speaking recently at a meeting of the European People’s Party in Bonn and said that EU might have to obtain direct responsibility over the fiscal policy of highly indebted countries such as Greece. How might this come about? The rules forbidding bailouts will probably be changed/sidestepped, and the EU will impose policy on Greece in return for aid - IMF style.

What about the risks of contagion? Will EU politicians be brave enough to let Greece plunge over the cliff, forcing her to radically reform economic policy, because unthinkable default is the only other option? Many believe the EU will prematurely bail out the Greeks as sovereign credit spreads on other Eurozone member states deteriorate. Yet I believe the risk of contagion is containable because Greece's appalling dishonesty justifiably puts it in a totally separate category.

Nevertheless, it is absolutely critical that the EU is seen to be taking the lead, and it must do so quickly, before it is forced into a fire fighting mode. The markets have to feel that the EU is making an example of Greece, that other member states have more support, that the EU is willing to sacrifice the profligate and dishonest Greeks in an awesome display of political courage and will. The fate of Greece, at the end of day, does not really matter much one way or another; the key is to scare Italian voters into more responsible policy making; without that lesson, the Eurozone's long term survival is at risk. Besides, under such pressure Greek voters will save themselves because the consequences of default are so horrendous. Recall the story of Abraham, who was asked to sacrifice his son's life, in a test of his willingness to comply with the will of God. As he lifted the knife, the point was proven, and the Angel of the Lord intervened to stay his hand.

Traditionally it is the IMF which dictates economic policy to failing states in desperate need of aid, but the EU is likely to take charge of Greece's case. The IMF's intervention in Argentina collapsed after popular protest against the severe austerity measures, but I believe the EU would have a much better chance in Greece. First, the EU would wield a bigger stick because the consequences of default are far worse for the Greek people. Second, the EU would certainly dangle a bigger carrot than the IMF did in Argentina. Third, the feelings that would be experienced by Greek voters being dictated to by EU technocrats would be less galling than the feelings once experienced by Argentinean voters being dictated to by more culturally and geographically distant IMF technocrats.

What sticks and carrots should the EU be considering in its dealings with Greece? Beginning with sticks: The EU needs to amend the ECB collateral rules to punish Greek debt asap. In fact the whole ECB funding system needs a shake up, it makes no sense for bonds of different qualities to be treated equally. The EU also needs to make clear that a defaulting state will permanently loose Eurozone membership (personally I think a defaulting state should loose its EU membership as well). Finally the EU needs to announce the implementation of financial penalties, beginning with the suspension of all aid, then escalating.

What about carrots? As long as Greece commits to a stringent rescue program, the EU can lend her unlimited amounts of ultra cheap overnight euro funding structured as a super senior loan (in the event of default this loan takes preference over all other government creditors). When confidence in Greece returns she can repay all the funds by returning to the commercial bond markets, and then be free of the onerous policy. Lay out the whole rescue program in black and white and subject it to a referendum if necessary. Hit as hard as possible in the initial publicity, the more punches are pulled, the harder it will be to maintain momentum when the policy starts to bite and the going gets tough. Also, maintaining public support for a series of increasingly aggressive policy initiatives is much harder than laying out all the gory detail up front.

What should the rescue program look like? It will have a to be a mixture of austerity and reform. Beginning with austerity: the Greek public sector is notoriously overpaid and overstaffed and must be hacked back. Simply set Greek public sector compensation rates and pension ages etc to precisely the same level as in Germany in one vast swing of the axe. What about reform? The goal of the rescue package must go beyond public spending, it must help to rapidly bring about the deflationary fall in asset and wage levels Greece needs to compete. Add in all the Thatcherite supply side reforms that EU economists have been suggesting for so long. Thatcher broke the unions, Merkel won their support, but in Greece the unions are far more likely to break the austerity program. Only one radical policy can ensure Greece's survival - a suspension of the right to strike whilst the austerity program is in place. Perhaps the EU should also mandate an across the board 20% cut in wages and rents. Can a democratic EU behave so aggressively? Yes, because the politicians who will make this decision are elected by voters outside Greece, and the credit crisis tells us how public anger works against those in need of bailouts. The politicians need to use the German taxpayer's anger to toughen the austerity package. Can the Greek people resist? Not if they are made to understand the only appalling alternative.

Why do I believe that if EU officials were to obtain a degree of responsibility over Greek economic policy it could turn around a seemingly intractable situation? Because I am convinced that the economic crisis faced by the West is only the product of incompetent democratic policy making. I believe the gap between our democratic policy making and the best possible policy making is vast. For example, I believe China has not been growing at 10% per year for thirty years running simply because it is catching up with the West, but primarily because it is run efficiently not democratically. By it's dollar peg China has also forsaken flexible monetary and exchange rate policy, yet it grows and grows. I believe that if a panel of EU technocrats ran Greece the country would be rapidly and utterly transformed. Many credit Margaret Thatcher with messianic powers, but she simply applied a few elementary rules of economics, her skill was political, she simply succeeded in enacting a few obvious changes despite democracy (aided by the preceding fiscal crisis and the Falkland's War). Thatcher's revolution was no more than glimpse of the vast potential which would be possible if we could contain democracy.

The EU has a depressing history of political gridlock and failure, but this crisis offers something new which transcends member state horse trading. By liberating the apolitical expertise which exists at the heart of the organisation from democratic politicking the EU has chance to finally perform. To date this expertise has been mostly confined to highly technical concerns, such as trading standards, this new challenge is far more exciting and groundbreaking. Only Agricultural policy is controlled by the EU, some have speculated that poor democratic policy making could be overcome by extending EU competence to Energy Policy, and then other areas. Yet this crisis offers a shortcut. Most radically the EU even has the power to provoke this policy transformation by publicly refusing unconditional bailouts and turning the spotlight onto errant member states to such a degree that the markets and credit rating agencies precipitate a crisis. For politicians in a failing Eurozone state outsourcing policy is far easier than fighting domestic political battles, so the intervention of fellow Europeans may be welcomed if it could be proven to work.

If the EU gets this right it still has a chance to survive the 21st Century, and it will finally achieve the leading role it has always aspired to, slowing the tide of global leadership now heading so quickly toward China. On its shoulders the fate of the Western World may rest.

Update May 2010

So what has actually happened since I wrote this article?

As far as economic policy is concerned, democracy in Greece has indeed been effectively suspended, and an austerity/reform package has been imposed in return for IMF/EU aid. The Prime Minister of Greece has called the the new political model "trusteeship". 

However, the IMF/EU program is less aggressive than the IMF programs imposed on countries such as South Korea during the Asian Crisis. In my opinion, neither the fiscal austerity measures, nor the structural reforms, go far enough. The program certainly does not contain the radical no strike law I suggested.

To what extent did the EU dangle the threat of ejection from the Eurozone over the Greek people? In March 2010 German Finance Minister Wolfgang Schaeuble said:

The eurozone must remain credible... Financial aid from fellow member states must never be taken for granted... Strict conditions must be attached... It must, on principle, still be possible for a state to go bankrupt... Should a member state ultimately find itself unable to consolidate its budgets or restore its competitiveness, this country should, as a last resort, exit the Eurozone...

But his points fell on the deaf ears of politicians such as Nicolas Sarkozy, and commentators such as Gideon Rachman (see Wolfgang Schauble’s Torture Chamber). Pressure was piled onto Merkel, and she capitulated, even against the wishes of the German people. People just don;t understand that the long term survival of the Western world depends on two questions:  Can medicine powerful enough to cure the rot be brewed, and can failing nations be forced to swallow it? Both are now less likely.

The 110 billion euro loan at 5% being offered to Greece is no where near as generous as the unlimited ultra cheap overnight funding I suggested. The trillion euro package announced yesterday is something else again. Buying the bonds of ailing states damages the EU's leverage over errant member state economic policy. I think this move looks irresponsible.

Increasingly commentators are talking about solving this crisis through greater political union. The economies of the Eurozone are diverging as the Darwinian pressures bite, so the problem of one size fits all monetary policy is growing. Worse, if an ailing country runs deflationary policy in order to regain competitiveness, its real rate increases, so Eurozone monetary policy actually works in reverse. Capital markets are in a state of panic, Eurozone members may not be able to borrow at rational rates. Germany benefits from Eurozone membership by selling to its neighbours without exchange rates adjusting, one could argue that it should redistribute some of these gains. I do not disagree with these arguments, yet a powerful enough medicine can cure all ills, we must not allow these arguments to cloud our realization that economic policy must improve. I see advantages in remaining mostly separate for now.

In conclusion, it is not over, but it is not looking good...