Sunday, November 27, 2011

Living in Default: The Greek Debt Crisis and the Future of the Euro

The crisis over how to resolve the excessive debt of peripheral countries within the Euro zone, especially the case of Greece, seems to drag on incessantly. Presumably a new decision will be taken by the next EU summit on the 23rd of this month.  In the meantime opinions proliferate.  As is often the case the majority of opinions in circulation are little more than ill-informed political slogans.  What is needed, of course, is a comprehensive analysis of the background to the crisis and commentary on alternative ways forward.  Having lived and worked in Greece for much of the past four decades, perhaps I am in position to provide such an analysis.

Greece has had a history of debt problems.  It was a country that was born into debt at the time of its emergence as an independent nation after the revolution against the Ottoman Empire in 1821.  After World War II there was a period of economic stability and growth. However, in !967 a coup resulted in a 7 year dictatorship. And following the reestablishment of democracy in ‘74 an unfortunate trend took hold in favour of populist policies and state intervention in the economy.  Most observers blame Andreas Papandreou for this legacy, but in fact both major parties have contributed to the process. 

The first Prime Minister following the dictatorship was Konstantin Karamanlis, the leader of the conservative New Democracy Party. His government prosecuted a case against a banking and industrial group (Andreadis) and nationalized two large banks and a large shipbuilding facility.  When Andreas Papandreou[1] came to power in 1980 he began a wholesale ‘socialization’ of vast sectors of the economy. Since then Greece has remained one of the most Statist economies in Europe. In fact many economists consider Greece to be the last bastion of an Eastern European styled, state run economy.  At numerous times since then there have been proposals to privatize state owned companies, but very few privatizations actually took place.  And despite the fact that over the ensuing three decades power shifted several times between conservatives and socialists, this extended public sector realm remains in tact.  A local newspaper recently commented that we have in effect had a shared political leadership between the party in power and the unions of the state run companies.

Over the course of nearly four decades (i.e. since the collapse of the military dictatorship and the return of democratic rule) the Greek economy ran twin deficits, both a public sector deficit and a negative trade balance.  During the ‘80s and ‘90s some discipline was provided by the markets and by the programs established in accordance with membership in the European Union.  So the deficits were held within limits during those years, but the structural trend was never reversed.

Maastricht and beyond
The Maastricht Treaty, which established the rules for the Euro currency, is considered either as a visionary plan for Europe or as a poorly designed project for currency union, depending on one’s perspective. The latter view is more prominent today because of the crisis at hand.  At the time there were ample critics to point out the flaws in the project.  The EU included members with greatly divergent economies.  So it was obvious that any country joining the Euro should be subject to scrutiny.  The Maastricht Treaty dealt with the problem by proposing to permit entry only to those countries with a public sector deficit of less than 3% and total public sector debt of less than 60% of GDP.  In practice these criteria were relaxed to allow countries such as Belgium and Greece with debt to GDP ratios of more than 100% to enter as long as their trend was positive.  Popular support for the Euro project was weak in more developed countries[2] but strong among the weaker, peripheral economies.  

The Simitis’ government devalued the Drachma in ’97 and began an earnest attempt to impose discipline on the Greek economy in preparation for the country’s entry into the Euro in January 2002.  This austerity program was largely successful with the result that the public sector deficit was brought under the 3% barrier, inflation was tamed and the Drachma actually appreciated to recover about half of the value lost in the devaluation.  Still there were few structural reforms of the economy aside from the banking sector. The debt ratio remained above 100% and interest rates on the Drachma remained high, declining from double digits at the beginning of 2001 to several points above the European average at the end of the year.  And yet Greece entered the Euro on schedule January 1st 2002.

Following Greece’s entry into the Euro club it was clear that there was a need for an extended period of careful economic management toward convergence with more developed European economies.  Unfortunately that never happened.  A strong trend began within the Euro zone where interest differentials between national economies began to decline sharply.  This trend was known in the markets as the ‘convergence play.’  So the rates charged on government bonds of the various Euro zone nations began to decrease.  For Greece the premium over Deutsche Bunds declined from nearly 200 basis points (2%) to just over 10 (one tenth of a percent).  The assumption was that the Euro economies would naturally converge and that there was an implicit guarantee that a country within the Euro would not be allowed to default.  But during this period of easy credit under the influence of this convergence play no global institutions emerged other than the European Central Bank (ECB).  And national governments were only loosely monitored to ensure true economic convergence.

So Greece failed to implement the necessary reforms; easy and cheap money was readily available to fund the ongoing twin deficits.  The economy grew at rates well above the Euro zone average, but all of the growth was based upon borrowed capital.  And then the banking crisis of 2008 struck.  Suddenly markets realized that risks too need to be managed.  And traders came to understand that money could be made through short positions as well as long, as described in Michael Lewis’s book, The Big Short.  Since then the Greek economy has been under pressure.  Capital was no longer available, so Greece had to turn to its Euro zone partners to service its existing debt.

Populists and Pundits
From the moment the current PM, George Papandreou, was elected in the fall of 2009 and discovered that the public sector deficit had risen to 15% Greece has been under EU support and supervision.  But the EU and more specifically the Euro zone countries have pursued a muddling though policy trying to deal with the crisis piecemeal.  Greece has endured a severe recession for two years now with no end in sight. 

In part the problem stems from populist politics.  In Germany the idea of bailing out profligate countries is anathema.  Yet as the crisis subsequently spread to Ireland and Portugal and now threatens Spain and Italy, pragmatism suggests that something needs to be done to stem a major systemic tremor across the EU and the world.  In Greece the government has managed to pass legislation to finally commence economic reforms and a privatization plan.  But they have been slow to actually implement these policies.  What they have done is to decrease public sector salaries and pensions and increase taxes.  But these measures have merely exacerbated the recession.  The fact that economic convergence can never take place without growth seems to have escaped the collective consensus among European leaders.

Discussion now centers on the sudden realization that the level of Greek debt is not sustainable.  In fact without growth no national debt in any economy is sustainable.  So in July the EU approved a new plan for Greece that included a voluntary program for banks to forgive 21% of their holdings in Greek Government Bonds (GGB).  That agreement is now seen as inadequate, so discussions are underway to increase the write down of Greek debt.  Of course there is a nasty detail that raises its ugly head under such a scenario.  The banks that hold this debt, banks not only in Greece but across Europe, will sustain heavy losses and require new capital to remain solvent.  So the debt crisis will morph into a banking crisis.

There are two issues to consider here.  The first is why the banks accumulated such large concentrations of Greek debt.  In fact it was the result of faulty regulation.  Under the rules for capital adequacy for banks exposure to OECD governments in the same currency were deemed to be risk free.  So banks were able to stock up on the debt of peripheral economies within the Euro zone without consideration of risk.  And up until 2008, while the convergence play was the vogue, banks earned nice profits on those positions.

Many may feel that it would be appropriate to simply allow the banks holding GGBs to fail.  I belong to a minority of the progressive community who believe that to be a mistake.  The problem is that the banking sector is the best conduit to economic growth and depression as well.  The reason is that banks stand at the center of the so-called multiplier effect.  When deposits increase at banks, loans to companies and individuals increase many times over.  Likewise when banks collapse depositors lose their capital together with the capital of the banks themselves and this creates a tsunami effect through the real economy.  So, in spite of public opinion and demonstrations against bank bail outs, at the end of the day banks will most assuredly be recapitalized whatever the costs.  The curious thing is why European leaders would prefer to recapitalize banks rather than provide the capital necessary to support the convergence of the peripheral economies such as Greece.  The answer to this lies in populist politics.  The same was true during the mortgage crisis in the US.  No one wanted to support the ‘poor schmucks’ who couldn’t pay their mortgages.  But when the banks came under pressure from their foolish and fraudulent practices ample capital was available to save the day.
Pundits are as always readily available to offer opinions during crises.  To be fair some of the opinions circulating in the blogosphere are well reasoned.  But others go off the deep end.  One of the more radical opinions is that Greece should unilaterally leave the Euro and resurrect the Drachma.  That would allow the country to devalue its way to competitiveness and to maintain its national sovereignty.  This view is terribly short sighted.  The devaluation that would be required before reaching some stable level has been guestimated to exceed 50%.[3]  And even after devaluation, Greece would still require an extended period to reform its economy.  Capital for growth would not be available from the market without such reform.  Moreover there is no appreciable support in Greece for the idea of exiting the Euro.  And the issue of economic sovereignty is bogus.  A currency union must entail some measure of common policies and institutions.  The failure so far within the Euro zone has been that such policies have not been implemented.

The Road not Taken
The fact is that the Euro currency has been in place for a decade now and despite the current crisis it has in many ways been successful.  If European leaders allow a Greek default, the crisis will almost surely spread to other peripheral economies.  Markets will rightly surmise that there is a lack of political will to defend the Euro area in its entirety. Consequently they will intensify an attack already underway against Portugal and Ireland and quite probably then Italy and Spain.  A break up of the Euro zone would be a very messy affair.  Public opinion in Germany is toying with the idea that Germany should bring back the D Mark.  But, if they were to do so, the new D Mark would appreciate so rapidly that it would bring about a sharp recession in Germany and in any countries which chose to follow suit and peg their own new currencies to the Mark.  The former German PM, Helmut Schmidt, made exactly this point in a recent interview.

The most promising way forward on the contrary is to strengthen the Euro zone.  So the real question is how to achieve the strengthening of the Euro zone economy.  The starting point would be to recognize that all outstanding Euro zone debt is a reality.  Trying to play games by writing down that debt as an exception for Greece only to necessitate recapitalization of banks is frankly a back-assed forward means to resolving the crisis.  The appropriate thing to do is to replace all outstanding government bonds within the Euro zone with Euro bonds backed by the ECB and the combined governments of the currency union.  (A watered down version of this solution was floated in fact, whereby such bonds would be issued up to 60% of the GDP of Euro zone economies, but the proposal fell upon deaf German ears.) 

This Eurobond mechanism would, of course, need to be linked with a parallel process to create and enhance Euro zone institutions.  Let me summarize briefly the institutions needed to move the collective Euro zone economy forward.  First the ECB should have its mandate revised to include a bias in favour of growth as well that of being a guardian against inflation.  Second, a Ministry of the Euro Area Economy should be created.  All national budgets would be approved and monitored by this super sovereign ministry.  Unemployment insurance must be administered across the zone to ensure that regions which temporarily have high unemployment, such as Spain and Greece today, are provided with insurance without burdening national budgets.  Similarly public pension programs across the zone should be merged and monitored to ensure stable income to pensioners in times of crisis, but also to ensure that the pension funds remain actuarially sustainable into the future.

Of course, there will be resistance to such new policies.  But allow me to suggest that it is the only viable way forward. Of course, there must be plans to reform profligate national economies such as Greece.  But if such reform is not supported by the necessary transfer of knowhow and capital, but instead by naked austerity, then the peripheral economies of the Euro zone will enter a downward spiral of recession.  The recession in the periphery will eventually infect the stronger European economies.  And, the common currency project for Europe will end in disaster.

While the policies and institutions needed to shore up the future of the Euro are unpopular, they are precisely those that eminent economists recommended when the Euro was launched.  But given the imminent economic downturn and the state of public opinion, only visionary leadership will be capable of dragging the people in tow in the direction of resolution and renewed growth.  Unfortunately it is hard to be optimistic when one surveys the quality of leaders in Europe today.  We are probably in for a rough ride.  And October 23rd will most likely come and pass without a comprehensive resolution of the crisis.

[1] Andreas Papandreou was the leader of the socialist party, the Pan-Hellenic Socialist Movement, PASOK. He was the father of the current PM, George Papandreou.
[2] The French narrowly approved the Treaty in a referendum known as the ‘petit oui.’
[3] Some pundits have actually said more than 100%, but it is impossible to devalue a currency by more than 100%.