Known Unknowns! Grexit or Austerity?

Varoufakis, Greece’s ex-finance minister, is a professor of mathematical economics who specializes in game theory. But, his negotiating tactic was quite the opposite of what standard game theory would state. Varoufakis’s idea of a successful strategy was to hold a gun to his head and then demand a ransom for not pulling the trigger. “Stop and pay me, or I will shoot myself.” To put it in context, he threatened his European counterparts to forgive some Greek debt or suffer from a Greek default and exit from the single currency area. Why don’t we take a step back to understand how Greece built up its mountain of debt? It will help us reason whether the demands for austerity being placed by the Eurozone members are fair or unjust. It will also show us why the event of a Grexit has been so uncertain for any so-called ‘Economist’ to predict correctly!

One of the problems lies in the design of the Euro. Usually, when a given country’s economy falters, one of the easiest automatic stabilizers is for its currency to depreciate. Although, this reduces the countries’ real purchasing power, it has the benefit of boosting the country’s exports and tourism. In the Euro, this simply isn’t possible. A country that lacks this flexibility is more likely to suffer a long period of mass unemployment – which is what’s happening in Greece now. For a more in-depth historical analysis of the formation of the Eurozone and problems faced by its members, please read Appendix 1.

“Before the euro, Greece, in particular, was saddled with high interest rates since its economic policies were held in low esteem, and it was widely believed the country would need to resort to devaluations. When the euro came into place, those worries vanished — and, wrongly, were not replaced with worries about Greece paying off its debts — which lead to plunging interest rates for Greek bonds. This let both the Greek government and the Greek private sector go on an unsustainable borrowing binge that created extremely rapid debt-fueled growth. To meet the fiscal requirements to join the Euro, Greece fudged its accounts for many years in the 2000s to paint a rosy picture of its state of the economy. Greece’s actual budget deficits were 6.44% and 4.13%when they needed to be under 3% to be eligible to join the euro [1]. In retrospect, both the borrowers and the lenders should have known better” [2]

Was the Greek debt used for constructively? Let us have a look. The major causes for the astronomically high debts of Greece include the following: –

  1. Excessive government spending:

Greece allowed the wages of the public sector workers to nearly double over the last decade. Moreover, it also had one of the most generous pension payments in the world. Further, the retirement age in Greece is low by modern Western standards [6].

  1. High Tax Evasion:

The government was also unable to fix cases of tax evasions and henceforth could not fund the high outlays of its welfare programs. Since the expenses soared and the revenues shrunk, the balance had to be met through huge borrowings creating a debt trap for the nation.

  1. Access to cheaper capital:

Even before joining the Eurozone, Greece was one of the poorest economies in Europe. Raising capital in its currency (drachma) was difficult on account of the budget deficits. However, by entering, Greece adopted the Euro currency and enjoyed its credibility to secure capital at low rates that, in reality, it did not deserve.

  1. The 2004 Olympics:

Hosting the Olympics in 2004, which cost double the original estimate of €4.5 billion, only made matters worse for Greece. [5]

Thus, the borrowed funds were used to meet the revenue expenditures of the government, particularly for payment of interest on the debts it owed. This led to little or no funds being available for capital expenditure (for new assets) and, therefore, no substantial long-term revenues could be generated in the economy.

“Greece is sitting on a debt of over 300,000 EUR Million in the first quarter of 2015.” Further, “Greece recorded a Government Debt to GDP of 177.10 percent of the country’s Gross Domestic Product in 2014. Government Debt to GDP in Greece averaged 91.96 percent from 1980 until 2014, reaching an all time high of 177.10 percent in 2014.”[7] Figure 1 and 2 illustrate these points.

Figure 1

1

(http://www.tradingeconomics.com/greece/government-debt)

Figure 2

1

(http://www.tradingeconomics.com/greece/government-debt-to-gdp)

The high debt itself isn’t the sole root cause of the problem. Some argue that the crisis also stems in its poor handling. In simple terms:

  • “Greece owed a bunch of money to European private banks that it could not pay. As per Test Tube News, Greece has a total debt of $320 billion. (Break-up of creditors can be seen in Appendix 2)
  • Rather than have Greece default, and then possibly need to bail out their banks, European governments gave Greece giant loans so Greece could pay the banks what they owed.
  • This left Greece owing foreign governments money that it could not pay, which put Greece in a position of political subservience.

This succeeded in kicking the can down the road for several years (no small accomplishment) but it didn’t change the fact that Greece lacks the means to pay what it owes, and foreign governments lack the means to govern Greece.”[3]

Thus, there might be some value in supporting the hardline Greek negotiators in their arguments. It is surely not as straightforward to say that the Greeks need to cut back on spending, bring in a budget surplus and pay back the loans. With negotiation talks breaking down last week, the country has had to declare a Bank Holiday for the fear that most banks would experience a ‘run’ on their deposits. 500 of the 7,000 ATMs in the country ran out of cash over a single weekend, which then led to a daily withdrawal limit of 60 Euros. The government was forced to impose capital controls in the fear of a flight to quality. So, is austerity the only means with which Greece will be able to pay back the 330b Euro in debt that it owes to its neighbour and the IMF?

Agreed that austerity can hold the country’s credit rating it can bring weak promises that the government will have more to spend in the future, but is that enough to give hope to the consumers who face lower pensions and higher taxation? The referendum was a loud and clear voice from the Greek people to reject the austerity demands placed by Eurozone members [Appendix 3 lists out the austerity measures being placed]. It has certainly improved the cards that Greek Prime Minister, Alex Tsipras can play with while sitting at the negotiations with his European counterparts. Germany might be seen as ‘unfair’ if it doesn’t pay heed to the voice of Greek voters. In some cases, Germany is already facing the wrath of global political opinion for letting the situation reach this uncontrollable juncture where the Grexit looks quite likely.

As we write this article, the summary of the discussions on negotiations at Brussels has been released. Hot off the press: “Greece’s future in the common currency remained uncertain despite attempts by France to broker a compromise in the biggest crisis to face Europe since 2012.

Greek Prime Minister Alexis Tsipras looked set to bow to pressure to pass tough new reform laws, including on tax and pensions, and prepare further rapid reforms this month. But he and his creditors remained divided over other key issues, notably the role of the International Monetary Fund and a German-led plan to put up to €50bn in assets into an externally managed fund for future privatisation.

With the leaders’ tempers frayed, it was unclear whether this deal could be implemented in time to satisfy German Chancellor Angela Merkel and other critics to open the way to formal rescue negotiations — or to forestall Greece’s financial collapse.” [8]

The recent developments:

Greece voted a “No” for the bailout on July 5, 2015, demonstrating resistance towards the austerity and other terms of the bailout. The voting was succeeded by rounds of negotiations with other members to get funds through the European Commercial Bank. On July 13, Greece managed a provisional agreement bailout for 7 billion euros with the final prints of the terms expected to be discussed in the subsequent weeks.

The broader picture:

A Grexit ramification would not only be limited to financial and economic implications but also to culture and geo-political dimensions. The entire premise of the very existence of EU as a binding force will come into deep water. Greece has an uphill task to implement the stringent measures of reforms meted to them The Greece workforce has to play a pivotal role in the revival of its economy by enhancing its productivity and quality.

Appendix 1: History of the Eurozone & Debt Crisis:

The countries of the European continent had long strained relationships with its other member nations. After World War II, a dire need was felt to re-unite and re-establish the distressed economies from the damages of the war. With the fall of the Berlin Wall, unification of countries seemed much more probable.

Finally, The Masstrichit Treaty formed the European Union (EU) in the year 1993. Later, on 1st January 1999, Euro was launched as an identical currency for EU nations creating the Eurozone. It aimed to facilitate easier trade across the Eurozone and to lower the risk of exchange rate fluctuations. Out of the current twenty-eight EU members, nineteen members form part of the Eurozone.

The Eurozone Crisis:

It is the debt crisis that is being faced by several Eurozone members. It is the failure of the common Euro currency that ties together major European countries in an intimate but inconsistent manner.

Though a unified European Commercial Bank (ECB) was instituted to take care of the monetary policy, there was a lack of one consolidated fiscal policy. Many European countries are different from each other in ways of language, culture, customs and their economies structure. Hence, harmonious fiscal policies of the governments were required to acknowledge this diversity.

Further, with the joining of Greece, easier and more credit was available even to the weaker and debt-ridden economies viz. Portugal, Ireland, Italy, Greece and Spain (PIIGS). And it was believed that even if such economies failed to deliver, stronger economies like Germany would chip in and save the poor countries from bankruptcy.

As against Germany’s stringent policy regimes, indebted countries failed to maintain fiscal discipline and lavishly spent on retirement programs, employment allowances, etc. Moreover, funds were not directed towards the creation of new assets but were used up in meeting revenue expenditure. Further, on account of the relaxed lifestyles of the people, productivity decreased thereby contributing less to the economic output.

With a single currency across most of the European nations, lending became easier and, in no time, threads of businesses got intertwined in the whole of the continent. With the sub-prime crisis of 2008, easier credit was not made available to such weak economies. Defaulting in Asset generation and soaking more credit even for already borrowed money; the overall value of Euro got depreciated resulting in a domino effect.

Bail-outs were possible in conditions of strong fiscal austerity measures. However, due to political reasons and easy working lives of the people of these economies, austerity measures are not seen as effective. Moreover, these measures work only a tad bit as less of government spending means less of tax collection from the citizens and less of economic activity for the nation.

Appendix 2: Greek Debt by Creditor

  1. 47% ($150 billion) to European Financial Stability Facility (EFSF)
  2. 22% to Banks (European Central Bank, International Monetary Fund & Treasury Bill holders)
  3. 19% to other Eurozone Governments and
  4. 12% to Private investors [4]

Appendix 3: Austerity Demands

  1. Targets for government budget surplus, to 1, 2, 3, and 3.5 %of GDP in 2015, 2016, 2017 and 2018
  2. Value-added tax changes intended to bring a net revenue gain of 1%of GDP on an annual basis. This would:
    • Unify VAT rates at a standard 23%, which will include restaurants and catering
    • Include a reduced 13% for basic food, energy, hotels, and water
    • Include a “super-reduced rate” of 6% for drugs, books, and theater
    • Eliminate discounts, including on islands.
  3. Pension related commitment to legislation to discourage early retirement
  4. Raising corporate tax rate from 26 percent to 28 percent
  5. Introducing a tax on television advertisement
  6. Extending tax increases on luxury vessels

References

[1] “Real reasons behind the Greek crisis: inefficiency and a fudged budget deficit”. http://www.brisbanetimes.com.au/comment/real-reasons-behind-the-greek-crisis-inefficiency-and-a-fudged-budget-deficit-20150706-gi5xca.html#ixzz3ffbm7yMC

[2] and [3] “11 things about the Greek crisis you need to know”; http://www.vox.com/2015/6/30/8868363/greece-crisis-default-austerity

[4] “Why Does Greece Have So Much Debt?”

https://www.youtube.com/watch?v=i9fPrSMlkn0&feature=youtu.be

[5] “Greece: why did its economy fall so hard?”

http://www.telegraph.co.uk/news/worldnews/europe/greece/7646320/Greece-why-did-its-economy-fall-so-hard.html

[6] “An Idiot’s Guide to the Greek Debt Crisis.”

http://abcnws.go.com/blogs/headlines/2011/11/an-idiots-guide-to-the-greek-debt-crisis/

[7] Tradingeconomics.com

(http://www.tradingeconomics.com/greece)

[8] Greece’s Eurozone future uncertain as Germany steps up pressure

http://www.ft.com/intl/cms/s/0/8681a02a-287d-11e5-8613-e7aedbb7bdb7.html#slide0

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