What I've read about Greece in both the mainstream media and social media has left me feeling frustrated. Much of it is written from a dug-in perspective of who is more at fault –
Greece, or Germany? This is far too simplistic of a dichotomy. I've
also read a number of conspiracy theories involving the EU, the IMF,
and the other usual suspects. I normally shy away from writing about national or global political issues, but I decided to make an exception as the core issues are more economic than ideological. It also helps me process my frustrations caused by all of the misunderstanding,
half-understandings, and misinformation being spread about.
Background – the
Greek Economy prior to 2001
Many countries have their own preferred ways of
doing things. They come with pro's and con's that look strange to
those outside their borders, but this is a universal truth. Many Americans look askance at Spaniards for their afternoon siestas, and many Spaniards in turn think Americans are soulless workaholics. The modern
Greeks have had an idiosyncratic way of dealing with taxes: for the most part they don't pay them.
How does a government survive if their
expenditures chronically exceed their tax revenues? By printing
money to cover the gap, which is exactly what Greece did when they
had their own currency (the Drachma) prior to 2002. Printing money
in such a manner creates inflation, which has also been referred to
as the “invisible tax.” Real wages and savings accounts are
correspondingly reduced, and interest rates and exchange rates are
adjusted accordingly. Isn't this worse than just taxing the
populace? Most other developed economies seem to think so. Earlier in the
century John Maynard Keynes theorized that inflation didn't have to
be an economic negative if it were just a universal shifting of a
“numeraire” (think decimal point). Real world experience has
repeatedly proven otherwise. Inflation (and expectations of
inflation) reduce investment and capital formation, which in turn
reduce job creation, real wages, and personal income, which in turn
reduces GDP and general welfare. This makes intuitive sense, and
anyone who remembers the U.S. economy of the late 1970's and early
1980's doesn't need much proof beyond that. Counties are better off in
the long run if they balance their budgets without printing more money to do so.
Prior to joining the EU, the Greeks were perennial inflators. The Drachma
drifted ever downward, sometimes in a particularly abrupt fashion
around political events and other periods of high drama. But at
least this worked after a fashion until Greece could no longer print
its own money.
Enter the EU
The European technocrat class which essentially runs the governments
of Europe have been floating the notion of a European Union since
the end of the Second World War. As the United States of America
gained world ascendency as an economic power in the first half of the
20th century, it was natural for Europe to consider
emulating its success. European leaders saw some of the necessary components to emulate this success
as:
The
creation of a single currency;
The
removal of intra-European tariffs and borders;
Allowing
citizens of any country in the union to travel, move, or work in
another.
These
technocrats were right in the sense that all of these factors would
improve the economies of most if not all members of the union and in
turn vastly increase the economic output (measured by GDP) of the
whole. What they did not
take into account is that economic union is not truly feasible
without political union. Americans discovered this truth with their own failed attempt to create The United States of America Version 1.0, otherwise
known as the Article of Confederation. This union avoided the issues posed by federal government (e.g. how to keep both
Massachusetts and Virginia happy? How to balance states' rights and federal powers?) by essentially not creating a credible federal government at all. They skirted these issues and failed, and the EU seems to have made a similar choice in creating EU Version 1.0. United States Version 2.0 defined a creditable Federal government within the context of semiautonomous states. Europe most likely faces a similar inflection point in its future.
The
economic essence of a Federal government isn't just to print money
per se – it's to determine jointly how to spend it. An economic
union can only have one currency, and that's one of its major
benefits. But with that, the entire union can only have a single
monetary policy: individual states and/or countries can't print
their own money. This also mandates that the union must agree on a
single fiscal policy (e.g. taxes and expenditures) at a federal
level. This is where things got dicey, and arguably unsustainable,
in Europe.
The
core of the problem is that fiscal union implies true political
union, which 1000 plus years of European history demonstrates that
Europeans most definitely do not want. Germans, Italians, French,
Spaniards, and Greeks do not share core political values. They don't
envision their governments running the same way, and this goes way
beyond the differences Americans experience among their State
governments. Our states cannot print their own money so they are
required to run balanced budgets. They can borrow to a limited
extent, but the debt markets and the states' citizens limit the scope
of deficits an individual states can run for how long. Since there
is a single currency, these is only one inflation rate for all 50
states. The level of inflation is determined on a national basis, so
it cannot be used as a policy variable to bail out any given state from its budgetary issues.
The
technocrats realized the physics of this problem and tried to address
these issues mechanically. In the five years leading up to the EU,
individual countries were required to meet fiscal goals and
thresholds (inflation, budget deficits levels, etc) as they synced up and joined hands. This was to prevent any one state or economy
from experiencing too much economic shock if the Union differed too
much from what came first. The idea was that the Germans had to
accept slightly more inflation than they wanted to, while the
Italians, the Spaniards, and – yes – the Greeks – had to
tighten up their budgets to accept less. During this “ramp up”
period allowances were made for what was felt to be the common good.
Also, numbers were fudged and books were cooked all in the name of
the greater good, and the details would be dealt with
later. After all, the reasoning went, the size of the weaker
economies was so much smaller in aggregate than the stronger
economies that the anticipated wealth gains of forming the union may
more than subsidize the various shortfalls of the poorer countries.
So
from the outset the braintrust behind the European Union anticipated
that Spain, Portugal, and Greece, to name but three countries, would
have struggles. This was ok and not necessarily symptomatic of failure, just as
Mississippi and Arkansas being poorer, than say California or Texas
doesn't signal a failure of the U.S. model. The most important
problems that emerged stemmed from the fact that the European
countries were pretending they didn't need to get married even though
they moved into the same house and merged checking accounts.
The
problems weren't just among rich and poor. Germany, France, and
Italy have very different ideas of how their countries should be run.
Germany favors near-zero inflation, high savings rates, and
balanced budgets. Italian government is almost an oxymoron. Prior
to the EU it was a controlled cycle of continual collapse, featuring
higher inflation, occasional currency devaluations (nature's periodic
way of dealing with a government's denial of fiscal reality), frequent labor battles, lax work rules, etc. France was somewhere in
between. Actually, the French economy was far stronger but the
French also saw no reason to run zero deficits when they could essentially
free-ride off of Germany's uber-conservatism given the
opportunity. Yearly budget cycles were filled with accusations,
apologies, and allowances by the respective governments. Germany
realized it had to accept a tradeoff. Yes, they were being taken
advantage of to a certain degree by the other EU members (both strong
and weak), but they were effectively kings of a much larger kingdom
than they would be on their own. There was also nothing
inappropriate in the notion of the richer countries subsidizing the
poorer countries in the interest of the whole, as this is what all
countries do within their borders in dealing with their “poorer
relations.” Yes, Spain and Portugal were poor, but their labor
force, natural resources, etc contributed to the welfare of the
whole. This disparity in of itself, nor the resulting chronic
deficits of the poorer countries did not create a crisis per se, at least initially.
So What Happened?
Greek
fiscal policy was markedly different from that of other poorer EU
countries pre-union. While Spain and Portugal were similarly poor,
their countries collected a respectable amount of tax revenue given
their levels of economic output. Once the EU was formed, nothing
about Greek culture magically changed, faked metrics pre-2002
notwithstanding. Greece was running its “normal” budget
deficits only they could no longer print money to cover the balance.
What to do?
They
had two options. First, they could beg the EU for charity, and they
did so. This was not a terribly promising avenue for several
reasons. First, since the EU did not have a real federal government,
there was little or no federal budget, taxing authority, etc. The EU
could print money, but only under a tightly controlled regimen
decided by all. Germany had a very strong say in the vote and
Germany simply hates inflation of any kind for any reason. So there
really wasn't much official monetary or fiscal mechanism to provide continual charity on
a scale that would solve Greece's annual budgetary problems.
The
other answer was for Greece to borrow. Here's where the real trouble
started. In an ideal world, Greece's borrowing capacity should have
been limited by their overall creditworthiness. If an borrower starts to borrow more and more, their ability to find new lenders should diminish. Lenders need to believe there's a decent chance of
getting paid back, and they understand how to underwrite properly or
they'll fail. Underwriting involves fully understanding the balance
sheet (i.e. current state of assets and existing loans), and income
statement (i.e. budgets - tax revenues vs expenditures, this year and
ongoing). After a point too much borrowing should have been a red flag
which cut Greece off from future lenders.
So how
did this not happen sooner? Four reasons:
The
power of sovereignty. Sovereign (government) debt is its own
category. I won't go into the full history, but governments are
generally considered to be excellent credit risks. Even still,
entities within the countries (e.g. states within the US) are
credit-rated just like private companies because they cannot print
their own money. If they borrow too much relative to their ability
to tax, their credit rating goes down and their debt becomes lower
quality – degraded sometimes to junk. The interest rate these
entities have to pay goes higher and higher until finally they can't
borrow anymore at any price. At a certain point, the markets should
cut off even sovereign nations or states;
Strength
of Currency. When Greece was outside the EU, their debt was issued
in Drachmas. This scared lenders off even more, because everyone
knew the government could (and often did) devalue the currency and
reduce what they had to pay back. Now that Greece was in the EU,
this risk was taken off the table. Debt denominated in a strong
currency (Euros) had a much richer and deeper market.
Implied
Guarantee. Greece was now part of the EU. Would the EU allow a
member nation to default? The results could be catastrophic so
surely the stronger countries – which were SO much bigger than
Greece – would step in. Since the size of the economy of
the EU is roughly similar to that of the US and the size of the
Greek economy is about the size of the city of Miami, this
seemed like a “no brainer” from an investor's (i.e. lender's)
perspective;
Derivatives
which shield transparency. Several investment banks – most famously Goldman Sachs – devised ways to issue derivatives which provided
funds to Greece yet made it difficult for all of the lenders
involved to see the true amount they were lending in aggregate.
How
should Item 4 be possible? An entire book could be written on this
subject, but suffice it to say that a great deal of the world's
investment funds were (and still are, unfortunately) managed
relatively robotically by people who don't understand nearly as much
as they should. Many of the professionals investing for banks,
governments, mutual funds, and large institutions are constrained by
fairly basic rules concerning:
Who
the issuers are and what they're rated by the major rating agencies
(e.g. S&P, Moody's, Fitch). Sovereign debt often has it's own
categories. Prior to 2008, many of the countries in the EU were
automatically placed in or among the highest categories without
qualification;
What
currency the debt is denominated in? Greece issued debt in Euros.
Strong currency – check!
What
the maturity of the debt is (i.e. how many years do the loan go
out?). There was nothing unusual or alarming about the Greek debt
maturities/schedules.
What
is the interest rate? The higher the interest rate in a given
credit bucket, the more attractive a given bond looked. Greek debt
was in a fairly high credit bucket – right until it wasn't – yet
the interest rates were very attractive relative to other EU
countries. This attracted even more willing investors.
Investor
groups often act as a herd. If one major European bank accepts the
risk of Greek debt, then it is easier for the rest to follow suit.
The more who do so, the easier it gets. If everyone is wrong, then
nobody is wrong and no one entity can be blamed .
European institutional investors decided as a group that they were
comfortable with Greek debt.
In 2008
as the world economy teetered on the brink of collapse, European
commercial banks were suddenly made aware that the total amount of
Greek debt outstanding was many, many orders of magnitude greater
than any of them had realized thanks to the magic of Goldman's
derivatives. The recommended course of action when a bank or any
other entity is the subject of fraud (which this de facto was from
their perspective) would be to write off the debt and move on, only
they couldn't do so. Since they had categorized this debt as “among
the highest grade”, the prospect of it becoming immediately
worthless – on top of all of their other losses and demands –
became life-threatening. The EU and other world governments got
involved because the prospect of this Miami-sized economy defaulting
was suddenly transformed into a global systemic risk. This was not
so dissimilar to the concept of a gaggle of subprime U.S. borrowers
bringing down the global economy, which nearly happened at about the
same time.
The
lenders patched together a temporary solution:
The
EU would print money, grant aid, and roll over the debt;
Nobody
would call in their debts;
The
global banking community would continue to treat these assets as
higher-quality current-pay performing debt - even though it most
certainly wasn't anything of the kind - so no individual entity
would be forced to incur capital-draining write-downs.
The
latter was extremely important because had they not done so, a number
of major European banks, and perhaps some government central banks,
would reach critical capital levels which could trigger all sorts of events –
default, shut-down, liquidation, etc.
Over
the next several years, the various authorities worked to deleverage
the problem. Much of this toxic debt was transferred in one way or
another from private institutions to public ones, and to stronger,
well-capitalized public ones. At this point if Greece defaults it is
very unlikely to trigger a global financial meltdown.
So What Now?
Here's
where my narrative may veer somewhat toward opinion, but that is
inescapable.
The
word “austerity” is continually evoked as if it is a binary
concept. Greece must either tighten its belt, balance its budget by
limiting spending and collecting taxes, and then in turn make good
every dollar of obligation it borrowed; or, Greece must shed the
shackles of the bankers who enslaved it and boldly move forward to
seize its destiny. Both positions are more rhetorical than
practical.
I think
it makes sense to start at the root of the problem and understand how
we got here. At its core Greek citizens have a dysfunctional way of
(not) funding the level of government services it desires. I'll
start by positing the notion that all economic problems are easier
when there is more money to go around. Staying in the EU creates a
far wealthier Greece than one who reissues the Drachma and attempts
to go it alone. So a compromise could be crafted along the following
terms:
Greece
should (mostly) pays its way forward. I placed the word “mostly”
in parenthesis, because this should be in the same sense that
Mississippi or Louisiana “mostly” pay their own way. They
collect taxes and do not run chronic state deficits, but they
receive more resources from the Federal Government in aggregate than
they put in, and that's not necessarily a bad thing. Greece should
receive some form of base subsidy from the EU, but it should be some
manageable percentage of its GDP, tax base, or whatever set of
metrics make sense – far, far below current levels. A line has to
be drawn from this point forward. The old ways of chronically not paying for
government services have to end. That being said, Greece should not
be made strictly “pay as you go” as this will create a vastly poorer, and far less stable Greece which is no one's best interest within or outside of its borders.
The
mountain of bad debt that was created as a result of a collective regional and
global failure. Greece should not (and cannot) bear this alone. By
my calculation, Greek debt is trading at approximately 70 cents on
the dollar which indicates that by one mechanism or another –
default, devaluation, delay – that's how much the market thinks
investors are getting paid back. Let's start by setting a goal of
writing off 30% of the debt and come up with a plan of which
combination of governments and global organizations, and Greek
participation to the degree that is realistic, foot the bill.
A
good deal is defined by one that makes all parties better off,
but also requires that they accept some things they'd prefer not
to. Greece is clearly better off in a deal structured as defined
above than they'd be otherwise. There are theories put forth that
the EU would be irreparably harmed by a Grexit, but the logic sounds
eerily similar to the “Domino Theory” that kept the U.S. in
Vietnam for 10 years and tens of thousands of lives longer than
it should have been. Austerity per se is not the long-term solution
to Greece's problems, but basic fiscal responsibility is. A pure
“austerity-based” solution to the problem makes even less sense
than did demanding excessive German reparations after World War I, which is
somewhat ironic.
So,
on the whole it makes sense for the Greeks to stay in the EU
provided they meaningfully embrace the concept of fiscal
responsibility on a going-forward basis just as every other
legitimate nation-state does. They need to understand that it is no
longer 2008 and that they cannot frighten the world into dictating
terms. If they decide to drive the car off of the bridge, they are
going to be the only ones hit by the splash.
It
is imperative that the Greek government comes up with a sensible
budget and fiscal blueprint, and that there be objective milestones
and metrics put in place to monitor progress. That being said, there
is no plausible way for the existing debt load can be dealt with via
austerity alone. Greece needs to be released from “debtors prison”
provided they present a sensible plan to avoid ending up there again.
They should have some role in the paying of legacy debt, but it
should be a realistic and pragmatic role relative to the size of
their economy going forward and the size of the overall problem. To
do otherwise just ensures future failure.
