Greece – Who's At Fault?

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 20^th 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:

1. 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;
2. 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.
3. 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;
4. 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.