Παρασκευή, Απριλίου 29, 2011
Earth to Greece: It’s Over
When a developed, sovereign nation finds itself borrowing at VISA card interest rates, it’s time to declare (really, admit) bankruptcy. With market interest rates on its 2-year notes now exceeding 22%, this is the position that Greece is in today. By making a bargain with the bailout devil to raise taxes in the name of “austerity”, Greece has pitched itself into an economic death spiral from which there is no escape short of defaulting on its debts.
On April 26, Eurostat reported that Greece’s budget deficit for 2010 was 10.5% of GDP, much higher than the Greek government’s target of 9.4%, or even the European Commission’s 9.6% forecast made only two months ago. In what should serve as a warning to the Obama administration, the main cause of Greece’s higher than expected deficit was lower than expected revenue. In other words, the tax increases that Greece piled on at the behest of the IMF and the EU did not work as anticipated. In 2010, the Greek government collected 39.1% of GDP in taxes, which less than the 40.0% it collected in 2007. And, real Greek GDP was 5.2% lower in 2010 than it was in 2007.
Whether it involves Greece or the U.S., politicians, economists, and budget analysts seem hypnotized by “static analysis”, the naïve belief that if you raise tax rates by 10%, you will get 10% more revenue. This superstition leads to “austerity packages” that attempt to reduce budget deficits via combinations of spending cuts and tax increases. If austerity actually worked, Greece would not now be hurtling toward the deficit dumpster, with Portugal close behind.
Austerity is always self-defeating, because tax hikes suppress economic growth, and economic growth is the only thing that really matters to government finances. Here are some numbers.
In 2007, Greece had debt equal to 105.4% of GDP. However, real GDP had grown at an average rate of 4.2% over the previous ten years, and the real interest rate on Greek government debt was only about 1.5%. Looking at these numbers, lenders calculated that the present value of both Greek GDP and Greek government revenues was infinity, and that its debt capacity was infinite. And, back in 2007, the markets pretty much dealt with the Greek government as if it had infinite debt capacity, lending to it all of the money it wanted, at interest rates only slightly higher than those charged to Germany. The important thing to understand is that the markets were behaving rationally based upon the facts at the time.
Fast forward to 2010, and the picture is very different. Greek government debt is now 142.8% of GDP. However, Greece’s economy is contracting at a real annual rate of 1.8% (2008 – 2010 average) and the real interest rate on (10 year) Greek government debt is around 10.0%.
If lenders plugged these numbers into the same model that they used in 2007, they would calculate that Greece could only avoid default if it could devote 17.2% of GDP to debt service. Given that Greece collects 39.0% of GDP in taxes, and currently spends 5.6% of GDP on interest, this would require that they immediately cut non-interest government spending in half, from 43.9% of GDP to 21.8% of GDP. Any rational lender would conclude that this was not likely to happen, which is why Greece is now being financed not by the capital markets, but by the IMF, the EU, and the ECB.
A number of European analysts have suggested that Greece “must not be allowed to default” because “the consequences (mainly to European banks) would be too severe”. If one of these analysts jumped off the Empire State Building and was interviewed as he passed the 50th floor, he would probably say that he did not expect to hit the pavement below because “the consequences would be too severe”.
Even if the EU elites have a desire to continue flinging billions of euros into the fiscal black hole that Greece has become, the taxpayers supplying those euros do not. Political forces are building to put an end to the bailout game. Then what?
Some have said that Greece would be in a better position today if it had its own currency and could devalue. This is purely hypothetical, because Greece uses the euro and cannot go back to the drachma even if it wanted to.
Right now, if Greece were to default on its debt and lose all external financing, it would be forced to immediately cut its non-interest spending from 43.9% of GDP to 39.0% of GDP. However, if it were to reintroduce the drachma, the new currency would quickly become worthless, while the private Greek economy went underground and continued to do business in euros. Because what taxes were paid would be paid in drachmas, the real revenues of the Greek government would fall from about 90 billion euros per year to just about zero. The outcome of all of this would not be pretty.
The fact that Greece is stuck with the euro would actually be an advantage in the event of a Greek sovereign default, if things were handled correctly. This is because when a government defaults, the immediate challenge is to keep the economy moving, which means to keep transactions going and new investment flowing.
When a government defaults explicitly, it defaults alone. When it defaults via inflation, it forces private debtors to default along with it. Creditors receive only a small fraction of the real value promised. This poisons the environment for financing new capital investments. Also, as Argentina demonstrated in 2002, when a new currency with no credibility is suddenly introduced, monetary conditions have to be kept savagely tight in order to maintain any exchange value for the new currency at all. This depresses demand and forces a deep recession. Unless the ECB were to do something stupid, a debt default by Greece would have no impact upon the value of the euro, so the Greek economy would still have a viable currency.
The most important thing for the Greek government to do in the event of a default would be to adopt policies that would produce rapid real economic growth. Logically, this would include getting rid of their personal and corporate income taxes, which cost Greece much more in economic growth than they are worth in terms of revenue generation. Regulation of business should also be greatly reduced and streamlined. The default itself would force a needed cut in government spending.
Of course, if these reforms had been made in 2008, Greece would not now be facing fiscal Armageddon. The lesson for America is simple: economic growth now or debt default later.