Τρίτη, 7 Φεβρουαρίου 2012

Greek Crisis, Debt and Competitiveness: A Case Study of Irrational Expectations

Republished from the Business Thinker magarzine

Dr. Periklis Gogas is an invited contributor to The Business Thinker magazine. He is Assistant Professor at Democritus University of Thrace, Greece, teaching Macroeconomics, Banking and Finance. Recently, Dr. Gogas was a Visiting Scholar at the Ross School of Business, Uinversity of Michigan.
The economic crisis that troubles Greece since 2009 is the worst since WWII. A cascade of measures were taken by the Greek government and the troika supposedly trying to steer the Greek economy into primary surpluses and ultimately growth in order for Greek debt to become sustainable. The recipe chosen for this turnaround was apparently simplistic, one dimensional and is proving to be wrong severely damaging the Greek economy, its bond holders, the EU and casting serious doubts for the euro’s survival. The main ingredients of this failed recipe consist so far of huge direct and indirect tax increases, severe pay-cuts to public sector employees, a virtual halt in all government spending in education, health and government investment in infrastructure, research and technology. It is obvious to anyone, whether economist or not, that this policy is doomed for failure. Greece’s official statistics came to prove this belief. Two and a half years after the crisis unraveled, all the measures failed and this was no surprise to anyone but to the people that conceived them. Every single target projected by the troika’s “wise” and the Greek officials for government revenues when introducing a new tax or contractionary policy, was met with flat out failure. In economics we say that people have rational expectations when they do not make consistent errors in their forecasts about future events. They may be wrong many times but on average they must be correct. In this case, every single expectation is always over-optimistic and tax revenue falls short of the set targets. Anyone can see this, but the people who make the decisions. And even worst, instead of taking this as evidence that their policies are wrong and implausible they come back with new arrows from the same arsenal.
The examples of incompetence are numerous: one of the first measures taken was a major fuel tax increase that resulted in gas prices doubling from €0.85 to €1.70 per liter. At the same time, the annual road tax and car excise taxes increased in a similar manner. Apparently, naïve government officials assumed that government revenue will also double or at least increase significantly. Wrong! Government revenue from automobiles saw a sharp decrease from €1.7 billion per year to €0.7. Someone forgot to estimate the elasticity of demand on such huge price increases. To make the story even worst, after the huge decline in government revenue no one yet bothered to correct the mistake and increase revenues! This simple fuel and road tax hike of course had a multiple effect on the economy by burdening Greek production and worsening its competitiveness across-the-board.
Another example is tourism: supposedly tourism can be promoted as the heavy industry of Greece. At the same time, Greek government actions through indirect taxation actually divert tourism income from Greece to other countries. My master’s class students just organized a trip to Frankfurt. The whole trip including a direct flight to Frankfurt and a three-night stay in a down-town hotel costs €150 per student. A round trip from Thessaloniki to Athens by car would cost €150 for gas and €50 more for tolls. Apparently the Greek state is subsidizing the German tourism industry by making it prohibitively expensive for Greeks or others to travel within the country. Why would anyone implement such measures and even more so why stick to them when they are proven wrong?
Now, the bog issue is that the troika demands that private sector wages must decrease so that Greece will become more competitive. This is strange. Not even Greek employers themselves think this is necessary. A recent discussion with the president of a Greek chamber of exporters revealed something very important: total labor cost reflects not more than 8% of the final product price! Thus, even an extreme 50% decrease in private sector wages would not increase Greek competitiveness by more than 4%. Moreover, eliminating the 13th and 14th wage would further reduce government revenue through income taxes and social security contributions that are associated with these payments. The impact of these proposed cuts of course would be a vicious cycle that will further reduce total demand, production, employment and government revenue.  There is no economic reasoning for these contractionary and recession inducing policies. The evidence from their implementation is decisive beyond any doubt; they lead to a dead-end.
What is the solution then? Usually complex problems have simple solutions. The private sector is very efficient finding solutions to these problems when no governments or international institutions intervene and interfere. A firm that bears an unsustainable debt and is on the brink of bankruptcy would come into an agreement with its creditors to write-off part of the debt. This is a mutually beneficial solution. The firm will not go insolvent and the creditors will face the minimum possible capital losses. In the Greek crisis there is now the danger that both Greece will go bankrupt and bond holders will lose all of their investment. A real haircut of 50%-60% of nominal debt could render it sustainable. This haircut necessarily should include bonds held by both private investors and the European Central Bank (it is exempt now) and other creditors with only exception the bonds help by pension funds (they are not excluded now). The Greek banking sector could survive this hit by substituting Greek government bonds with an appropriate amount of government involvement in their capital structure financed by the troika. At the same time, a reduction of all taxes, direct and indirect, would help to stimulate the private economy, increase demand and jump-start production, employment and growth, ensuring that Greece could service the remaining debt and become credible again in international capital markets. And finally, Germany musts decide what it wants: a truly united Europe, or just some close trading partners for German products? If the former is the case, then they must immediately make the next necessary step for economic integration. This step will set the ground for the euro to survive and EU to become a true and stable union that can leave behind the fiscal problems that seriously challenge its structure and ultimate existence. This step is no other than the Eurobond: a united Europe that collectively borrows and distributes funds according to the need and economic cycle fluctuations. This, will speed up the convergence process within the national economies and significantly reduce from one hand the cost of borrowing to the economies in need and also one the other the risk assumed by international investors.