Lessons from the Greek debt crisis: How Greece could have done things differently in 2010

According to macroeconomic theory, a country needs to go through painful unemployment and recession in order to adjust within a fixed exchange rate or common currency regime when an external imbalance arises. This is repeated by politicians to justify the drop in GDP and living standards that follows. It can also however mask bad economic policy-making, as I suggest has happened in the case of Greece with the blessing of the IMF, the EU and the ECB. I will propose 3 ways this could have been done in Greece in 2010 to significantly reduce the magnitude of the 30% contraction to date.

Greece, between 2001 and 2010 lost competitiveness with inflation c.15% above the eurozone average. The usual mechanics of a fixed exchange rate, loss of demand leading to a fall in prices/containment of inflation did not happen as German and French banks lent the Greek state and thus sterilized the external imbalance, with an equal current account and government deficit (the double deficit). During 2009, the private lending was replaced by Greek bank borrowings from the ECB and purchases of government debt, equal to 15% of GDP in one year. And thus came about the Greek sovereign debt crisis when in late 2009 the ECB said it would no longer fund the greek banks for this purpose*. 

A 30% contraction of real GDP, all of it coming from the private sector of the economy as a simple reading of unemployment figures shows, has rectified the double deficit. Portugal did a much smaller adjustment of its economy for a pretty large deficit also. Here are the 3 things that Greece could have done in 2010 to minimize the impact of the adjustment, which are equivalent to an internal devaluation:

1. Take measures to increase productivity of the economy as a whole and particularly of the spendthrift state apparatus, whose expenses fueled the problem. Many such measures were included in the first MOU, such as reenforcing the competition authority, liberalizing markets, closing sectors of the government with useless or overlapping tasks, simplifying administrative requirements. Not only did almost nothing happen on these fronts, but competition in the downstream oil and the banking markets was wiped out; the state apparatus is even more bureaucratic and ineffective than before, with self contradicting and everchanging legislation and increased bureaucracy for non-tax evaders; and motorway concessionaires were given state aid to protect them from bankruptcy. And a failed renewables policy only added to energy costs.

2. Revamp taxation so as to affect both prices downwards and reduce income inequality that increases domestic demand at the demise of imports, and even increase tax revenues. On this front it was a complete failure with the exception of cars/hydrocarbons/alcohol. Indirect taxes went through the roof, even access to justice charges at the expense of democracy and contract enforcement; direct taxes were increased for the majority but reduced for the top earners; a new property tax had a dramatic negative wealth effect on consumption/GDP/government credibility, and actually reduced property taxes**.

3. Identify the sources of the problem and address these, not crush all. This is a eurozone wide problem hidden nicely behind the words economic crisis which does not identify the source of the problem. In Greece, the existence of the double deficit, despite an increase in tax earnings as a percentage of GDP between 2003 and 2009 without a big increase in business borrowings, clearly identifies the problem, the overspending greek state. And instead of what any individual would have done, cut expenses (and possibly default), the greek state preferred to enter their shareholders' houses and demand extra equity on a non stop basis, without downsizing at all except for maybe 10,000 jobs compared to 1,000,000 in the private sector. And the same for the banking sector, which after being dragged into the problem in 2009 and facing the declining economy, and for the sake of saving the banks or their creditors at the expense of the people, has already required infusions in excess of 20 bln, lending margins for healthy companies have gone up 800 basis points compared to the rest of Europe, while personnel has only been given soft landings and shareholders of the systemic banks kept whole.

Although having done the right thing would not suffice and some real adjustment would have taken place, it is clear that this could have been limited in the range of 10% and not 30%, keeping also the debt to GDP ratio at closer to 140% rather than 180%.

*This is often blamed on "greek statistics" yet all the data was there for anyone wishing to see it, including a big increase in greek debt costs in late 2008 onwards and a reduction in hodlings of greek debt by foreign funds. So the market knew it... the new government admitted the problem formally hoping that admitting it would restore confidence and borrowing.

** Ronald Reagan would have used this as an example: the new tax actually worked so as to reduce total tax receipts from property as transactions stopped and property prices plummeted, excluding secondary effects from the wealth effect.