Saving Greece: Austerity and/or growth

Econ 101: When discussing Greece’s economic problems public officials and the press regularly toss out the need for “austerity” and/or “growth” as if they were clearly defined and understood concepts. I suspect that they mean quite different things to different people. While it is convenient to summarize complicated policies with single words, it can also stand in the way of understanding what is really meant. So what are the policies needed for Greece’s recovery and what should we call them?

Stocks and flows: For starters we need to distinguish the stock of Greek debt (the existing outstanding amount of previous, unrepaid borrowing) from its annual deficit. Greece’s debt reflects the past history of its annual deficits. Its current and prospective deficits foreshadow the future stock of debt. A full default on Greek debt—wiping it all off—would reduce Greece’s annual interest payments on its debt but beyond that would do nothing to reduce its annual deficit and the build up of its future stock of debt, which eventually would again become unsustainable. So forgiving (defaulting on) all existing Greek debt, by itself, will not resolve Greece’s problems.

Sticking with broad simplifications, Greece has two major economic problems. First, its government spends more than it can pay for without borrowing (the deficit — the flow of new debt). Moreover, like the U.S. and many other governments, it has made commitments to spend in the future (e.g. unfunded pension commitments) that are not yet reflected in its stock of debt or its annual deficits. This must change because it is not sustainable. Lenders will lose confidence in the government’s ability to service its debt and will stop lending. This calls for “austerity”, i.e. eliminating the annual deficit, by some combination of reducing expenditures and increasing tax revenue. I will return later to the distinction between structural and cyclical deficits.

Greece’s second major problem is its low productivity and uncompetitive prices. By themselves these would simply imply a lower standard of living for Greeks. But the average Greek has been spending more than his income by borrowing, giving the temporary illusion of a higher standard of living. To the extent that Greek spending is for foreign produced goods and services and these imports are not fully paid for with Greek exports, they must be paid for by borrowing. This artificial standard of living is obviously not sustainable.

Greece shares the same currency, the Euro, with 22 other European countries (including non members such as Monaco, Kosovo, and the Vatican).  If Greeks borrow domestically to pay for imports, Euros will flow out of Greece, tightening liquidity. This should put downward pressure on wages and prices in Greece, which would help restore its competitiveness with the rest of the Euro zone. If Greeks borrow abroad, interest rates on such borrowing should eventually increase to cover the increased default risk. This will discourage Greek borrowing. Greece has reached this point.

Some argue that if Greece had its own currency it could reduce its real wages by devaluing its currency and thus restore external competitiveness. Cutting real wages in this way would be easier, they argue, than cutting nominal wages directly as Greece has just done for government employees. Experience in other countries suggest that devaluing its own currency, if it had one, would set off domestic price increases to offset the loss of real wages unless labor markets were made more competitive. A spiral of devaluations and inflation would likely ensue. Only when real wages can be reduced to competitive levels one way or another can Greece hope to grow out of its current problem.[1] Thus the Greek government is undertaking structural adjustments to liberalize labor and product markets in order to make them more efficient and to make wages and prices more responsive to market conditions.

Some argue that the emphases in Greece should be put on growth.  Given the debate in the U.S. between Keynesian and neo classical economist over whether growth requires “stimulus” to increase demand (the Keynesian view) or “structural adjustments” to make labor and product markets more efficient and to encourage investment (the neoclassical view), it is not completely obvious what the proponents of growth in Greece have in mind. Attempting to promote growth with government stimulus to demand is not in the cards, as that would require more government spending and/or lower taxes and thus even larger deficits that no one is willing to finance. The only way for Greece to enjoy a higher standard of living is to undertake structural reforms that will allow the economy to be more productive and its wages and prices to be more competitive with the rest of the world.

So Greece needs to eliminate its deficits (actually run surpluses to reduce its outstanding debt) and liberalize its labor and product markets to establish balance in its external trade. All serious students of the Greek situation agree with this. The policy debate is complicated, however, by the interaction between growth and deficits and the speed with which an economy adjusts to changes.

If the Greek economy grows more rapidly it helps its debt problem in several ways. First, a growing economy generates more tax revenue from the same tax system. This reduces the deficit. It also tends to reduce government expenditures linked to safety net expenditure (e.g. unemployment insurance). This also reduces the deficit. In addition, the capacity of an economy to sustain and service debt is linked to its size. Thus economists look at the ratio of debt to GDP. A more rapidly growing economy tends to reduce the debt/GDP ratio by increasing the denominator.

While Greece must eliminate its deficits, the initial impact of expenditure cuts and higher taxes is to temporarily reduce income and tax revenue. Greece is experiencing this now. Its expenditure cuts have not reduced its deficit as much as expected because the temporary slow down in economic activity as displaced government employees (for example) look for new jobs, has been larger than expected thus reducing tax revenue by more than expected. A reduction in income has the same but opposite effect on the deficit as does an increase in income. This phenomenon is called automatic stabilization. Both Keynesian and neoclassical economists favor allowing such cyclical swings in government deficits and surpluses. But in the long run the government’s structural deficit (its full employment deficit) should be zero or at least smaller than the economy’s long run average growth rate. In Greece’s case it should be in surplus for a number of years to reduce its existing stock of debt.

The positive impact on competitiveness and income of liberalizing labor, services and product markets will also take time to develop. Balancing Greece’s fiscal budget now, before structural reforms have had time to work, would require much larger fiscal corrections (spending cuts and tax increases) than would be needed for long run balance.

This background should help understand and evaluate Greece’s options. Without external financial help (as is now provided by the EU, IMF and ECB), Greece could not adjust its fiscal deficits enough in the short-term to avoid the need to continue borrowing temporarily. Under these circumstances market lenders are likely to charge such a high risk premium to buy Greek sovereign debt to cover the prospects of default that deficits would become worse rather than better. Greece would default (with or without leaving the Euro). If it had defaulted in December 2011, it would have saved 16.3 billion Euros in interest payments on outstanding debt out of total government expenditures of 76.8 billion, but would have had to cut expenditures instantly an additional 6.3 billion to keep it within its tax revenues of 54.2 billion, over a 10% cut in non-interest expenditures instantaneously. This is austerity on steroids. The Greek economy had already stopped growing in 2008 and shrank by 3.3%, 3.5% and 5.0% in 2009, 10, and 11 respectively. The shock of default would surely depress the real economy further than the 2.0% decline currently forecast for 2012, reducing tax revenue further and requiring even larger cuts in spending. This does not take account of the impact of a Greek default on its banks, which hold a significant amount of Greek sovereign debt, and which the government would no longer be in a position to support. Default is no panacea, and this has not taken into account the possible negative effects in Spain and Italy, to name but two other European countries.

The approach taken by the IMF and EU is to agree with Greece on targets for both deficit reduction (austerity) and structural reforms (growth) that aim to restore full balance by 2021 and to finance the declining deficits in the interim at modest interest rates so that Greece does not need to borrow from the market. The program requires the “voluntary” write down of private sector holdings of Greek sovereign debt by about 70%. Greece would reduce its deficit from almost 10% in 2011 to less than 5% in 2012 (a primary surplus – i.e. not including interest on its debt—of 0.2%, raising to a primary surplus of 2.4% in 2013 and 5.0% in 2014). This “austerity” is being supplemented by significant structural reforms. The program is a balance between the pace of austerity and growth. Slower implementation of austerity requires a longer period of IMF/EU financing but with potentially more rapid growth.

Government employment is being reduced by 22% between 2010 and 2015 (150,000 employees). Future pension commitments have been reduced. Inflation has fallen below the Euro area average. However, external competitiveness has improved as the result of wage reductions in Greece rather than improved productivity, i.e. living standards have fallen. In general, labor market and business sector reforms have lagged. Changes in labor laws to allow more flexible wage bargaining and to ease the cost of lay offs are showing positive results. A number of services and professions have been liberalized to subject them to greater competition (cruise ships, highway freight, tourist coaches, regulated professions). The cost of starting new businesses has been reduced (“The new law reduces the number of steps (from 11 to 1), days (from 38 to 1), and cost (by more than 50 percent) required to start a business.”). Nonetheless the slow pace of such reforms is the major weakness of the program. Public acceptance of its changed circumstances and how best to deal with them has not be easy or smooth either.

It is noteworthy that the Greeks work more hours on average than any other European county (2,017 hours per year compared to 1,408 hours a year for Germans). German’s enjoy a higher standard of living because they produce more each hour they work. Greece needs to liberalize its markets to become more productive. Lowering wages will make Greek output more competitive beyond its borders but will not raise the standard of living for Greek workers.

The euro group has stated in its communiqué, “We reiterate our commitment to provide adequate support to Greece during the life of the program and beyond until it has regained market access provided that Greece fully complies with the requirements and objectives of the adjustment program.” The proviso is standard but also reflects Greece’s poor record of honesty and implementation.

IMF financial support is parceled out in quarterly installments contingent on Greece meeting the conditions agreed to for each quarter. This combines the carrot of financial assistance with the stick of close monitoring of Greece’s compliance with the reforms needed for long run success. There are no good options for Greece, but the current agreement between Greece and the IMF/EU seems to hold out the best hope for potential success. It balances austerity and growth. It will not work without public acceptance. Government promises to its public are being and must be broken. The Government needs to convincingly explain that these promises cannot be kept and that a brighter future requires the reforms that have been promised to the IMF/EU/ECB and the increased productivity and growth they should make possible.

Iceland and Ireland are well on their way to recovery from their debt disasters. If Spain and Italy can get and stay ahead of the adjustment and reform curve, and they have new governments committed to doing so, Europe should pull through and be stronger for the experience. But the next few years will be difficult.

[1] Mario Blejer and Guillermo Ortiz, “Latin Lessons”, The Economist February 18, 2012, page 94.

Afghanistan: Koran burning

Updated February 26, 2012

Associated Press: “More than 30 people have been killed in clashes since it emerged Tuesday that copies of the Muslim holy book and other religious materials had been thrown into a fire pit used to burn garbage at Bagram Air Field, a large U.S. base north of Kabul.

The death toll from days of unrest includes four U.S. soldiers – two killed last week by an Afghan soldier, and two military advisers shot Saturday at the Interior Ministry.”

By AMIR SHAH, Associated Press, February 23, 2012

“The unrest started Tuesday, when Afghan workers at the sprawling American base noticed that Qurans and other Islamic texts were in the trash that coalition troops dumped into a pit where garbage is burned. Some Afghan workers burned their fingers as they tried to salvage some of the books. Afghan government officials said initial reports indicated four Qurans were burned.

“The materials had been taken from a library at Parwan Detention Facility, which adjoins the base, because they contained extremist messages or inscriptions. Writing inside a Quran is forbidden in the Islamic faith, although it was unclear whether the handwritten messages were found in the holy book or other reading materials.

“A military official said it appeared that detainees at the prison were exchanging messages by making notations in the texts.

“A delegation of Afghan religious leaders, lawmakers and government representatives visited Bagram as part of the investigation. They issued a statement late Thursday calling for an end to protests and accused insurgents of infiltrating the gatherings to foment violence. They said they expected those responsible for the Quran burning to be prosecuted through the U.S. military court system.”

In response to these events I addressed the following question to a group of young Afghan intellectuals in Kabul:

“I am very interested in your comments on the Koran burning event in Afghanistan.

“The U.S. military made a regrettable mistake in burning some Korans at Bagram airbase. It was the result of ignorance of Afghan and Muslim attitudes toward the destruction of their holly book.  It was not the results of malice. President Obama personally apologized for the act to President Karzai, an extremely rare thing for American Presidents.

“In the West, idolatry is not respected. What is holly in the Bible, Koran, or Torah are their words, not whatever pieces of paper they might be printed on. Thus the reaction of some Afghans to burning some Korans is incomprehensible to us. Over a dozen lives have been lost because of this reaction.

“The Washington Post reported the following yesterday: “Those behind the act should be asked about their deed and must be punished,” said an officer near a U.S. military base in Kabul. “If I find the opportunity, I would shoot them in the head.” For us it is truly barbaric to put the burning of a book on the same level as taking a human life. I assume such views do not represent modern Afghan thinking and seriously doubt that Islam teaches such things, but I would be grateful for your views on these questions.”

Here is the resulting exchange followed by some non-Afghan comments first:

Diba Hareer

Warren Coats, you are right. For us, the educated Afghans, it does not make any sense at all. The incidents and the killings, which happened, cannot be justified. How on earth you could say, “We are killing each other, destroying buildings because our holy book was burned”. It’s unfortunate that we have very few educated people in our country. Our elites are getting out of the country and living in the west, as they cannot tolerate the chaos in Afghanistan. Their security is also at risk at times. We have only 34% literate men and 13% literate women. In our schools students are not taught the right values. If we teach our kids love, respect and patience, we can prevent these incidents to a high extent. The illiterate isolated masses can easily be manipulated. The manipulators took advantage of this opportunity and further encouraged the public to get crazy. I still believe the educated youths even few can bring a change since its proved that you can make a difference with as few as two persons. I hope those of us who are studying right now, get together and find a way to get Afghanistan out of this situation.

Masoud Dost

Miss Diba,
With respect to those elites that realize value of our holy Books.
It seems you are in big misunderstanding that our elites are out of country, it might be your own perception.
Any how, I really condemn those who do not respect holy books whether it’s mistakenly or with full understanding.
I accept that the illiterate isolated masses can easily be manipulated. The manipulators took advantage of this opportunity and further encouraged the public to get crazy.
The questions arises who pave such illiteracy, low level or high level, educated or uneducated, elite or …?

Diba Hareer

Masoud, by elites who are out of country I was pointing to those whose knowledge can contribute to reconstruction of our country but they do not want to work with the corrupt government. The majority (if not all, while I think so) are working with the government only to serve their pockets by taking the advantage of the corrupt system. Azizullah Lodin the chairman of high office of oversight and anti- corruption was complaining from corruption at his own office. I and you know that many of the current and ex-ministers’ files are with the office of Attorney General who are accused of corruption.. I wish I was able to tell u who the elites are. I am sure neither you nor I want to argue over those figures. The point here is to confirm that, killing and injuring one another and destroying the buildings are not sensible ways of showing that you are angry over burning Quran. What can u achieve by killing your country folk? I doubt if even a few number of these protestors know what is written in Quran and what does that mean. Besides that, they are destroying the image of Islam. They once again represented us as barbaric to the world.

Shoaib Rahim

Warren Coats i’ll try and share an observation on why this reaction took place then. The Jihad against the soviets created a new identity for the majority of Afghan population; i believe this identity to be obsessively revolved around a very specific and rigid interpretation of Islam. We were occupied, slaughtered and kicked out of our country during the Soviet war for being Muslims..and on the flip side, we were funded, armed and supported by all for strengthening the same identity. After the soviets left, although we failed to form a nation and keep the peace, Islam was the only alleged uniter among our people and more or less still is since notions of nationalism are still in its infancy. Secondly, life is not valued in our society and a life lost in the path of ‘defending islam’ is a virtue…it was enshrined in our value system during the Jihad against the soviets and this value lives on strong. This essentially means that you can’t compare Afghan society with other non-war afflicted societies because the values differ greatly. Third is a very strong notion of victimization by the ‘imperialist west’ and its anti-islamic agenda. Neo-conservative policies during Bush, Guantanamo Bay, constant targetting of muslims by western media..all play its role in demonizing the masses with anything “western”…and the US forces have had many instances of killings and quran burnings which have made the image worse. so we have Rigid Religious Interpretations + Cheap value of life in our society/celebration of life lost for religious cause + anti-western sentiments. Add in foreign hands and opportunists and you get the reality behind Afghan riots. At least I would see it like this.

Alessandro Califano

Warren Coats, I’d like you to focus on a different setting on regard of your question. Let’s imagine a Western country (why not the US?) being occupied by armed forces of a different religion and culture. Let us now imagine someone among these “alien” forces throwing a New Testament copy in the garbage can, along with used kleenex tissues and potato peels – are you really sure that locals would say: “Oh, please, we are strongly against idolatry, keep going in your doing…”? In my humble opinion, malice or not, people have been mowing down reciprocally for much less in some un-barbaric Western countries… Ever heard anything about Northern Ireland, yourself?

Two non Afghan comments. The first comment, from a Saudi friend, sheds light on the seeming anomaly of the routine practice of the Saudi government burning Christian Bibles confiscated in the Kingdom with no public outcry from anyone.

Yousef (Riyadh, Saudi Arabia)

I think the main cause of outrage in Afghanistan is because of “who” did it. As of my knowledge, the only way to dispose Quran in Islam is to actually burn it. It is not to be thrown with other waste since it contains the words of god. Basically because it’s holy.

I think if they let Muslims do the burning and clarified the reasons behind it before actually doing it it wouldn’t have had the same public response.

Tom Lutton (Washington DC)

Warren, thank you for sending this; it is good to hear from you.  Your simple act of asking a question, listening to the response, and sharing the response with others is a welcomed start to bridging a cultural divide that has been so wide for so long.  The lack of education on both sides certainly does contribute to the deplorable violence.  Honest communication and consistent efforts to understand differences ironically seem to be the weapons of choice to eliminate the cycles of violence.

The British American Relationship

I saw The Madness of George III in London yesterday evening on my way to Kabul. The evening included a nice dinner and visit with old friends Tim and Jan Conway, first met in St. Andrews Scotland in 1976. The play, and David Haig’s portrayal of King George III, was spectacular. British theater is the best in the world century after century.

The play set me thinking again about why American’s are so fascinated with England and the English monarchy. My ancestors are mainly English so I may have a slanted perspective. But America’s basic values and institutions, which are respected by all American’s what ever their ancestry, were built upon those of the United Kingdom. We see it most clearly when contemplating the role and place of the British monarchy in British governance.

What fascinates us, I think, is the interaction between the King (or Queen) and his government. From the Magna Carta on Britain has evolved a system of governance based on the rule of law. The powers of the King are limited and checked the powers of Parliament and The Law. This interplay, these checks and balances, are on display in every movie or play about the British monarchy. This, I think, is the core of our fascination with the British monarchy. The King is all-powerful and unquestioned within his household but constrained by tradition and law in his broader exercise of authority.

Indeed, with all of it’s shortcoming, Britain benefits a great deal from the rule of law. The rule of law is much more than having good laws evolved from practical experience (the common law approach of Britain and America rather than the civil law tradition of Europe). The rule of law is an attitude of the members of society. It is the orderly, voluntary adherence to the norms society has agreed on. The result is a much more efficient and relaxed social and economic life.

The English famously queue (line up in an orderly way). It makes the experience of waiting to be served so much more relaxed. Waiting in “line” in Italy, on the other hand is a tension filled, guerrilla warfare effort to minimize being taken advantage of by shamelessly rude Italians, all of whom have relatives or friends ahead of you in line holding their place. On average Italians are more charming than the English. I have concluded that this is necessary to compensate for their disregard for the rule of law. Italians don’t pay their taxes, don’t cue, and in general circumvent at every opportunity the law.

A consequence of the rule of law in Britain and northern Europe more generally and its weaker hold on the behavior of Italians and southern Europeans more generally is that the United Kingdom functions more efficiently. Social interactions are smoother. And members of society enjoy more true liberty. The weaker hold of the rule of law in the south is like a tax on the functioning of the system. The explicit taxes that are not paid by Italians are replace by the tax of higher cost social interactions as they struggle to improve or at least defend their place in line. Italian’s are only fooling themselves to think that they have gotten away with not paying their taxes.