A Brief Update on Recent Developments

On Friday, the Greek government has submitted its latest reform proposals to the EU. According to press reports, these are supposed to raise €3 billion and consist of the following:

“[…] moves to combat tax evasion, more privatizations and higher taxes on alcohol and cigarettes. […] The Greek government said the 18-point reform program did not include any “recessionary measures”.”

In the meantime it has also emerged that the privatization of the port of Piraeus, which Syriza had previously reportedly opposed is about to go forward after all, and is expected to bring in proceeds of around € 500 m. Pressure on the Greek government has recently increased, not only due to the fact that it is expected to run out of money soon, but also as a result of a downgrade of its credit rating by Fitch late last week to a lowly CCC rating. This makes it even less likely that the government will be able to roll over maturing treasury bills. 

Photo credit: Yorgos Karahalis. Reuters

Below are the most recent updates of domestic deposit outflows and central bank credit to the banking sector, showing the situation as of the end of February. Note that we have adjusted the data on deposit outflows by deducting all government deposits from the domestic deposits time series, so that only the deposits of Greek households and business are shown.

As can be seen, our most recent estimate of the likely size of the additional decline in deposits since the end of January was pretty much on the mark. In March, outflows have reportedly continued 

The next chart shows total central bank credit extended by the euro system to Greece’s commercial banks; this includes normal refinancing operations as well as ELA. As deposits are withdrawn, commercial banks are increasingly replacing them with central bank funding.

Liabilities of Greek commercial banks to the Bank of Greece – i.e., the amount of central bank credit provided by the euro system. Not surprisingly, this figure has soared of late

Since deposits – especially large ones – are often shifted to banks in other euro area countries, Greece’s TARGET 2 liabilities have been climbing rapidly as well.

TARGET-2 liabilities on the balance sheet of the Bank of Greece

At the end of last week, the upfront spread on 5 year CDS on Greek government debt soared to between 4,500 to 4,700 basis points, indicating that investor confidence continued to rapidly evaporate:

The upfront cost of credit default insurance on Greek government debt has soared.

However, over the weekend, the Greek government has released an upbeat assessment of its ongoing negotiations with creditors:

“”Today the Brussels Group discussions continue in a good climate of cooperation,” a Greek government official said, referring to the country’s European Union and International Monetary Fund creditors. “We have agreed that we need to draw up suitable policies which will shift the burden from those on the lowest incomes to those on the highest.”

Greece said its reforms were costed and that, once agreed upon, the details would be discussed with its lenders’ technical teams in Athens. Prime Minister Alexis Tsipras told a Sunday newspaper that the country’s liquidity problems would be resolved immediately after an agreement and that he sought no rift with Europe.

It is certainly not sensible to burden the poor with higher taxes in a severe economic crisis. However, so-called austerity in Europe remains characterized by the fact that new ways of squeezing blood from the shriveled turnip of the private sector are continually thought up en lieu of reducing the size of government.

There is a Better Way

In a recent editorial in the FT, entitled “Greece versus the Baltics is not an argument for a heartless state”, John Dizard compares the successes achieved by the Baltic nations to the ongoing malaise in Greece. We believe he is definitely on to something. An excerpt:

“There are, however, some practical lessons to learn from keeping our eyes on the contrasting ways that Greece has dealt with the world after the global financial crisis compared with the relatively poor Baltic states. Greece took a path of gradual fiscal adjustments weighted towards tax increases, accompanied by a partial debt default. The Baltic states adopted rapid and deep cuts in their state expenditure and current account deficits.

Late last year, Greece was just beginning to emerge from six years of depression that cut its gross domestic product by more than 23 per cent. Now it could be powerdiving into an even steeper decline. Estonia’s GDP declined from €16.5bn in 2008 to €14.1bn in 2009. In 2014 it rose to €19.5bn. Latvia, which was more debt- and oligarch-ridden than Estonia, and which also had to overcome a domestic banking crisis, is nearly back to its pre-crisis GDP. Lithuania has now exceeded its pre-crisis GDP. The big issue in the Baltic states is upward wage pressure from tight labour markets. That is what we call a high-class problem.

This understates the Baltic countries’ achievements. Their pre-crisis GDPs were inflated by unsustainable debt and import-fuelled construction and consumption booms. They have continued to grow despite their export sectors’ dependence on the depressed Russian market.

They also did this without much benefit from concessionary multilateral finance or international debt haircuts. In contrast, in 2008, Greece had a high level of debt to GDP (127 per cent by 2009), but as a euro member state, it had much readier access to sovereign debt markets. Estonia, Latvia and Lithuania, on the other hand, all had independent currencies that were voluntarily pegged to the euro.”

However, the three Baltic states shared a common experience of life under Soviet rule and their people had no intention of moving any distance back to the past or away from orthodox market economics. They lacked faith in state-directed investment or in policies to maintain demand through accommodative monetary policy and fiscal stimulus. So they collectively decided they would have to pay themselves less, but in real money — what was called “internal devaluation”, or “austerity”.

This was not easy. Latvia had the sharpest fall in output, losing 24 per cent in two years, while sustaining a fiscal adjustment of 14.7 per cent. Over the same period, Greece’s fiscal adjustment was 6.6 per cent of GDP, even though its budget deficit and debt levels were far higher.

A more significant contrast was in the nature of the Greek and Baltic fiscal and structural adjustments. There were virtually no dismissals from the Greek civil service over this period. Salaries were cut, but public sector staffing was reduced with lay-offs of temporary contract workers and early retirements. This had the effect of reducing already low service levels and transferring costs from payrolls to pension obligations. Latvia fired one-third of its civil servants.

Even though EU money was made available to the Greek government for reducing the public’s compliance burden through the application of IT, resistance by public sector unions and the bureaucracy have left the public shuffling through even longer lines than before. The tax burden on salaried workers, compliant domestic businesses and property owners was substantially increased. In contrast, the Baltic states have fairly flat and relatively low tax rates, and are moving most of their compliance procedures online.”

Of course empirical economic data always have to be taken with a grain of salt. Especially an aggregate measure of economic activity such as GDP is not really telling us much about the true state of the economy, given that is is primarily a measure of consumption, including government consumption. As David Stockman recently remarked in this context with respect to Greece:

“Today’s raging crisis in Greece was hidden from view for many years in the run-up to its first EU bailout in 2010 because the denominator of its reported leverage ratio—national income or GDP—–was artificially inflated by the debt fueled boom underway in its economy.

In other words, it was caught in a feedback loop. The more it borrowed to finance government deficit spending and business investment, whether profitable or not, the more its Keynesian macro metrics—-that is, GDP accounts based on spending, not real wealth—-registered a falsely rising level of prosperity and capacity to carry its ballooning debt.

When the denominator of the pubic debt ratio comes back down to earth after an artificial boom expires, the ratio of government spending to GDP is bound to temporarily rise as well, even if the government imposes rigorous spending cuts. However, if such cuts are indeed implemented, this will become visible once recovery takes hold, as the ratio will quickly decline again.

Looking at the trend in the share of government spending to GDP in Greece, it becomes immediately clear that our above contention that “austerity” essentially means “austerity for the private sector, while the State remains largely untouched”, correctly describes the prevailing state of affairs (consider that Greece has recently reported a mild recovery in GDP as well):

In spite of a recovery in GDP, the share of government spending relative to GDP has continued to soar in Greece. Relative to the pre-crisis low, it is up by a staggering 14.6%

The above chart shows that the role of the State in Greece’s economy has become extraordinarily large. Below is a chart showing the same data from Latvia. During the worst phase of the crisis, when GDP was down a full 24%, Latvia’s public spending briefly increased by about 7.6 percentage points relative to GDP, to a peak of 43.6%. The ratio subsequently swiftly declined again close to the level it inhabited prior to the economic downturn, with the most recent available reading clocking in at 36.1%:

The trend in the share of public spending to GDP in Latvia illustrates the difference to Greece quite strikingly

Latvia’s approach to the downturn was essentially the exact opposite of the standard Keynesian prescription. Since this path is only rarely chosen (one such rare instance was e.g. the 1921 recession in the US under president Harding), historical evidence is sparse, especially evidence of recent vintage. However, what evidence there is seems to confirm that the approach results in a thorough and swift clearing out of malinvestments in the economy and allows sound economic growth to resume fairly quickly. In a nutshell, it amounts to enduring severe short term pain in exchange for lasting long term gain.

One must keep in mind that every cent government spends is a cent the private sector can no longer spend or invest, since the private sector is the sole source of government funding. Whether government expenditures are financed by increasing taxation or by borrowing is secondary, as the funds must be obtained from the private sector in any case. As Ludwig von Mises pointed out:

“At the bottom of the interventionist argument there is always the idea that the government or the state is an entity outside and above the social process of production, that it owns something which is not derived from taxing its subjects, and that it can spend this mythical something for definite purposes. This is the Santa Claus fable raised by Lord Keynes to the dignity of an economic doctrine and enthusiastically endorsed by all those who expect personal advantage from government spending. As against these popular fallacies there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.”

(emphasis added)

This should actually be blindingly obvious, but common sense has been missing in action from the public debate on this topic for quite some time.

It seems though that the idea of actually reducing the size of the State is still considered anathema in most of Europe, as tax hikes were generally favored over cutting spending in countries implementing austerity polices. There is also very little political will to implement genuine economic reforms as long as it can be avoided.

Conclusion

The EU and the Greek government may well come to an agreement this week that allows for the “extend and pretend” scheme to be resumed, although Euclid Tsakalotos, the alternate minister for international economic relations, has asserted that the Greek government is “prepared for a rupture with its partners” if negotiations don’t go well. He didn’t provide details as to what that might mean.

EU Commission president JC Juncker recently bemoaned the potential “loss of prestige” the EU would suffer if Greece were to be grexited. This remark didn’t received much attention in the press, but it basically represents word from the centralizers as to what they expect to be done. It should become clear in the course of this week whether an agreement that allows both sides to save face will indeed be struck.

Charts by: Acting Man, Markit, TradingEconomics, Data by Bank of Greece