EEAG: Greece should leave the euro area and devalue the drachma
Ralitsa Kovacheva, March 2, 2011
Germany would support a possible extension of the Greek bailout programme from the EU and the IMF, Chancellor Angela Merkel suggested after a meeting with Greek Prime Minister Georgios Papandreou in Berlin. The argument she pointed out was that the Irish rescue loan had the term of seven years, and the Greek one - only three. “But this can only ever be decided on in concert with all of the other measures, whether the maturity of the Greek package ought to be prolonged”, Merkel underlined. As you know, at their summit on March 11th the leaders of the eurozone countries are expected take important decisions about the size and functions of the current rescue fund for the euro area, the design of the future permanent fund (European Stability Mechanism) and the Pact for competitiveness, proposed by France and Germany.
In turn, the Greek Prime Minister expressed his support for the purpose of the Pact to restore competitiveness of the euro area: “Part of the problem in Greece was not only the debt and the deficit, but it was the fact that Greece was not a competitive economy. We were not a competitive economy. We were buying much more than we were selling, if you like, very simply.”
These words of Mr Papandreou's are fully in line with one of the main conclusions in the report of the influential European Economic Advisory Group (EEAG), which consists of seven internationally acknowledged economists from seven European countries. According to them, namely the huge current account deficit is the most serious problem of Greece and to deal with it, it needs to leave the euro area and devalue the drachma. The economists say that if the rescue programme ended in 2013, as planned, Greece could also not avoid debt restructuring. According to the report of the Brussels think tank Bruegel, as euinside wrote, Greece has no time to wait, because it has already become insolvent and measures should be taken for an emergency debt reduction. At this stage, however, Greek Prime Minister Papandreou is persistently excluding this option.
According to the EEAG report, however, the Greek government does not have many useful moves and can only choose between two evils. The bulky analysis is curious as in terms of recommendations so in terms of explanation of the reasons for the Greek problems. The economists go 30 years back and thoroughly analyse the development of the Greek economy and the behavior of governments. Furthermore, the report clearly differentiates Greece from the rest of the eurozone countries, mostly the so-called peripheral economies, regarding the specific problems and their causes.
The greatest sin: wastefulness
From the early 90s of last century and in the beginning of the new millennium the Greek economy has grown. However, this growth “did not have solid foundations, but was based on an unsustainable public and private spending spree.” Up until the 1980s the government spending was significantly below the average for the countries that became the initial 12 countries of the euro area (EA-12), but only 10 years later it exceeded those of the EA-12. In view of the euro area membership Greece applied some restrictions, but „it appears that after gaining entry in the euro area, Greek policymakers stopped being as vigilant in their efforts to further curb government spending”. In 2009 it reached 52% of GDP and exceeded the average for Ireland, Portugal, Italy and Spain.
The largest share in the increase of government expenditures belongs mainly to the social transfers and pension benefits which, according to the report, are “the fastest growing category of social spending, and the biggest risk regarding the sustainability of public finances in Greece.” Another burden is the public employee compensations. “Between 1976 and the second quarter of 2010, the number of government employees almost tripled (from about 282 thousand to 768 thousand), while private sector employment during the same period increased by about 24 percent (from 2.95 million to 3.66 million”.
Meanwhile, public sector wages rose swiftly: „the cumulative increase over the period from 1995 to 2009 in (gross) nominal private sector compensation per employee (excluding the banking sector) was 116 percent, whereas the cumulative increase in the public sector was 159 percent, and in publicly owned enterprises 221 percent.” At the same time, the cumulative increase in nominal GDP was 160%.
The numbers speak for themselves, but even more interesting is the explanation of the reasons. According to the analysts, “public sector employment has remained a major channel through which political parties in Greece dispense favours to partisan voters, as well a “redistributive” tool in periods of high unemployment.” Therefore, wage growth in the public sector significantly outpaced that in the private sector, thus additionally increasing public spending, it also undermined competitiveness of the economy.
Along with rising costs, tax revenues declined. Some reasons for the reduction of indirect taxes are objective - harmonisation with EEC and the creation of the Single Market. But the biggest problem of the Greek tax system is tax evasion. The problem is exacerbated by the high percentage self-employment, which is very characteristic of Greece - self-employment is accountable for 30% of total employment. It is a common practice doctors, dentists, lawyers and architects to declare income lower than that of workers in manufacturing. On top of that, the trend spreads to the employees, as firms do not pay social contributions or do not register their workers.
The reason for this phenomenon sounds very familiar to each Bulgarian: „A weak connection between individual contributions and benefits has created incentives for collusion between employer and employee in order to minimise their social security contributions.”
The Public debt
Declining revenues and rising costs have led to a rapid accumulation of public debt. Persistent budget deficits in the 1980s and early 1990s caused an increase of debt from 20% in 1975 to 100% in 1994. Consolidation measures undertaken by governments until the entry into the euro area were subsequently abolished. So in 2009 Greece met the dawn with a debt level of 127% and 15.4% budget deficit.
As the analysts say, the main factors for the accumulation of public debt are:
-“over-generous programme spending and lax tax policy (and administration)”;
-“primary deficits arising as a result of output being below potential”;
-“the (real) interest rate exceeding the GDP growth rate, so that the debt-to-GDP ratio would rise even if programme spending and revenues are equal”;
-“various activities undertaken by the government that affect the accumulation of debt but are not reported as deficit – the stock-flow adjustment” (the difference between the change in government debt and the government deficit/surplus for a given period, Eurostat).
An example of the latter is when in the early 1990s, the government assumed the debts of “restructured enterprises” to the banking system worth 5.3 billion euros, adding 10 percent to the debt. Or the consolidation of the government accounts in the context of the entry in the second phase of the Economic and Monetary Union (EMU) between 1994 and 2000, which added 16 percent to the public debt.
The big problem - the current account deficit
According to the report, however, although "bringing the government’s finances in a sustainable position is a key priority for Greece”, the.maim problem appears to be the very high, and rising, net foreign indebtedness. “In fact, it may have been unfortunate for Greece that the global crisis did not come earlier – for, in this case, both the public debt-to GDP ratio and the net foreign indebtedness-to-GDP ratio would have been smaller, thus making the adjustment less painful, and the probability of default or debt restructuring smaller.”
Basic “contribution” to the enormous increase of external debt (from 3% of GDP in 1997 to 86% in 2009) belongs to the current account deficits accumulated since 1997. As a result, to the public debt were added another 25 percentage points or it increased from 102% in 1997 to 127% in 2009. ”When a large proportion of public debt is held externally and debt interest payments to foreigners are a large proportion of the country’s GDP, foreign investors may start to question the ability (and/or willingness) of the government to generate the resources required for debt service to foreigners.” As a result of such doubts, the interest payments began to grow rapidly.
The Bailout Loan
In October 2009 the newly elected Greek government announced that the deficit for 2009 was 12.7% of GDP, rather than 2%, as envisaged in the budget. From this moment until the official help request in April 2010, the Greek government delayed the official announcement of the loan agreement because of „domestic political and economic considerations, including the need to persuade the traditional voters of the governing party as to the necessity of the conditionality-based bailout package”.
As you know, Greece received a package of 110 billion euro, of which 80 billion in the form of bilateral loans by eurozone countries and 30 billion from the IMF. In return, Greece has to carry out consolidation of 20% of annual GDP within 4 years (2010-2014). “Note that none of these consolidation measures force the Greek government to save and actually reduce its debt. The measures are merely designed so as to reduce the net increase in debt.”
Under the agreement with the EU and the IMF, Greece has to make cuts in public sector expenditure and to increase indirect taxes, as well as to conduct pension and structural reforms, to promote exports and to reduce the huge trade deficit. The pension reform is particularly important because the European Commission forecasts show that with an unreformed pension system, even if Greece would apply all the other consolidation measures, the public debt will reach 250 percent by 2050.
According to the analysts, however, even if Greece implemented all measures agreed, with the level of debt around 150% it would continue to be heavily dependent on very uncertain variables, such as the expectations that the economy would grow, not just in the country but globally, and the spreads would decline. And the creditors will continue to doubt the country's solvency. Therefore, according to analysts, “the probability that Greece will not be able to return to the markets to roll over its debt at defaultavoiding spreads is not negligible.”
The lesser evil
The analysts do not discuss the option for the prolongation of the rescue loan, so they consider what the options for action are after its expiration in 2013. According to them, the country has limited options and can only try to choose between two evils. Greece may seek market-based financing by issuing new debt instruments with the new CAC (collective action clause) as provided in the future European Stability Mechanism. Athens will probably resort to assistance from the ESM, “but only
after private creditors have agreed to a haircut.”
However, this would not not solve the main problem, analysts say – the huge current account deficit. “To reduce its huge current account deficit, Greece will have to undergo a period of internal or external depreciation, which will lower the euro-value of Greek wages, prices and GDP.”
“Politically, the question of whether or not Greece will or should exit from the euro area will depend on which of these choices are made, but from an economic perspective it is a separate issue, as we have argued above. Greece should make this decision based on its judgement of whether or not an internal or external depreciation will bring about less hardship.”
Reading the bulky report, I was obsessed by a feeling of resentment against the cheap cheating of the Greek politicians – a feeling that is too familiar to the Bulgarian society. Political parties have literally bought influence and votes for years at the cost of massive public debt and budget deficit. Now the citizens are protesting, but the restrictive measures are the price they must pay for the years of affluence. And judging by the report, it appears to be lower cost compared to the other perspective - leaving the euro area and returning to the drachma. Although it is likely to be a solution of certain economic problems, it would be a major political blow not only to Greece but to for the whole euro area and the EU.
Moreover, if in the meantime the expectations are proved that Portugal will require a rescue loan too, all measures to safeguard the euro may simply lead to a prolongation of agony of the single currency. From this perspective, European leaders are unlikely to allow Greece to leave the eurozone, but rather will extend its loan, while preparing the ground for real opportunities for restructuring as of the government debts, so of their failure-threatened lenders.