Sovereign Debt Crisis in Greece: Is there a way forward?

A short note on the debt crisis in Greece and the remedies offered.

Even as we were hearing of the news of tapering off of the Great Recession, as the current economic crisis is now popularly known, Europe started witnessing an increased share of the crisis. While it is true that we see Greece as the country reeling under the sovereign debt crisis at the moment, there are ominous signs that there are other countries like Spain and Portugal where public debt is growing at a fast pace. Whether these countries would follow a similar trajectory as Greece's is a difficult question to answer at the moment. Much of it would depend on the fate of the Greek economy itself. In this note we would like to argue the following. First, if the IMF conditionalities of fiscal 'consolidation' are adhered to it would further prolong the crisis and make the recovery extremely painful, especially for the working class and the poor sections of the population. Second, if it wants a long term solution, the only option that might be left for Greece would be come out of the European Monetary Union (EMU). Though the paradox is that, in the short run, this itself would fuel the crisis even more both for Greece and Euro. So, Greece finds itself in a catch-22 situation and it has very limited options.

Magnitude of and Reasons for the Debt Crisis

There are different facets of the debt crisis in Greece. Public debt is the difference between government expenditure and its tax receipts. Greece has 13% of fiscal deficit and 113% of public debt as percentage of GDP[i]. There are a few reasons for this.

First, income inequality has been growing in Greece where the real wages of workers have grown at a much lower rate than the growth of productivity. This means the share of wages in GDP has been declining. This process has led to a declining domestic market since workers spend a higher proportion of their income on consumption than the capitalists or the rentiers. A declining domestic market ipso facto means lower tax incomes. For a given level of government expenditure, this means a higher fiscal deficit over a period of time, and, therefore growing public debt.

Second, despite declining unit labour costs, aimed at increasing export competitiveness, Greece, among other European countries like Spain, Portugal and Ireland, lost out to Germany. In an era of export-led growth, it is the relative nominal labour costs that matter. A comparison between Greece and Germany would make the matters easier to understand. Heiner Flassbeck shows that while unit labour costs in Germany rose only by 5 percent between 2000 and 2010, it increased by 30 percent in Greece. Therefore, Germany was at a relative advantage over Greece in its effort to maintain export competitiveness. It comes as no surprise that while Germany runs a trade surplus, Greece is saddled with a trade deficit. A leakage of Greece's GDP in the form of imports from Germany again means a decline in tax revenue of Greece since the expenditure of Greeks is going into the pockets of German exporters. Paradoxically, this process increases the tax revenue of the German government. Thus, Greece is at a double loss because of the export policy of Germany. For this reason alone one could argue that Germany is also a factor in this crisis.

Third, there are two portions of government debt — principal and interest payments. In an open economy with hot international money flows, a government facing a crisis, has to keep increasing the interest rates to make its bonds saleable. An attempt to lure the international finance in this manner reinforces the very problems that it seeks to address. This seems to particularly be the case for Greece since their interest payments are growing at a very high rate.

Last but the most important, this would not have been such a big problem had Greece not been a part of the EMU. By becoming a part of it, they have limited their policy responses. Let us see why. If they had an independent currency, they would have had an independent central bank. This bank could have bought government bonds to finance the deficit expenditure. This is how most central banks function when the government runs a fiscal deficit. Moreover, such an arrangement would have stabilised the interest payment portion of the government debt. Since interest rates in the economy are pegged to the interest rate announced by the central bank, the bank could help the government by keeping its own interest rate low.

But as soon as a country becomes a part of a unified currency under a common Central Bank, its independent monetary policy practically disappears, particularly for the relatively poorer and less powerful countries. An analogy in an Indian context could make it simpler to understand. Bihar can potentially run a budget deficit today and still not face a crisis similar to Greece's because it has the backing of the RBI which would always be ready to buy bonds floated by the Bihar government. Therefore, Bihar despite being in a similar position as Greece, in the sense that they both have a monetary union with other states/nations, enjoys the luxury of not going bankrupt since it has the support of a Central government. That is not to say that Bihar has the luxury, especially in today's world of fiscal 'prudence', to run high budget deficits but at least it will never face the problem of bankruptcy in so far as there is an RBI and a Central Government. Greece's problem is that although there is a central currency, there is no central government. This is Greece's predicament today. It could have solved the problem if it were out of the EMU but getting out of EMU at this juncture could further fuel the crisis.

The Way Forward

Paul Krugman has argued there are only two ways forward. Either Greece comes out of the European Monetary Union or it stays in it but bailing it out in that case becomes implausible due to various political forces at work. He argues that there are three possible routes through which it can stay in EMU and still come out of the crisis.

First, Greek workers could redeem themselves through suffering, accepting large wage cuts that make Greece competitive enough to add jobs again. Second, the European Central Bank could engage in much more expansionary policy, among other things buying lots of government debt, and accepting — indeed welcoming — the resulting inflation; this would make adjustment in Greece and other troubled euro-zone nations much easier. Or third, Berlin could become to Athens what Washington is to Sacramento — that is, fiscally stronger European governments could offer their weaker neighbors enough aid to make the crisis bearable.

The trouble, of course, is that none of these alternatives seem politically plausible.

We would like to argue that there are certain problems with what Mr. Krugman is arguing. Moreover, there are ways other than what he has proposed which could help Greece come out of this crisis.

Let me begin with the problems with his argument. First, drastic wage cuts might not increase the export competitiveness since German goods could still be preferred to the Greek goods purely because of their quality. Moreover, Greece would be competing with other nations as well for the external markets and there is no guarantee that they would not follow suit. At any rate, if the wage cuts increase their competitiveness one does not know whether it would be sufficient to allow Greece overcome its debt crisis. This would particularly be the case because decreasing wages also means a declining domestic market. Therefore, it is very likely that the marginal increase in exports would be overweighed by the decline in domestic consumption. Far from alleviating the problem, it could further add to it. It is surprising that what Mr. Krugman is arguing is similar to what the British Treasury was arguing during the Great Depression i.e. to decrease wage costs to increase profitability of business and make it competitive. The fallacy of such an argument is that wage bills not only enter as cost of production, they also enter as a source of demand into an economy.

Second, it is not true that if the European Central Bank indulges in buying Greece government's bonds it would necessarily lead to inflation. This is based on an unsubstantiated belief that a higher money stock automatically leads to inflation since "more money chases the same goods". Inflation would result only if the increased government fiscal deficit is not met by an increase in real output. In so far as Greece has idle capacity and unemployment, European Central Bank's money would chase an increased amount of goods instead of the same goods, thereby, avoiding inflation. In fact if they step in, they could also help keeping the interest payments on public debt of Greece low. At the moment, Greece has to perforce increase its interest rates on government bonds to make them attractive to the rentier interests.

Third, though Berlin and EMU, along with the IMF, are coming to the rescue of Greece by announcing the bailout package, it is coming with strings attached. The most stringent of them all is to force the Greek government to decrease its deficit in its immediate future and balance its budget in the long run. Now, budget deficit can be decreased through increasing tax rates or by decreasing government expenditure or both. It is implicit in this offer that the direct tax rates should not be increased. It is based again on an unsubstantiated belief that any increase in these tax rates acts as a disincentive to private investment, a factor so important in any recovery. Therefore, the entire burden falls on declining government expenditure or increasing indirect taxes. Within government expenditure, the burden falls entirely on social sectors and other redistributive instruments since the other big factor i.e. military expenditure cannot be decreased for so-called strategic factors. This decline in budget deficit, therefore, has two effects. First, it means a contractionary policy leading to increasing unemployment rates, which adversely affects the working class. Second, it completely reverses the redistributive powers of the government since it decreases net income of the poor both due to increasing prices of essential commodities (increasing indirect taxes) and decreasing income transfers. Therefore, such an adjustment is inequalising and deflationary by its very nature and would not solve the Greek problem in the long run.

To conclude, let us see if there is any other way out of this crisis without accepting the IMF's deflationary and extremely painful path to recovery. The answer lies in what IMF does not want Greece to do i.e. increase tax rates. The Greek government could decide to increase the direct tax rates while maintaining its expenditure on job-creating activities. This would have a dual effect. It would increase the growth rate and at the same time decrease the debt burden of the government by increasing the tax revenues for the same expenditure. Moreover, there is very limited evidence that increasing tax rates decreases private investment. What it indeed does is, if implemented properly, control speculative activities, which would be more than desirable at the moment. In fact, there is ample evidence that increased government expenditure, and thus increased real GDP, has a positive effect on private investment. This happens because it increases the domestic markets for the private capitalists. Even if the private investment does not increase, the government could play the role that private investment would have played.

Also, instead of joining the rat race for export competitievness which leads to declining wage share, they should concentrate on domestic sources of growth. One of the primary sources is the wage growth which increases the domestic consumption.

This path, however, would require Greece to gradually break away from the EMU and have strict capital controls. Only then can they pursue an independent fiscal as well as monetary policy without getting bound by the IMF logic of small government as a one-size-fit-all remedy to any crisis that emerges in the world. In this respect, we agree with Mr. Krugman that this is the only way forward for Greece i.e. to break away from the EMU. What effect this would have on the future of Euro is a moot question. The debt crisis that is erupting in Spain and Portugal of late is a pointer in that direction. But by breaking away from the EMU, at least the Greek people would not have to face the brunt of the adjustment process to a crisis in which they had no role to play in the first place.

[1] It is important to note here that the concept of public debt as a percentage of GDP is quite misleading. While public debt is the sum of all the accumulated debt over the past many years or what is called a stock in Economics, GDP is a one year variable i.e a flow. If at all, the correct figure would be a weighted average of the share of fiscal deficit as a proportion of GDP over the period in question.