November 6, 2011
Greece and the Euro
Greece and the Euro-Becker
I will discuss the following two crucial questions about Greece and the euro:
Should Greece have become part of the euro? No.
Should Greece leave the euro? Not now, but probably in the future.
Greece initially gained many apparent advantages from becoming part of the euro zone. The Greek government could borrow on the international capital market at interest rates that were only a little above the rates paid by Germany, the strongest EU economy. These low rates probably reflected a belief among investors that the strong members of the EU would support investors in the weaker economies if these economies ran into financial difficulties. Being part of the euro zone also led to easier access of Greek goods and services to the markets of other euro members, especially France and Germany. As a result, Greek GDP grew at good rates until the financial crisis hit.
However, being part of the euro zone created many problems for the Greek economy that only surfaced after the financial crisis began to take its toll. Since the cost of borrowing was low, Greece borrowed a lot from banks in France and Germany, and also from domestic banks, to finance a bloated government sector that had too many employees who retired early and did not have to work hard. It also had an inefficient and ineffective tax system that did not raise enough revenue to finance its ambitious spending programs. The government continued to operate inefficiently railways, mining and vehicle companies, and enterprises in many other sectors. Moreover, little effort went into reforming labor and product markets to make them more competitive and flexible.
These fundamental weaknesses of Greece were hidden during the good times after the creation of the euro. When the financial crisis and the Great Recession hit in 2008, investors began to require much higher risk premiums for government bonds and other assets issued by Greece and other weak members of the euro zone. Tax receipts of the Greek government fell significantly, which made it still more difficult to meet interest payments on Greece's large external debt.
If Greece had continued with the drachma instead of replacing it by the euro, Greece would not have been able to borrow so much on generous terms because support from the EU would not have backstopped Greek government bonds. After getting into economic trouble, Greece would have had to devalue its currency to increase exports, reduce imports, and cut its borrowings. Since Greek wage rates and prices are not flexible, devaluation would have substituted for direct reductions in the real wages of Greek workers through labor market adjustments. In addition, the Greek government would have defaulted on much of its debt, as Argentina did at the beginning of the 21st century. Greece would still have had to go through painful adjustments that would have significantly reduced the standard of living of the typical Greek family, but these adjustments would have been smaller and of shorter duration than what Greek is going through now with no end in sight.
I opposed the euro when it was created in 1999 because I believed it would prevent member countries from devaluing their currencies if they experienced negative shocks from the international economy. I expected the main shocks to originate in balance of payments problems instead of in capital accounts. After a while I began to believe that I had been wrong since the euro did very well during the early years of this century.
The past few years of major difficulties by the weaker members of the euro zone convinced me that the skeptics regarding the workings of a common European currency were right after all. Members of the euro zone with inflexible labor and product markets, the majority of members, have to endure painful and prolonged economic adjustments to negative shocks to their economies, such as Greece is experiencing, in part because countries in the euro zone are unable to devalue the international value of their currency. If it were not the financial crisis, other major shocks would have hit Greece and the other weak euro zone economies that would have badly stymied their economies.
To come more briefly to my second question, should Greece vote yes on a potential referendum to withdraw from the euro? The advantages of leaving are that Greece could greatly devalue its own currency, and default on much of its debt. The main disadvantage is that it would lose the substantial bailout assistance from the other EU members, especially France and Germany. Since Greek banks are also major creditors of the Greek government and Greek companies, default on the Greek debt would place these banks in unsustainable positions unless they received aid from the IMF or elsewhere. In addition, depositors would try to pull funds out of Greek banks to protect against losses from a depreciated drachma, and companies with euro-denominated debt would face financial ruin.
In light of this, the best solution for Greece would be to stay with the euro for the present while it receives additional aid from the EU and the IMF. But Greece should seriously contemplate pulling out of the euro zone later on, especially if by staying in Greece is forced to continue to undergo a painful and prolonged depression of its economy.
How the United States Is Like, and Unlike, Greece—Posner
The economic situations of the United States and Greece are more alike than one might think. In both countries, the government is insolvent, in the sense that its taxing power, constrained by politics, is insufficient to finance the government's liabilities, which include not only bonds but also entitlements (such as social security and medicare) and essential public services (such as defense). (See my post, "Is the Federal Government Broke?," Aug. 29, 2010, regarding our government's insolvency under standard principles of bankruptcy.) In both countries, government is cutting spending when (from an economic standpoint) it should be increasing it, to take up the slack in private investment and stimulate employment and in turn consumer spending (which drives business spending, which increases the demand for labor). In both countries a major cause of the current economic problems was cheap interest rates that encouraged the governments to finance public services by borrowing rather than taxing—taxing would have generated opposition to the extravagant level of those services. And in both countries another major cause of the current problems was the opacity of key financial data, a result in part of regulatory laxity and in part of the complexity and scale of modern financial instruments and operations. And finally, both countries have dysfunctional governments, made more so by the depression triggered by the financial collapse of September 2008.
There is another, slightly less obvious, parallel between the United States and Greece: neither country can stimulate its economy by devaluing its currency. Devaluation is a traditional response to depression, because it reduces the price of exports while increasing the price of imports. This has a dual effect: exports expand, and since they are (by definition) domestically produced, the domestic demand for labor rises; and imports decline, which increases the domestic demand for domestic over imported products (unless imports are a substantial input into exported products), further stimulating the domestic demand for labor. (According to Keynes, the high rate of English unemployment in the 1920s, which is to say even before the 1930s depression, was due to the fact that the British pound was overvalued.) Greece cannot devalue its currency because it doesn't have its own currency; in that respect it's like a U.S. state. The U.S. has the capability of devaluing its currency simply by selling dollars abroad, but would be reluctant to devalue substantially because the dollar is the major international reserve currency (the currency used in international transactions between companies that don't trust their local currencies), which creates a large demand by foreign central banks for U.S. dollars even when those dollars don't buy U.S. goods, and so is a source of wealth for the United States, in part because dollars cost nothing to produce. Its status as the major international reserve currency would be imperiled if its value fluctuated as much as local currencies in many countries do.
And still another parallel between the two countries: Greece spends a much larger percentage of its budget on defense than any other member of the European Union. Greece and the United States are two of the very few countries in the world in which defense expenditures exceed 4 percent of GDP.
Among the major differences in the economic situations of the two countries, the United States can still borrow at very low rates, because there is confidence that even if it defaulted, it would not default on its bond obligations (and certainly not on its bond obligations to foreigners) but instead would default on its entitlements obligations. Greece, however, having much greater debt relative to its income, is teetering on the brink of defaulting on its bonds. It is trying to negotiate a "voluntary" halving of its debt to its foreign bondholders; the hope in getting this de facto default to be accepted as being "voluntary" is that financial institutions that have insured the bondholders' debt through credit-default swaps and other exotic means will not be entitled to the insurance proceeds because there will be no formal default, the usual event triggering liability of an insurer of credit. Very little is known about the scope of the market in bond insurance, and so there is fear of a domino effect if the insurers of Greek debt are forced to bail out the bondholders who are being asked to take a "haircut."
Apparently even if Greece cuts its bond indebtedness in half, this will merely postpone default. The Greek government will either have to continue borrowing, but presumably at very high rates that will maintain its debt service at a high level despite the reduction in the principal that it owes, or have to slash public expenditures to a degree that the populace simply will not accept; or both. But another odd aspect of the comparison between the two countries is that because the Greek government's management of the economy is even more inept than our government's, it is, in principle, easier for Greece to reform: the government can fire a large fraction of its public employees not only with no loss in efficiency but with a gain as soon as they find private jobs; it can begin to collect taxes in a serious fashion; it can sell off a variety of public assets acquired by its socialistic predecessors (it is beginning to do this); it can, correlatively with firing its employee parasites, cut the red tape that impedes the formation of new and the operation of existing businesses; it can reduce pensions and other entitlements. But that is in principle, not in reality, because of public opposition; Greece is a democracy. Moreover, although what I have outlined are measures that could be instituted immediately, their effect would be delayed, creating the following dilemmas: while the surplus public employees are seeking jobs, they will have to be supported; collecting taxes and slashing pensions and other entitlements will reduce household income and thus reduce consumption and in turn production; and uncertainty about the nation's economic future will discourage business formation and expansion even if licenses become freely available.
There is waste in our federal government (and in state and local government as well), but proportionately much less waste than in Greece—so much less than few productive economies can be achieved without cutting entitlements, in particular the huge and rapidly growing Medicare program. But apart from the well-organized political opposition of the medical profession and the elderly to any cuts in Medicare funding, reducing public funding of medical care is more likely to shift than to reduce costs. Costs can be reduced only by heavy copays and deductibles, which would reduce demand for medical care, or by withholding treatment. These measures are unacceptable to the public.
Tax reform can go some distance toward increasing revenues without increasing tax rates—can even reduce the misallocative effects of taxation—but is immensely complex and contentious. Raising tax rates on just the wealthy will not increase revenues greatly, and raising it on the "middle class" as well (as the nonwealthy are misleadingly referred to) seems to be politically impossible.
Also off the table is further stimulus in Keynes's sense—which is to say, borrowing by the government to finance projects that employ people. We have learned that our government is entangled in red tape (like the Greek government, thought less so), precluding prompt execution of a Keynesian program, and we are reaching our borrowing limits. In addition the $800-odd billion stimulus enacted in February 2009 is widely regarded as a failure, though most neutral observers believe that it saved several hundred thousand jobs and by doing so may have helped to arrest the downward spiral in the economy, which in the first quarter of 2009 seemed on track to match the downward spiral during the Great Depression. It is regarded as a failure because the incoming Administration foolishly predicted that without a stimulus the unemployment rate would reach 8 percent and with it would fall to 6 percent, and because the unemployment rate rose to 10 percent and has come down only to 9 percent, the stimulus has been discredited—what should have been discredited was economists' confidence in their economic forecasts.
So, for neither country, is a solution for insolvency in sight. Fortunately, because the future is unforeseeable, despair would be premature.