Greece’s bailout program is not working. After receiving hundreds of billions of Euros in new loans to stave off a sovereign default, Greeks are on the verge of electing a new government that may throw Eurozone politics into turmoil.
From the outset, this was always going to be a tricky one for European bureaucrats and lenders. Restoring the solvency of a state which historically had great difficulties in collecting taxes from its citizens was not going to be easy. Moreover, the crash exposed fundamental flaws in the Greek economy, which at the time turned out to be a leading indicator for other Southern Eurozone countries.
With the world still reeling from the Great Recession, in 2010 Greece applied for a rescue program as its funding costs soared once the fragility of its finances could no longer remain hidden.
It can be argued that if debt balances had been restructured there and then to levels where they could actually be paid off over an extended period of time, together with unpleasant but sensible fiscal policies – as we shall see, taking into account important differentiators of the Greek economy – the cost of the bailout could have been much more manageable.
Instead, what the Greeks got was even more debt – so much in fact that a restructuring program had to be implemented just a couple of years later – together with a strict austerity program to quickly restore the country’s fiscal position, eventually leading to rising waves of unemployment and general discontent. Greece’s sovereign debts now represent almost 180% of GDP, a jump of some 20 percentage points from the post-debt restructuring levels of 2012.
The Eurozone and the International Monetary Fund have provided an eye popping €254 billion in loans to Greece since 2010. More than half has been used for debt servicing, and another 19% to recapitalize the domestic banks. Only about 11% of the total was used by the government for non-financial items. Greek taxpayers thus underwrote the whole deal but only got a fraction of the funds, at a time of severe government cutbacks and never ending tax hikes.
It is hardly surprising that they are close to a breaking point. The radical left-wing Syriza party is now in pole position to win the elections on January 26, campaigning on a promise to write off at least a third of Greece’s total debt and alleviate the austerity measures.
How things will play out in Greece and abroad is anybody’s guess. But it is important to consider the factors which have contributed to the current state of affairs.
Greece’s Brutal Adjustment Process
We have written previously on how the substantial real exchange rate appreciation of Southern European countries since the creation of the Euro contributed to the 2010-11 Eurozone crisis.
The real effective exchange rate is a weighted average of a country’s currency relative to an index or basket of other major currencies adjusted for the effects of inflation. As it appreciates, the goods and services of that country become more expensive in the international market. Faced with the prospect of losing market share, it can seek to devalue its currency to offset the higher inflation differential at home.
However, it is only price level differentials that matter within the Eurozone because the nominal currency is the same between trading partners. In other words, to improve its competitiveness, a member state cannot get any help from its exchange rate; it can only do so by bringing costs down.
This construct of course was devised to prevent waves of competitive devaluations between trading partners. But in Greece’s case it actually stacked the odds against the success of the bailout policies.
Why? Because a critical characteristic of the Greek economy was overlooked, or at least greatly undervalued.
Let’s look at the evolution of the real effective exchange rate in a selected group of Eurozone countries since 2000.
Real Effective Exchange Rate Index in Selected Eurozone Countries (2000 = 100)
Source: EuroStat.
As shown in the graph above, by 2009 Greece was only outranked by Italy in terms of its real effective exchange rate appreciation. This overvaluation is particularly noticeable in relation to Germany, which actually deflated within the Eurozone throughout this period (any wonder that their exports have held up?). This left Greece in a very uncompetitive position, becoming increasingly reliant on external credit. When foreign lenders closed the tap in 2010, the game was up.
Therefore, Greece had to quickly find ways to regain competitiveness. It could have resorted to the old fashioned way: devaluing its currency, meaning taking a sabbatical from the Euro (and would have certainly pushed the Drachma value of its debts even higher). Since this was not on the table, the alternative was to massively suppress costs and wages.
The resulting adjustment has been nothing short of brutal, rapidly converging to Germany’s levels in just a few years. In contrast, its Southern European peers actually reversed that adjustment process after the crisis (and might have to pay for it at some point in the future…).
And here’s why this adjustment mechanism was particularly difficult for Greeks.
In a country where everybody earns the same, say, €1000, if they have to cut earnings by 20%, people can moan and groan but will still be able to buy groceries and fuel. But in a country where a few people earn €5000 and the majority €500, that 20% cut will disproportionately impact the poorest, which will now be forced to make critical choices for their survival.
Poverty Rates in EU Countries: 2011
Source: EuroStat.
As shown in the graph above, Greece has one of the highest poverty rates in the European Union. In 2011, 21% of Greeks (901,194 households numbering 2.3 million individuals) lived below the relative at risk-of-poverty threshold. It is also one of the most unequal countries in terms of income distribution.
With these characteristics, Greece was simply not equipped to endure a lengthy deflationary process with no help from its currency. At some point something had to give.
And that is where we are today.
It remains to be seen exactly what policies will be pursued by the new government. Perhaps the real effective exchange currency has already deflated sufficiently to give the economy a meaningful shot at growth under much lower debt loads.
It seems, however, that quite a bit more will be needed.
A Catalyst for Improvement?
Can this massive shock to the system provide the stimulus to implement much needed reforms and changes to improve Greece’s overall competitiveness? This is indeed the question, because if the country is able to grow strongly, its ability to pay down debts and restore hope for the future without relying too much on financial engineering and devaluations would increase accordingly.
In fact, there is a great scope for improvement on many measures. And that is actually a big part of the problem.
After being a member of the European Union for decades, it is shocking how poorly Greece ranks in terms of key competitiveness variables; which is why another debt restructuring per se (nor, for that matter, another round of quantitative easing by the ECB) will not get that economy out of trouble – although it should provide some critical breathing space.
Here’s a quick snapshot of institutional strength metrics as per the latest World Economic Forum report (out of 144 countries):
- Global competitiveness ranking: #81 [Note: there are only 34 OECD countries]
- Judicial independence: #70 (after Zambia)
- Diversion of public funds: #81 (after Armenia)
- Property rights: #82 (after Gabon)
- Ethical behavior of firms: #99 (after Ukraine)
- Political favoritism: #109 (after Brazil)
- Transparency of government policymaking: #120 (after Hungary)
- Efficiency of legal framework in settling disputes: #126 (after Myanmar)
- Wasteful government spending: #131 (after Egypt)
- Burden of government regulation: #136 (after Kuwait)
See what we mean by “shocking”? What is thus required is a fundamental change at all levels of society.
To put what is needed in perspective, here’s what a former Portuguese Consul in France and Great Britain had to say about Greece when reflecting upon the situation of his own country:
“We are in a comparable, correlated state to Greece: the same poverty, the same political indignity, the same lowness of character, the same public corruption, the same usury, the same spiritual decadence, the same administration with grotesque sloppiness and confusion.”
