Friday, June 19, 2015

Prepare For Graccident?

In its latest issue, The Economist put out a comment, My Big Fat Greek Divorce:
It is never pleasant to watch a relationship founder. Greece’s prime minister, Alexis Tsipras, has charged its creditors with trying to humiliate the country; he has accused the IMF of “criminal responsibility” for Greece’s suffering. Prominent euro-zone politicians are saying openly that, without a deal to release rescue funds in the next few days, default and “Grexit” loom.

The urgency is because of a repayment of €1.5 billion ($1.7 billion), which Greece seemingly cannot afford, to the IMF on June 30th and because Greece’s European bail-out expires that day. Cue the last-ditch negotiations that have become a Euro-speciality: just after The Economist went to press, finance ministers were to assemble in Luxembourg; leaders may meet over the weekend; a European Union summit is scheduled at the end of next week. It may come down to a head-to-head between Mr Tsipras and Angela Merkel, Germany’s chancellor. A deal is still possible, but the sides have come to loathe each other. If this were a marriage, the lawyers would be circling.

Divorce would be a disaster—for everyone. The trouble is that, unless Greece and the euro zone change the terms of their relationship, staying together would not be a great deal better.

Exit Greece, stage far-left

To see why, start with the results of a default and Grexit. After arguing on and off for five infuriating years, some have begun to welcome the prospect. They are making a mistake.

For Greece the gains from defaulting would be slight, and the costs potentially vast. True, the country could walk away from debts of €317 billion, or almost 180% of GDP. But that is worth less to Greeks than it sounds. Although the debt is huge, it is at bargain-basement interest rates and repayable over decades. Interest payments until the early 2020s are just 3% of GDP a year. Even for Greece, that is manageable. Nor would leaving the euro do much good. In theory, with a new drachma and its own central bank, Greece could devalue and gain competitiveness. But Greece’s trade is modest. And it has already lowered nominal wages by 16% without a boom in exports.

By contrast, the cost of Grexit would be exorbitant: bust banks, slashed savings, broken contracts and shattered confidence (see article). Politics could be devastated. Syriza, Mr Tsipras’s hard-left party, is anti-market and anti-enterprise. Neo-fascist Golden Dawn and the Communists, with a combined 12% of the vote, would thrive. Most of the parties in the middle, already discredited, would struggle. This week Mr Tsipras was due to play footsie with Vladimir Putin in Russia. Ejected from the euro, and possibly the EU, a country with a history of coups would risk becoming violent and even more corrupt.

That is one reason for the euro zone to think twice before ditching Greece. A failing state on the Aegean would be the EU’s problem regardless of whether its politicians accepted bribes in euros or drachmas—indeed, it would be a greater and less tractable problem than Greece is today. In addition, monetary union was supposed to be irrevocable. If, in fact, its members risk ejection, then contagion will be more likely to spread to other vulnerable economies, such as Portugal and Cyprus—if not in this crisis, then in the next.

Some people, including possibly Mr Tsipras, have concluded that the price of Grexit is so high that Greece can count on the euro zone giving ground at the last minute. But that is reckless. If the euro is to endure, its rules must be enforceable. So long as the monetary union is forged between sovereign states the principles of irrevocability and enforceability are contradictory. Yet you can be sure there is a limit to what the euro zone will tolerate—even if nobody knows where it lies.

Till debt do them part

The upshot is that Grexit is a process, not an event. Even if talks fail, even if Greece defaults, even if it introduces capital controls and the government starts to issue paper IOUs because no more euros are left—even then, a referendum or a new government could still offer Greece a way back.

But a deal is a process, too. Though it would doubtless be hailed as a triumph, it would mark only a step towards the eventual restructuring of Greek debt. Trust is so low and Greece’s reluctance to honour its pledges so evident, that each slug of new rescue money will depend on Greece showing that it has kept its side of the bargain. Such conditionality is necessary and economically desirable (see article), but in today’s poisoned environment comes at a high cost. Relations between the euro zone and Greece are defined in terms of the “concessions” each has screwed out of the other. The marriage may endure, but even more unhappily than before.

A change of mindset is needed. Both sides have bungled the Greek crisis. Especially at the outset, the creditors put too much weight on rapid fiscal adjustment, in a doomed attempt to limit the size of Greek debt. As well as needlessly impoverishing Greece (GDP has shrunk 21% since 2010), this was a distraction from the real task, which is to sort out the structural impediments to growth—rampant clientelism, hopeless public administration, comically bad regulations, a lethargic and unreliable justice system, nationalised assets and oligopolies, and inflexible markets for goods and services and labour.

But Mr Tsipras has made a bad situation worse. In 2014 the Greek economy grew. Now it is shrinking again, partly because Syriza has proved incompetent and even more clientelist than its predecessors. But also because posturing in negotiations has absorbed all Syriza’s attention and set the country back years. The need for a crisis to bring the talks to a head and to wring concessions from the other side has wrecked market confidence. Capital has flooded out of the banking system. Investors have kept away. Every reform has become a bargaining chip that must not be traded away before a deal and will not be exceeded once a deal has been struck. The idea that reform is actually good for Greece has been lost.

Most Greeks want to stay in the euro. But their politicians still look to Berlin for salvation, rather than to reform at home. Greece must understand that, if this does not change, the creditors will lose patience. Avoiding divorce would be better for everyone. But this marriage is not worth saving at any price.
So we had another "emergency meeting" in Luxembourg on Thursday and just as I predicted, nothing came out of it, forcing eurozone leaders to hastily call a crisis summit Monday. Creditors upped the pressure on their big fat Greek squeeze and Varoufakis wasted no time posting yet another blog comment outlining Greece's proposals to "end the crisis" and his intervention in the Eurogroup meeting. Afterward, he warned: "we are dangerously close to a state of mind that accepts an accident".

What about Greek Prime Minister Alexis Tsipras? Where was he as all this was happening? Where else? He flew off to Russia again looking for some love and is expected to sign a preliminary agreement for the country’s participation in Russia’s planned extension of a gas pipeline through Greek territory, a provocative move which will surely piss off his European and American allies.

Welcome to the whacky and frustrating world of European politics where leaders from all sides are clearly incapable of leading and agreeing on anything. Then you wonder why I'm still short the euro and think that the worst of the Euro deflation crisis lies ahead? This union is a sham, a total farce and everyone is to blame for this Greek debt crisis.

The more I'm reading, the more I realize this crisis isn't about economics, it's about politics and ideology. Bloomberg came out with an excellent comment, European Disunion: For Two Rivals in Greek Crisis, It’s Personal, which outlines the ideological rift between Yanis Varoufakis and Wolfgang Schäuble. 

Right now you have a major political battle going on in Europe between the north and the south where the Germans, Finns and Dutch want to impose fiscal discipline on their southern neighbors. And as I stated last year, Greece is at the epicenter of the the Euro crisis

Some argue that Greece will be made a scapegoat, an example of what happens when you run contra the powerful German machine which has adopted the hard line stance President George H. W. Bush once adopted versus U.S. allies: "Read my lips, what we say goes" (He also once quipped "Read my lips, no new taxes," but ended up regretting that comment).

On the opposite side of the spectrum, you have Tsipras, Varoufakis and SYRIZA members who think they're fighting the new Battle of Thermopylae and that they will bring about a new world order in Europe, one based on social justice, solidarity and an end to the"tyranny of oligarchs". They're willing to commit economic suicide and under no circumstance are they going to blink first

All sides are hopelessly delusional and their positions are so entrenched that it's difficult to see how they will reach any deal at Monday's "crisis meeting." I still maintain that creditors will blink first and provide Greece with some form of debt relief because they're not willing to risk Grexit and another global financial crisis. 

But even if by some miracle a deal is reached, it won't be the endgame for Greece and Europe. Far from it, as I stated in my last comment on Greece's pension paradox,  no matter what deal is struck or not struck, I'm worried that the country I love so dearly has fallen so far behind that no matter what deal it gets, it's doomed for decades of economic weakness.

Former Greek finance minister Stefanos Manos is right, unless Greece leaves its statist habits behind, the country will never stand on its on two feet. The size of the Greek public sector is the biggest problem; you simply cannot have 1.5 million public sector employees for a country of 11 million, especially after austerity measures have disproportionately hurt the private sector made up of roughly 2.5 million workers and falling fast.

The ratio of public sector to private sector workers in Greece is completely out of touch with reality and unsustainable. I don't care what Varoufakis, Stiglitz, Krugman, Sachs, or other economists say, this ratio is the noose that has slowly but surely suffocated the Greek economy over the years.

The Greek economy is in desperate need of other reforms too (see here and here) but until they cut the public sector down to a more manageable size, their economy will never thrive again and will always drown in unsustainable debt.

Having said this, I'm sympathetic to those who criticize creditors for their foolish and myopic stance. James Galbraith, a professor of economics at the University of Texas and close friend of Yanis Varoufakis, wrote a great comment in Project Syndicate, The IMF’s “Tough Choices” on Greece:
The International Monetary Fund’s chief economist, Olivier Blanchard, recently asked a simple and important question: “How much of an adjustment has to be made by Greece, how much has to be made by its official creditors?” But that raises two more questions: How much of an adjustment has Greece already made? And have its creditors given anything at all?

In May 2010, the Greek government agreed to a fiscal adjustment equal to 16% of GDP from 2010 to 2013. As a result, Greece moved from a primary budget deficit (which excludes interest payments on debt) of more than 10% of GDP to a primary balance last year – by far the largest such reversal in post-crisis Europe.

The IMF initially projected that Greece’s real (inflation-adjusted) GDP would contract by around 5% over the 2010-2011 period, stabilize in 2012, and grow thereafter. In fact, real GDP fell 25%, and did not recover. And, because nominal GDP fell in 2014 and continues to fall, the debt/GDP ratio, which was supposed to stabilize three years ago, continues to rise.

Blanchard notes that in 2012, Greece agreed “to generate enough of a primary surplus to limit its indebtedness” and to implement “a number of reforms which should lead to higher growth.” Those so-called reforms included sharply lower public spending, minimum-wage reductions, fire-sale privatizations, an end to collective bargaining, and deep pension cuts. Greece followed through, but the depression continued.

The IMF and Greece’s other creditors have assumed that massive fiscal contraction has only a temporary effect on economic activity, employment, and taxes, and that slashing wages, pensions, and public jobs has a magical effect on growth. This has proved false. Indeed, Greece’s post-2010 adjustment led to economic disaster – and the IMF’s worst predictive failure ever.

Blanchard should know better than to persist with this fiasco. Once the link between “reform” and growth is broken – as it has been in Greece – his argument collapses. With no path to growth, the creditors’ demand for an eventual 3.5%-of-GDP primary surplus is actually a call for more contraction, beginning with another deep slump this year.

But, rather than recognizing this reality and adjusting accordingly, Blanchard doubles down on pensions. He writes:
“Why insist on pensions? Pensions and wages account for about 75% of primary spending; the other 25% have already been cut to the bone. Pension expenditures account for over 16% of GDP, and transfers from the budget to the pension system are close to 10% of GDP. We believe a reduction of pension expenditures of 1% of GDP (out of 16%) is needed, and that it can be done while protecting the poorest pensioners.”
Note first the damning admission: apart from pensions and wages, spending has already been “cut to the bone.” And remember: the effect of this approach on growth was negative. So, in defiance of overwhelming evidence, the IMF now wants to target the remaining sector, pensions, where massive cuts – more than 40% in many cases – have already been made. The new cuts being demanded would hit the poor very hard.

Pension payments now account for 16% of Greek GDP precisely because Greece’s economy is 25% smaller than it was in 2009. Without five years of disastrous austerity, Greek GDP might be 33% higher than it is now, and pensions would be 12% of GDP rather than 16%. The math is straightforward.

Blanchard calls on Greece’s government to offer “truly credible measures.” Shouldn’t the IMF do likewise? To get pensions down by one percentage point of GDP, nominal economic growth of just 4% per year for two years would suffice – with no further cuts. Why not have “credible measures” to achieve that goal?

This brings us to Greek debt. As everyone at the IMF knows, a debt overhang is a vast unfunded tax liability that says to investors: enter at your own risk. At any time, your investments, profits, and hard work may be taxed away to feed the dead hand of past lenders. The overhang is a blockade against growth. That is why every debt crisis, sooner or later, ends in restructuring or default.

Blanchard is a pioneer in the economics of public debt. He knows that Greece’s debt has not been sustainable at any point during the last five years, and that it is not sustainable now. On this point, Greece and the IMF agree.

In fact, Greece has a credible debt proposal. First, let the European Stabilization Mechanism (ESM) lend €27 billion ($30 billion), at long maturities, to retire the Greek bonds that the European Central Bank foolishly bought in 2010. Second, use the profits on those bonds to pay off the IMF. Third, include Greece in the ECB’s program of quantitative easing, which would let it return to the markets.

Greece would agree to fair conditions for the ESM loan. It does not ask for one cent of additional official funding for the Greek state. It is promising to live within its means forever, and rely on internal savings and external investment for growth – far short of what any large country, controlling its own currency, would do when facing a comparable disaster.

Blanchard insists that now is the time for “tough choices, and tough commitments to be made on both sides.” Indeed it is. But the Greeks have already made tough choices. Now it is the IMF’s turn, beginning with the decision to admit that the policies it has imposed for five long years created a disaster. For the other creditors, the toughest choice is to admit – as the IMF knows – that their Greek debts must be restructured. New loans for failed policies – the current joint creditor proposal – is, for them, no adjustment at all.
Galbraith is touting Varoufakis's modest proposal, but again, why should creditors focus on this and other growth initiatives when the Greek public sector beast runs amok?

And he's right, the math is simple, as GDP contracts, the percentage of pension payments to GDP goes up but someone can argue that when your economy contracts, you have to make difficult decisions and make cuts to pensions, public sector wages and fire civil servants.

The previous Greek coalition government cut wages and pensions in the public sector but nobody had the courage to make drastic and much needed cuts to the size of the Greek civil service. All Greek politicians were too busy buying votes, increasing not decreasing the size of the public sector, and if you think Tsipras, a power-hungry leftist demagogue is any different, you're nuts!

Below, Greek finance minister Yanis Varoufakis speaks following an early end to Eurogroup talks on Thursday, warning 'we are dangerously close to a state of mind that accepts an accident'. Unfortunately, he's right on that but fails to take any responsibility for his government's actions for escalating this crisis to a point of no return.

Also, one of my favorite leftist economists, Michael Hudson, recently discussed the Greek debtline on The Real News Network. On the Naked Capitalism blog, Michael stated he will be in Athens this weekend where he will likely consult the Greek government and hinted there will be "no payment" and he doubts the EU will expel Greece from the eurozone because the IMF and ECB made bad loans in the past. I agree with Michael on that front but he too misses the bigger problem in Greece.

Lastly, one of my favorite market commentators, Michael Gayed, chief investment strategist at Pension Partners, says he expects Greece to be resolved in the short term, but warns of market complacency surrounding the issue. I agree, too many smart people are underestimating the contagion effects of  Grexit, and that can come back to haunt them.

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