Greece Cannot Reduce Its Budget Deficit So Long As Its Neighbors Pursue Mercantilist Policy

When the 12 European Nations raced to embrace the single currency, euro, it was supposed to be a forward step in the process of European Integration, towards the United States of Europe. In retrospect, the euro has not only not contributed to deeper integration but is certainly close to undermining its foundations. The economic and debt crises have forced countries to resort back to their bitter past relations up to the point where Greeks are demanding that Germany pay WWII reparations.

Much has been said about Greece’s debt crisis with a few proposals on how it should deal with it. All of these eventually turn into proposals of how the Greeks should manage their own country. A recent article in the New York Times critically examines Greece’s pension system which has 580 occupations that qualify for early retirement at the age 50. Greece has promised early retirement to about 700,000 workers and its average retirement age is one of the lowest in Europe, 61. While the effectiveness or the reasonableness of the Greek pension system is beyond the scope of this blog, what is incomprehensible is how does a developed and politically sovereign nation such as Greece completely give up its domestic policy space, up to the point where it is told what to do about its pensioners, how to behave with the unions, what to do about public sector wages, etc? Politicians, rating agencies and media commentators somehow feel that they all have the right to give some advice on how the Greek government should manage their country. As long as we know, Greece is a representative democracy where the people elect their government and can demand that it do whatever it has promised to its population. It is up to the people of Greece, through the Greek government to decide what to do with their country, not to us, to you and especially not to the fraudulent and corrupt rating agencies and media commentators looking to make a career. Moreover, it sounds like Greece is simply trying to solve its unemployment problems by making people retire earlier. Prolonging the retirement age won’t do much to solve the problem, as the government will still need to spend to boost aggregate spending to create jobs for all those people.

Most commentators of course overlook the main issue which is that by entering the monetary union and divorcing fiscal and monetary authorities individual nations have given up their currency issuing capacity. So unlike the Untied States government that spends by simply crediting bank accounts, i.e. changing numbers on spreadsheets (see here), the Greek and even German governments need to have tax and bond revenues prior to spending. But euronations differ vastly in their ability to collect taxes and raise revenue through bond sales. The convergence in debt levels, interest rates and number of other economic variables among individual countries that was being predicted by mainstream economists never really materialized. Germany and to some degree France have remained the important players in the euro landscape reserving the right to dictate policy prescriptions to their less powerful southern neighbors. At this point, Greece largely depends on Germany to determine its fate. It is now similar to a developing country being told what policy to implement by the IMF, only in this case it’s Germany that has assumed the role of the IMF.

It is useful to recall the financial balance identity for analyzing what policy options Greece has (see here). The balance of the private sector (surplus/deficit) equals the balance of the government (deficit/surplus) plus the current account balance (surplus/deficit). In plain English this means that private sector savings (surplus) is financed by government deficit (an injection into private incomes and hence saving) and by the current account surplus (net exports are an injection into nominal income and hence saving). By entering the monetary union the euronations have voluntarily agreed to the debt and deficit constraints imposed by the Maastricht treaty. So what are the policy options for these countries under these self-imposed constraints? We know that the private sector cannot be perpetually in deficit; in fact the normal situation is for the private sector to try to save some of its income. The current account balance of Greece was -9.98% in 2009. If Greece only had a budget deficit of 3% (the Maastricht limit) then its private sector would need to run a deficit of 6.98%. If we want the Greeks to have a positive saving (>0) what needs to be true about the government deficit? Simple math will show that it has to be greater than 9.98% of GDP. So to balance its budget, either the private sector needs to go in debt (making bankers richer) or Greece needs to balance its current account and even try to achieve a small surplus which is neither desirable nor achievable.

But what happens when all euronations try to export their way out of their economic problems? Basically, they will have to revert to mercantilist-type beggar-thy-neighbor policies where each country tries to solve its growth and unemployment problems by exporting them to their trading partners. Germany has already taken this route which has allowed it to be a “role model” for “fiscal responsibility” and given it the “right” to criticize other countries which don’t follow it. But all the countries cannot be net exporters; some have to be net importers. Germany can only be a net exporter to Euroland if some other euro nations are willing to be on the other end of the transaction. France, Italy, Belgium and Spain are among the 11 largest export partners of Germany with each of these countries having a net deficit with it. It is the government or private deficit in these countries that’s financing Germany’s exports.

So what options do net importer countries such as Greece or Spain have to maintain their aggregate demand at a reasonable level? If sovereign indebtedness is not acceptable, the only thing left is private sector indebtedness which will eventually lead to a financial collapse as we have witnessed in the US, UK and elsewhere. And some countries such as Spain don’t even have that option as their private sector is already highly indebted.

To summarize, the problem is not Greece’s profligate spending, but rather the design of the European monetary system. It has been specifically created to divorce the monetary and fiscal authorities to make the monetary authority super independent from “political pressures”. It has tied the hands of governments restricting them in using their fiscal capacity to employ their labor resources and has forced the countries into sluggish growth, high unemployment rates, stagnating wages, cuts in social services, etc. They have been able to achieve low inflation rates though. What a fair trade-off! Moreover, as countries on the periphery approach the Maastricht debt limits, the markets start betting against the country’s debt forcing it to pay higher interest rates. And of course no mess is complete without the rating agencies which are “diligently” monitoring the debt and deficit situations threatening to cut countries’ ratings further exacerbating the problem.

If Germany wants to increase its retirement age and cut social benefits it should be up to the German public to accept it or protest against it. But foreigners shouldn’t be allowed to dictate this to Greece and other nations. If they are doing that, and successfully so, it means that something is wrong with the way the system is set up. It is time for Greece and other nations in the outskirts of Europe to push for a change in the institutional structure which is obviously dysfunctional.