In the most recent debt service negotiations between Greece and its creditors, the media and financial coverage have focused too little on Greece’s potential economic growth and have overstated the risks that a Greece exit from the EU would generate a “Lehman moment.” In reality, whether Greece stays or exits, it requires significant reforms to generate any kind of sustainable economic growth, and although its current debt situation is bad, the situation is virtually opposite of a “Lehman moment” that would unhinge financial markets.
A starting point for considering Greece’s challenges is that with its sovereign debt-to-GDP ratio 175% and its real GDP declining, unless Greece can turn its economy around and generate sustained growth, its citizens’ standards of living will continue to erode and it will require ever-larger financial support packages to service its debt.
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Greece’s financial problems didn’t just come out of the blue, they are the cumulative impact of misguided economic policies: fiscal profligacy, misallocations of national resources and growth-depressing labor and economic regulations.
Greece’s real GDP has shrunk over 25 percent from its 2007 peak; it is back to its 1999 level, before it was admitted to the EMU. Even when Greece’s real GDP was growing from 2001-2007, its economic performance and policies were highly problematic. Ballooning government debt financed unsustainable growth in consumption, real estate activity and a bloated and over-paid government sector and excessive retirement pensions. During this period, industrial production was virtually flat and gross capital formation barely rose and actually declined as a percent of GDP. Greece’s trade and current account deficits soared to unsustainable levels. Capital inflows financed consumption-oriented activity, not investment or activities that added to productive capacity.
The global financial crisis and recession of 2008-2009 laid bare Greece’s debt-financed resource misallocations. It also revealed the folly of Greece’s foreign creditors who lent money to Greece at inflation-adjusted yields below those of Germany.
Looking forward, Greece’s longer-run growth prospects under current arrangements are truly dismal. A nation’s growth potential is typically expressed as a function of its capital stock, its population and labor force growth and productivity. During Greece’s 15 year track record as a member of the EU-EMU, its track on these fundamental building blocks has been about as bad as it gets, and the current thrust of policies and what its leaders advocate point toward potential growth that is close to zero (or even negative?)
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Greece’s real gross capital formation has fallen by two-thirds since 2007 and is now less than one-half of its 2001 level. After adjusting for depreciation, its net capital stock has declined persistently. The prospects for rebuilding Greece’s capital base are dim: private investment is deterred by uncertainties surrounding government’s policies and very high costs of capital; foreign direct investment is virtually absent; Greece has incurred a run on its banks; the top priorities for Greece’s government spending is for pensions, government employees and income support; and Greece’s relatively high unit labor costs of production and the constraints imposed by the Euro hamper its competitiveness.
Greece’s labor force trends are equally negative: its population has been declining since 2010 and its labor force has fallen steadily back to its early 2003 level. Greece’s unemployment rate is 25 percent and youth unemployment is near 50 percent. Measured labor productivity has been edging up because of forced labor cutbacks, but it remains well below its 2007 peak. Future productivity will be constrained by insufficient capital and a labor force with eroding skills.
Obviously, meaningful economic reforms are required to reverse these trends and lift growth prospects. The debate about reform in Greece goes way beyond the issue of how much fiscal austerity is required or harmful in the short run. Greece’s reform efforts must address a far-reaching web of government economic and regulatory policies that undercut economic performance. Greece must also aim to re-establish a rule of law and rebuild the government’s credibility. Without these foundations that would make Greece an attractive place to reside, work and invest, Greece’s citizens face further declines in standards of living.
Reforms must break down and streamline administrative laws that are hindering labor mobility, like regulations that control hiring and firing. Red tape in business licensing laws must be cut and the financial and administrative costs of new business startups must be lowered and streamlined. Regulations that adversely affect production processes must be cleaned up. Government corruption must be eliminated.
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Laws must be clear, enforceable and enforced. As a sustaining member of the EU, many of these initiatives would involve oversight by appropriate governmental bodies. Such oversight would align Greece’s regulations with the EU’s, and would be a vehicle for rebuilding Greece’s credibility.
On the government budget front, besides implementing mechanisms to reduce tax evasion, fiscal policy initiatives must be aimed at improving resource allocation that will support growth, rather than establishing deficit targets. This involves reducing obvious pockets of bloat in the government sector and spending more on infrastructure that adds to productive capacity.
In its negotiations for financial support from creditors, Greek leaders have been pushing away from this type of pro-growth agenda. Grudgingly, European leaders have been giving in, because they don’t want to face the realities of a Greek default. This “kick the can down the road” strategy virtually guarantees sustained underperformance, and ever-growing financial support burdens. Without pro-growth reforms, eventually Greece’s bailout requirements will overwhelm already-stretched European leaders.
What if Greece were to default on its debt and/or leave the EU? Although there are many potential sources of turmoil, the so-called “Lehman moment” that triggered a financial collapse in fall 2008 occurred under circumstances nearly the opposite of the current situation in Greece--and is not in the cards. The Lehman moment was an extreme liquidity squeeze that occurred when financial institutions realized that they did not know or couldn’t trust their counterparty’s asset quality or capital adequacy, and shifted to extreme risk aversion and cut short-term funding to other financial institutions.
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Contrast that with Greece’s current debt situation: the magnitude and value of its debt is well known, as it the precise amount that each large foreign creditors holds. The vast amounts of adjustments have already occurred and the remainder is anticipated. Moreover, private sector entities conducting business with the Greek government or its private sector businesses are fully aware of the situation. With so much knowledge of “knowns”, financial adjustments have already occurred.
Whether Greece remains in the EU or exits, economic reform is necessary to lift its dismal growth prospects. Let’s be clear: the costs of misguided policies have mounted, and after living so long beyond its means and allowing its fundamental economic building blocks to erode, Greece’s road to recovery will involve many adjustments. But the fairly quick positive economic responses to economic reforms in Ireland and Spain provide an incentive and example for Greece to emulate.
Mickey Levy is chief economist of Blenheim Capital Management and a member of the Shadow Open Market Committee. This commentary was published originally in e-21, a website of the Manhattan Institute.
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