Thoughts on Greece
May 2, 2010
This Greece situation is turning into a good way to talk about a number
of related ideas. I thought I'd put them all together in one place.
What should a statesman do in such a situation? What are the options
and possibilities? The present Greek government leadership was elected
in October 2009. It later revealed that the Greek government budget
much larger than the previous government reported (due to some Goldman
Sachs-assisted prevarication), thus starting off the crisis.
A baseline solution: My basic
solution would be to stay within the eurozone, and just default. Blame
it on past governments. Then, reduce government spending dramatically.
This is mandatory anyway because without the ability to issue debt, the
government won't have any money in its checking account. It's amazing
how much a government's spending can decline when it doesn't have any
money. Let's call it a good thing! This
is a great time to dump all sorts of parasitic hangers-on, from pork
spending to the oligarchs who have been sucking the Greek government
for vastly bloated contracts, to the excessive number of public
employees. Dump them all in one go, quickly and cleanly. Indeed, there
will hardly be any other option due to cash constraints.
This step would have mixed political results. Obviously, government
workers and the oligarchs would complain, but many other people would
be happy to see the mess in Athens finally being cleaned up.
The next step would be to implement a dramatic tax reform. I would
consider just keeping the existing 19% VAT. It was raised to 21% in
March, but lower it again back to 19%. Then, eliminate all other taxes,
and declare a tax amnesty for any previous tax evasion.
This is not so much different from the flat-tax systems implemented
throughout eastern Europe, to great success. Following Estonia in 1993
and Russia in 2000, we now have Bulgaria, Albania, Czech Republic,
Georgia, Kazakhstan, Kyrgyzstan, Lativa, Lithuania, Macedonia,
Montenegro, Romania, Serbia, Slovakia and Ukraine.
Would a VAT-only system be better than a flat-tax type system, as has
been implemented in many other countries in Eastern Europe? Personally,
I like the slight "progressive" character of the flat-tax system, but
it would be interesting to give the VAT-only system a try. I can pretty
much guarantee that the results would be good. Also, it helps to make
friends with the oligarch-types, who might be miffed since they are no
longer able to bleed the Greek government for endless billions.
Admittedly, I am influenced simply by curiosity. After many flat-tax
examples, we should have some VAT-only examples just to see what would
happen. If they didn't like the results, they can change it later. In
any case, it would be much better than what they have now.
A big tax reform like that would also be quite popular.
Thus, Greece would be left, after the default, with: a) a vastly
slimmed-down government; b) a stable currency (euro); c) the most
growth-friendly tax system in Europe; d) massive unemployment.
The unemployment is a given in any case. It would result from the huge
reduction in government spending (about 10% of GDP) caused by the lack
of capital markets access. If the Greek government defaulted, then
withdrew from the eurozone and issued its own currency, and then raised
its already-high taxes -- in other words the standard IMF playbook that
many others recommend -- the result would be even worse unemployment
and a moribund economy.
The difference here is that we now have a very pro-growth framework,
which invites capital to create opportunities to put those unemployed
to work in productive new jobs. Most "economic growth" is actually a
process of unemployment. Most people used to be farmers. As farming
productivity increased, there was a steady reduction in farming
employment, freeing up resources to provide new goods and services. If
you had two people farming, and then farming productivity doubled, you
would have one farmer and one person providing some other service, like
a hotelier for example. Thus, the production of the economy increases.
Thus, we could look upon the great numbers of people being released
from unproductive government jobs as a great resource for future
growth. This growth would never happen if the environment is one of
high taxes and unstable money. But, it would happen in our scenario of
low taxes and stable money. Those people would be employed in the
production of new goods and services. This creates greater wealth,
greater GDP, and of course greater tax revenue.
A stable euro: The Magic Formula is:
Obviously, the above 19% VAT-only system takes care of the low taxes
component. The stable money is provided by the euro. This presumes that
the euro is stable. It has been much more stable than the alternatives,
such as the independent drachma or many other options. However, the
euro management (ECB) is, alas, incompetent. They don't really
understand how to manage a currency correctly. If they did, this minor
Greek government default would be no problem. Why should the value of
decline just because someone missed some payments? Who cares? If the
value of the euro did have a sagging tendency, the ECB would simply
reduce the supply of euro base money by selling bonds on the open
market and making the cash received in payment disappear. What happens
in these situations, normally, is that there is some event -- it
happens to be the Greece situation but it could be anything -- and the
currency sags in value. The ECB is plainly worried about the situation
but does nothing effective to counteract it, such as reducing base
money in "unsterilized intervention." This is a big tell: the ECB isn't
doing anything effective because it
doesn't know how. Now we have two currency negatives: first, the
original condition, and second, the fact that the ECB obviously doesn't
know what it is doing. This causes the currency to fall further, and
then we are on the way to a currency crisis.
This incompetence by the ECB is driving the policymaking process
towards bailout. Nobody wants a currency crisis. They think that if
Greece's government can avoid default by way of some IMF-led lending
program, then a
currency crisis can be averted, supposedly. But, it would be much
better if the ECB just knew what it was doing, and then they would
avoid a currency crisis whether or not Greece's government defaulted.
Bailing out the banks: What's
really going on here? There is about 300 billion euros of Greek
government debt. Who owns it? Mostly banks, and other financial
institutions like insurance companies, pension funds and the like. The
pressure for bailout is growing because these entities -- not the
want to get bailed out.
Let's say you own 50 billion euros of six-month Greek debt. Greece
doesn't have the money to pay you. It can't get the money by issuing
new debt. When an entity doesn't have the money to pay you, what
happens? Guess what -- you don't get paid. However, if Greece is able
to borrow from the IMF etc., then you would get 100% of your money
back. It's just like AIG and Goldman Sachs. AIG had some committments
to GS, but it didn't have the money to pay. What was supposed to happen
is that GS wouldn't get paid. The government's "bailout" of AIG was
really a bailout of AIG's creditors, namely Goldman Sachs.
Look at it from the Greek government's perspective. Before, it owed 50
billion euros to some banks. Afterward, it owes 50 billion to the IMF.
Not much of a change there. But look at it from the banks' perspective:
before, they had a 50 billion euro loan
that they weren't going to be paid back on. Afterwards, they
have 100% of their money. Big difference. So who is really getting
bailed out here?
In a rather amazing scam, it appears that forthcoming IMF etc. loans to
the Greek government could be made subordinate to existing debtors. Eh?
completely the opposite of normal procedure for distressed/bankrupt
debtors, where the latest loans are made senior to existing creditors.
It's another bank bailout! For example, let's say that there is 300
billion euros of Greek government debt out there. The IMF deal might be
billion euros for the first three years or so, to allow the Greek
goverment to roll
over maturing debt. That's great for the bankers who own the 125
billion euros of maturing debt. They get paid off. But what about the
bankers who own the remaining 175 billion of debt? A year from now,
they might be facing default once again, just as they are now. And, the
price of the bonds will reflect that risk of future default. They would
trade at a discount. However, what if the IMF loans were subordinate?
The fateful day comes three years from now. The IMF now has loans of
125 billion euros to the Greek government, and the bankers have 175
billion. The government
defaults. Probably the next thing that would happen is that there would
be a restructuring, so the government agrees to pay 70% of the
value. Now the value of the Greek government debt falls from 300
total to 300*70% or 210 billion euros. Normally, everyone would take a
30% "haircut". This is 90 billion euros. However, if the IMF is
subordinate, then the IMF would take all
of the 90 billion euro loss. Since the IMF's portion is 125 billion,
the IMF would absorb the whole loss, and the bankers would get 100%!
The most important part is that this would be reflected in the price of
debt in the market today.
People could do the calcuation, and compute that the probability of the
existing debt taking a loss is low, because the IMF is subordinate. So,
the senior debt would trade for a high price. Thus, the bankers could sell their Greek government debt today at
a high price.
don't have to wait years.
Zerohedge: Greek (Inverse) DIP
Update: Bailout Loans To Be Junior To Existing Claims
"Bankruptcy" and "failure."
"Greece" -- the country -- isn't going to "fail." Short of
military invasion, it isn't going anywhere. Even the central government
will probably survive (depends on politics), and continue its
oprations, despite missing some loan payments. These terms that get
around are ridiculous. "Default" is the term used when a debtor does
not abide by the committments of the loan contract. Typically this
means missing a payment, but there are also varieties of "technical
default" such as breaking a loan covenant like misuse of funds or
exceeding some ratio like debt/assets, collateral coverage, or many
other things. "Bankruptcy" is the term for the legal process that
ensues after a default. What legal process ensues for a sovereign
government? Not much of anything, really. Nobody is going to seize the
assets of a sovereign government. The government continues to exist and
operate. The main difference is that, having failed to make the
payments, lenders are less likely to loan money to that government in
the future. So, the big change for Greece is that it would no longer be
able to run a budget deficit. That might be a good thing.
The government is not the country: We
"Greece" is doing this and "Greece" is doing that. I
usually try to use the terminology "the government of Greece." Greece
is a country with 50,944 square miles of land and about ten million
inhabitants. It is home to many millions of businesses and households,
but Greece is not itself an economic entity. "Greece" -- the entire
country -- does not have assets or liabilities, revenues or expenses.
Within Greece are many government entities. There are city governments,
county or prefectural governments, independent government "authorities"
like a public transit system or a water district, school districts and
maybe state-run universities. Possibly public hospitals or even a
public museum. All these government entities have their own balance
sheets, revenues and expenses. Among these dozens if not hundreds and
thousands of government-type entities is the central government. The
central government is an organization with certain revenues and
expenses, assets and liabilities. It has a certain number of employees
and so forth. Although the central government might be the largest
single economic entity in the country -- more employees, more revenue
and so forth -- it is relatively small compared to the sum total of all
the economic activities and entities in Greece, the country. So maybe
this one entity, the central government, doesn't pay back the bankers
on some of its debt. Who cares? If the Greek central government
defaulted, that doesn't mean that the Athens public bus authority
defaulted, or the Mykonos public school system has a problem. Let's say
you are an olive grower. You have plenty of cash to pay your debts,
which are of course euro-denominated debts. So Tweedledee and
Tweedledum in Athens are having a little crisis. This is no problem of
yours. Nor do Greek households go into foreclosure on their mortgages.
Unfortunately, the egotism and incompetence of typical central
government bureaucrats is such that they like to take everyone down
with them. Thus the tax hikes, asset stripping, currency devaluations,
and so forth.
The madness of the devaluationists:
The Mercantilist economists, now known as the Keynesians, have two
basic solutions to every economic difficulty: government spending and
currency devaluation, or at least some variant of an "easy money"
policy whether "lowering interest rates" or "quantitative easing" or
some monetarist construct or whatever. Obviously, with the Greek
government already running an enormous deficit and facing default, more
government spending is off the table.
Thus, they are restricted only to currency devaluation. Today, they are
absolutely frothing at the mouth with different variations on currency
Don't you think this is a little odd? For one thing, Greece doesn't
even have a currency. It is part of the eurozone. This is why the
Keynesians are apoplectic with their hysteric arguments about why
Greece should have its own currency, why the eurozone doesn't work and
is doomed to failure, how everything could be solved if only Greece
"had their own printing press," and so on and so forth.
Here's FT columnist Samuel Britten for example:
A country with its own currency has two
safety valves, which Greece and others that may be in a similar
position lack. First, it can issue its own money; so it can pursue a
fiscal policy attuned to domestic needs, without being dependent on the
international bond market. Second, and most important, it has the
safety valve of currency devaluation.
Second, it should be obvious to even the layperson observer that this
is definitely not a currency
problem. This problem stems from the government's long history of huge
deficits, and the debt resulting from that policy. Obviously the
solution must involve reducing government spending. How could a
currency devaluation/easy money possibly resolve this? It's inane.
Here's a history of the Greek drachma before the euro was adopted:
Actually, Greece had a long history of currency devaluation before
entering the eurozone. So, if you want to understand the effects of
currency devaluation, just ask a Greek person. We see here that the
drachma went from about 50/dollar to 400/dollar, or about an 8:1
devaluation during the 1980s and 1990s. That is a lot. Prices of things
would rise by 8x, which works out to 11% annual inflation, on top of
inflation left over from the 1970s, which ran in the 4%-6% range in the
If your country has a history of this kind of chronic currency
devaluation, why would anyone want to own debt denominated in this
currency? A few speculators might try it, as the interest rate might be
attractive for the short term. And, it might be useful for some
domestic entities as a short-term "money market" type asset. Thus,
interest in the debt tends to be low and the yield curve is short,
typically under two years.
That's why governments of countries with a history of poor currency
management typically can't issue large amounts of debt denominated in
that currency. All the devaluationist types are screaming that "Greece
needs to issue debt in its own currency, so that it could make the
payments by running the printing press." Guess what -- nobody would buy
this debt, including Greeks themselves. Greeks aren't forced to buy
this crap just because they happen to live in Greece.
That's why, before joining the eurozone, most of the Greek government's
debt was denominated in foreign currencies:
In the bad old days, in 1995, only about 25% of the debt was
denominated in drachma. This is not because the Greek government didn't
want to issue debt in drachma. They would love to! The problem was that
nobody would buy it.
This is true of most other governments too, especially those in Latin
America, which have a long history of currency abuse.
This is pretty simple stuff. Even an economic novice should be able to
understand what I'm talking about here. However, the madness of the
devaluationists is everywhere these days. The Keynesian nutjobs are
thick and heavy at the IMF. The typical IMF response to a government
that defaulted on its foreign
currency debt is an intentional devaluation. What does this
accomplish? The government's revenues are in local currency. If you
devalue the currency, then it takes more and more local currency to buy
the foreign currency. Thus, the government's ability (and ultimately
the taxpayers' ability) to pay the foreign currency debt declines. You
would think this couldn't be more obvious. However, the Keynesian
nutjobs are, as I mentioned, in a bind here. They can't rely on
government spending, and they only have one other trick. They try to
solve the problem with currency devaluation, because in their minds it
is an all-purpose generic solution for everything.
"Currency union requires political
union:" This is baloney. If the ECB knew what they were doing
-- able to adjust the supply of money appropriately -- then all the governments of Europe could
default, and it would have no effect on the value of the euro.
Remember, a "default" just means they didn't make some payments. So
what. There are another 23 countries using currencies pegged to the
euro. About 70% of all the U.S. dollars in circulation are used outside
of the U.S. Does that mean the dollar doesn't work unless there is a
political union with the whole world? The only thing a currency needs
to be is stable. Traditionally, this means pegged to gold. All that you
need to maintain stability is to properly adjust the supply of base
money, to accomodate changes in demand for the currency. Read that last
sentence again. There's no need for political union, or budget deficit
agreements, or whatever.
The euro was a good idea. Unfortunately. the bureaucratic class of
Europe doesn't have the talent base to properly manage the euro, or to
deal with problems that pop up like this Greece affair. These are easy
problems to solve, but only if you know how to solve them. If you don't
know how to solve them, they are insoluble.
Greece had a long history of currency devaluation before joining the
euro. This tends to keep wages low -- lower than they should be --
because the money that workers get paid in continuously falls in value,
and also because economies just don't work well under those conditions.
After Greece joined the eurozone -- and enjoyed the benefits of a
stable currency -- workers' salaries naturally increased from their
devaluation-depressed levels. This is now supposed to be a big problem,
when it is actually one of the big benefits of a stable currency. We
often see these arguments in the early stages of a stable currency
after a long period of devaluation. In an environment of devaluation,
the businesses which benefit most from devaluation -- those which use
cheap labor to produce some sort of exportable good or service -- are
the ones that thrive. Consequently, they also become more politically
influential, and start to complain that the stable currency and rising
wages are blowing up their cheap-labor-based business plan. In Greece,
one of the main "cheap labor exportable" industries has been tourism.
After a while with a stable currency, the industries that benefit from
a stable currency -- most of them -- recover and offer a political
counterbalance to the devaluation-obsessed cheap-labor-export group. In
the case of Greece, it appears that these arguments are coming mostly
from the Keynesians, who feel lost at sea without the ability to
devalue the currency.
"Spending cuts and inevitable tax
hikes:" The latest plan involves an increase in the VAT of
about 3-4 percentage points. This is on top of a two percentage point
rise in the VAT in March, to 21%. This never works. Tax evasion in
Greece is already at high levels. This is because Greek people have
already concluded that they are paying too much taxes. What happens
when you ask them to pay more? They already aren't paying it, so they
just continue on in that fashion. Indeed, the legitimacy of the
existing tax code just declines that much further, and the tax evaders
look like the smart guys. I bet the government's tax revenue/GDP
declines as a
result of this. Does anyone think that Greece's problems arose because taxes were too low? This can
actually happen sometimes. Sometimes, people want more government
services, and are willing to pay for them with taxes. This almost never
happens today, but was common around the end of the 19th century when
governments started to provide basic services like universal education.
Obviously, the solution for Greece is spending cuts without tax hikes -- just as it is
for California and many other bloated governments whose bloodsucking
habits have reached their natural conclusion. I would go for a full tax
reform in Greece.