Introduction
The worst Global crisis
since the “Great depression”, hit the World in 2008. The “Great recession” triggered by the Global
Financial crisis(GFS) fundamentally changed the external environment, while the
Euro countries continued to believe that the World was undergoing just another
cycle like the dozens they had seen & dealt with in the post-war period.
Thus in our view (as ED IMF 2010-12), their economic approach and solution to
the fiscal problem, of putting overwhelming emphasis on austerity was fundamentally
flawed and highly likely to fail in the absence of a quick return of the World
economy to high growth and moderate inflation. A speedy return to higher
growth, was however, made impossible by the flawed emphasis of the
governments/politicians of the Euro Area, UK and the US on hard & immediate
fiscal squeeze on their own economies, thus reducing global demand and
exacerbating the global excess capacity in tradable goods and services. On the
supply side China, continued to create new capacity in manufacturing by pumping
credit into the economy, offsetting the natural process of depreciation and
obsolescence that would have gradually reduced total capacity.
Greece Loan
A number of High Income
European Countries including Greece, were among the worst affected by the GFS
& associated recession. The IMF changed
its rules, to make loans to Greece that were > 10 times the ratio limits
applicable to loans made to developing countries during the previous 50 years.
The only argument for making such an exception was to minimize the risk of
contagion to other vulnerable European countries such as Portugal, Ireland and
Spain. An IMF ED(a professional economist) pointed to the flaw in the economic
analysis and projections underlying the Greek loan: “The scale of fiscal reduction without any
monetary policy offset is unprecedented… (It) is a mammoth burden that the
economy could hardly bear. Even if,
arguably, the program is successfully implemented, it could trigger a
deflationary spiral of falling prices, falling employment, and falling fiscal
revenues that could eventually undermine the program itself. In this context, it is also necessary to ask
if the magnitude of adjustment…is building in risk of program failure and
consequent payment standstill… There is concern that default/restructuring is
inevitable.”[i]
Austerity or Fiscal Reform
Our experience of the Asian & Latin American crises, had taught us
that that the domestic private and international sovereign debt overhang had to
be dealt with quickly and effectively, to stave of a “Balance sheet recession”
and give the economy a chance to recover.
Further, that growth recovery depended critically on offsetting required
Govt. expenditure compression (austerity) by expenditure switching (real
depreciation and/or monetary easing). Clearly both the global demand situation
and domestic supply side had to be conducive to produce a sustained increase in
net exports and investment to stimulate and sustain growth. In the absence of exchange rate flexibility
in Greece (PIIGS), austerity could only work by reducing the real wage rate.
Given the deflationary post crisis situation, austerity would reduce not just
the nominal wage rate(w) but also the price level(p) thus having (at best) a
small effect on the real wage rate(w/p). We concluded that restoration of Greek
competitiveness within the euro zone would require a level of austerity that
was socially and politically infeasible.
We therefore argued that in Greece(& contagion candidates) the focus
should be on fundamental fiscal (tax and expenditure) reform, which would put it
on a sustainable fiscal path through a gradual reduction in expenditures and
increase in tax ratios, which follow from such reform(e.g. of Pensions).
Instead of an immediate reduction of government expenditures, the focus should
be on limiting and reducing the growth of expenditures, perhaps in some cases
to zero and not on cutting everything drastically. The overemphasis of the
Trioka on “austerity” distracted attention from more fundamental fiscal reforms
that still remain unimplemented by Greece.
Lender of Last Resort
There were three other
issues critical to success of Greek macro adjustment. The immediate problem for Greece and other
Euro zone countries in danger of contagion was the absence of a normal Central
Bank or lender of last resort. The European Central Bank was hemmed in by rules
and constraints that kept it from acting like a normal Central Bank (FRB, USA;
BOE, UK; RBI, India). We argued that contagion couldn’t be stopped unless the
ECB got complete freedom to lend to illiquid but solvent Euro area Banks and
financial institutions (Virmani(2011)[ii]
This problem was gradually solved after
the appointment of Mario Draghi as the Head of the ECB in November 2011 and the
risks of contagion have been largely eliminated due to ECB empowerment and
tightened financial regulation. However, subsequent to the No vote in the Greek
referendum, the ECB has raised the collateral requirements for providing
liquidity support to Greek Banks. Greece is therefore effectively without a
Central bank to fulfill the lender of last resort function for its Banks and
payment system. If this support is not restored, Greece has no option but to
reintroduce its own currency (Drachma) and Central Bank.
The introduction of currency
has two parts: Bank deposits(financial deposits), which can be converted
instantaneously into Drachma, and by letting the market set a Drachma-Euro
exchange rate. If a one to one conversion is done and the market exchange rate
is 1.3 Drachamas to the Euro, say, then the implicit haircut on all deposits is
30%. The second part is for the Greek Central bank to get Drachmas printed and
then offer to exchange Euro cash held by the public for cash in Drachmas, at
the market exchange rate. To minimize disruption, the Euro would continue to be
legal tender in Greece, but all prices
would have (gradually) to be specified in Drachmas.
Debt Sustainability
The second important
problem was Greece’s Sovereign debt. It was
very clear to us in 2010, that Greek debt was unsustainably high i.e. there was
no credible time path of nominal GDP growth that would result in a sustained
& continuing decline in the Debt-GDP ratio (Virmani (2011) op cit). Without
a substantial debt restructuring, resulting in an effective reduction in the
present value of outstanding debt, any delay in debt reduction/restructuring would
worsen the debt problem. Thus we argued that IMF, Euro and other sovereign
loans would merely result in repayment to private lenders and a substitution of
private by public debt. Those who
facilitated Greek government profligacy would get away without bearing the
consequence of their bad decision or sharing in the pain of adjustment. This is
precisely what happened. The debt crisis
reappeared as predicted and a partial debt write-off occurred in 2012, with a
Trioka mediated agreement between private lenders and the Greek government. It was too little too late. The Debt-GDP ratio
moved back to its earlier peak, triggering the loan default to the IMF and the latest
crisis of 2015. Any agreement that does
not reduce the present value of Greek debt, will constitute another
postponement of the inevitable (i.e kicking the can down the road).
Structural Reform.
Finally there was and still
is the problem of broader economic reforms to improve the competitiveness of
the Greek economy. It is often alleged
that the Greek economy is riddled with monopolies and oligopolies. The policy &
regulatory structures that encourage monopolies and oligopolies must be
reformed urgently to encourage new entrants and promote competition in product
markets. This includes privatization of State owned companies. Labor reforms, including anti-work incentives
in the pension rules must be modified to make labor markets more flexible. Whether
Greece remains in the Euro or leaves it, fiscal and economic reforms will be
essential for restoring economic growth.[iii]
Effect on India
The Greek crises, being
a mixture of economic and political factors (dozen Euro countries) has created
great uncertainty in the investing community. This uncertainty affects most of
the World including India, and is likely to continue for the duration of the
crisis. Normally such financial uncertainty leads to heightened liquidity needs
in Europe, the sale of Indian equity and an outflow of capital and exchange
rate depreciation. This time there is an offsetting factor. If the crises slowed EU recovery, as is
likely, the expected outflow of capital from India to the EU could be inverted.
Thus as I predicted a week ago, India could have a rise in equity markets cum
capital inflow on one day and the opposite another day, for the duration of the
Greek crisis.[iv]
From a medium term perspective, the conventional
Wisdom is that the Greek economy is too small a part of the Euro area, the EU
and the World to have any effect on the economy. In my contrarian view the Greek crisis, is
likely to slow Euro recovery and thus affect India’s exports to it.[v]
Further a setback to EU recovery would
also affect its exchange rate with USA and other countries. This could be a
factor in the US FRB’s decision on the QE program in September. If Euro growth
slows sharply, leading to capital inflow into US and USD appreciation
(indicating a natural tightening of monetary policy) the FED could effectively moderate
the anticipated rise in interest rates. This would offset any negative effects
on Indian exports and growth from the Euro slowdown.
The main long term lesson of
Greek crisis for India is to eliminate its revenue and fiscal deficit and thus
eliminate the major policy driver of the increase in net external indebtedness.
Cyclically adjusted revenue deficit should be reduced to zero by 2020 and the
cyclically adjusted fiscal deficit should be reduced to zero by 2025.
Conclusion
For a permanent solution of
the Greek crisis there are five things that have to be set right
simultaneously: (1) Structural reforms of markets to improve the
competitiveness of the Greek economy, (2) Fiscal reforms: Including revenue
neutral tax reforms that lead to an improvement in the tax GDP ratio over time
and expenditure reforms that increase the ratio of investments to transfers and
reduce expenditure-GDP ratios over time. (3) A debt reduction that puts debt-Gdp
ratios on a sustained downward path given realistic projections of nominal GDP
(4) Austerity light: A let up by moralists on imposition of pain on the Greek
people, which will actually reduce nominal GDP growth and raise GDP ratio back
to higher levels. (5) Complete liquidity
backup of Greek banks by the ECB (ie monetary policy).
Creditors are right to insist on (1) and (2),
as Greece cannot revive within or outside the Euro area without them. Creditors
are wrong to oppose (3) and (4) as without them the Euro crisis will be back within
the next three years. Without (5) Grexit
is effectively already here, as the banking and payments system cannot survive
without a central bank to provide liquidity.
--------------------
A shorter version of this article appeared on the editorial page of
the Indian Express on Thursday July 9, 2015 under the banner, “Trojan Loans,” http://indianexpress.com/article/opinion/columns/trojan-loans/
[ii] Arvind
Virmani, “Averting A Euro Meltdown: Sharing Global Responsibility,”
December, 2011 https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6MjE0NmYyY2U2N2YxMDg
[iii]
Interestingly many of these reforms are similar to or parallel those suggested
for India in the 1990s.
[iv]
DD News,Mark Lynn, 10 pm Monday June 29th & TV Today, Karan Thapar, 30th
June 2015.
[v] Op
cit
