At some point in the very new future the Euro express will roll out of the station with at least one less compartment. Of course, it may not yet appear that way and, with appropriate smoke and mirrors, the final uncoupling may take place in some metaphorical tunnel far away from prying eyes. Indeed, it may have already happened. As all good German train drivers and passengers know, don’t flush the toilets while in the station! So what exactly has happened to the Euro express?
Back in 2001, and swept along on a tide of euphoria, having won the right to hold the 2004 Olympic games, Greece took the momentous decision to cash in its drachma, at a rate of dr 340.75 for 1 euro, to become the 12th member of the Eurozone. Greece joined the Eurozone despite widespread concerns, both within and outside Greece, about its ability to cope with a fixed exchange rate system. Indeed, Greece failed in its earlier attempt to meet the criteria laid down for membership (the 1992 Maastricht criteria), especially in terms of its poor inflation record, low productivity and interest rate instability. Despite some success at controlling inflation, for many the survival of Greece in the Eurozone was always in doubt, with its burgeoning public sector, lax tax collection and inflexible labour market.
As it became increasingly clear that Greece could no longer be sustained within the Euro framework, the momentum gathered pace and by late 2011 a Greek exit appeared a certainty. The final nail in the Greek Euro is likely to be hammered in when the Greeks vote on Sunday (17th June) to reject the austerity measures upon which continued membership depends. In the weeks running up to the new elections over one billion Euro has been flowing out of Greek banks each day.
I am reminded by Matthew Lynn (writing in History Today) that the Greeks have a long history of economic experimentation ending in disaster. For example, take Dionysius the Elder, who ruled the Greek city state from 407 BC. After running up massive debts to pay for his military campaigns and lavish lifestyle he had a cunning plan to force his citizens to hand over their one drachma coins whereupon he re-stamped them as a two-drachma coins. As every schoolboy or girl economist will tell you, this would have simply halved the value of the two drachma coin, reducing it back to its original real value. MV must equal PT…!! I hear you shout, in reference to the Fisher version of the famous quantity theory of exchange – where M = the quantity of money, P = average prices, T = the number of transactions in a period of time, and V = the velocity of circulation of money …..come on, keep up! Simply put, this means that, assuming V is constant in the short run, a doubling of the ‘quantity’ of the drachma would cause prices to double, leaving the real economy (T) untouched. Simple economics from Fisher, perhaps, but it certainly represents an equation that countless economists have thought worth modifying, tweaking and updating, and it remains a pretty accurate ‘rule of thumb’ today. Certainly, MV=PT is an expression that Dionysius might have consulted if he, or any of those well known Ancient Greek mathematicians, had thought it worthwhile to apply some basic mathematical principles to exchange, trade, and the value of money. Relating this to the current situation, and to put it in a nutshell, if money income in Greece is used to pay back spiralling debts to global investors, the effective money supply in Greece shrinks, and, unless prices and wages fall, the volume of transactions (T) or its velocity of circulation (V) must fall. Given that wages and prices are slow to adjust downwards, the outcome is a fall in the volume of transactions – in short, recession. Indeed, Greece is now 214th in the global rankings for economic growth, sandwiched between Cote d’ivoire and Anguilla*.
It should, of course, also be noted that the modern Greek state defaulted on its loans on three separate occasions in the 19th century (1843, 1860, and 1983) so it is no wonder investors have been looking nervously towards Greece while accepting the inevitable ‘haircut’. So was it the ‘illness’ or the ‘treatment’ that ‘did for Greece’?
With public debt spiralling out of control Greece was forced to implement a wide-ranging and deep structural adjustment programme as a condition for the receipt of loans. As a result, during 2010 Greece undertook what observers have regarded as the largest ‘fiscal consolidation’ (or, to you and I, the most severe cutbacks), of any EU country in history by reducing its deficit by 6% (yes, 6% is very big in economic terms!). This was achieved by increasing government revenues from €48.5bn to €51.2bn, while at the same time reducing government spending from €71.8bn to €65.2bn (Source: Greek Accounting Office). A stated aim of the Joint ECB/IMF structural adjustment programme is to get the Greek deficit-to-GDP ratio to the Eurozone average of 7.5%. A highly an unrealistic expectation – to say the least - given that GDP is in freefall.
As most will know, to facilitate the implementation of the programme, funds were made available to Greece through a series of tranche payments – running between May 2010 and June 2013 (13 payments, totalling €110 bn), with Germany and France contributing the lion’s share. So, that’s quite a lot of money really…in fact, it’s the equivalent of every Greek man, woman and child being personally presented with a cheque for $10,000. Of course, they won’t see a penny (or drachma) of it.
In return for the bailout, the measures implemented (or intended to be implemented) include an overhaul of the Greek tax system, measures to tackle tax evasion the passing of a new Fiscal Management and Responsibility Act in 2010, the establishment of a Greek Financial Stability Fund, widespread reform of local public administration, the restructuring of the railway sector, pension reform, the scaling-up of its privatisation programme, and the removal of red tape to enable new businesses to develop. These reforms are clearly very painful, to state the obvious. Defenders of the austerity plan, including the ECB, argue that the decline in Greek performance began well before any structural reforms were implemented – they are a response to it and not a cause of it. However, there is little doubt that the measures combine to create a short term and substantial net withdrawal of monetary demand out of the economy.
As with all previous ‘adjustment programmes’, austerity is the inevitable result. Greek individuals, families, businesses, borrowers and lenders are currently unable to calculate the absolute and relative risks associated with their financial and economic decisions, and those of other parties. Saving appears more attractive than spending, and hording more attractive than investing. Such a mentality prevents business from developing, and constrains growth in the economy and further economic development. The lack of growth means that tax revenues will remain weak. The weaknesses of tax revenues, combined with rising government spending (still running at 50% of the economy) means that Greeks will find it increasingly difficult to repay its existing debts, let alone fund any new ones – better to get out now while you can, and limit the damage. So while Germany prepares to uncouple the caboose, rich Greeks have been flocking to London.
Not to worry – the real effect of Greece leaving will be relatively small – its share of EU GDP is a very modest 2.02%*. Not many jobs in the rest of the EU depend upon Greek consumption – certainly a consideration that Euro politicians will not be unaware of. Even if the austerity parties win, expect a Greek exit any time during the next six months – probably 1st Jan 2013. Most of us are old enough to remember the drachma, and most Greeks may live long enough to forget the Euro. Now what about Spain? Well, that’s an entirely different story.
*Source: CIA Factbook
Copyright – George Higson – EconomicsOnline, 2012