The malaise of the Greek economy

23 08 2010

Greece’s fiscal and other problems are by now known to literally everyone. However, the recent developments in that economy make it an interesting subject on which, besides the fact that I have personal interest, I worked on in an Economics assignment during my MBA studying. I post much of that work here, enhanced with my personal and purely subjective point of view.

Context

Greece’s economy after WWII is known as the “Greek miracle”. What contributed to that miracle was the cheap and abundant labour available after a war followed by a civil war. A major contribution came from the operations of Greek ship owners, who, having acquired for low prices or even for free hundreds of war-time “Liberty” class ships revived Greece as a marine super-power. The short-lived miracle ended with a dictatorship that started producing a deficit. The 70’s marked the end of the dictatorship, but not a change in economic policies. The 80’s where marked by the accession to the EEC and for a first time in history a new socialist government. These two latter changes are a milestone as they introduce:

  • The increase in wealth due to EEC subsidies
  • The inflation of the number of public workers
  • The running of large deficits

The 90’s where slightly more balanced as the actual increase in output and productivity. The turn of the century and much of the first decade is characterised of financial and housing bubbles.

Overview

During the early months of 2010 Greece entered a vicious circle of increased borrowing costs that evolved into a sovereign debt crisis threatening to spill over many EU economies. This crisis even challenged the Euro foundation and tested the limits of governments towards their voters. Currently Greece is under a tight austerity plan in order to mend its public finances. This plan devised by the IMF, ECB and EC, the so-called “Troika” aims at putting the economy back in track. It is supported by a bail-out package of 110bn that covers the debt needs of Greece.

The debt crisis came after the banking crisis that threatened to push the world economy into the worst recession after the Depression. It was not surprising that this crisis helped unveil the deep structural problems of Greece. Figure 1 and Figure 2 show the general government deficit and debt respectively for the period 2003-2009. Although Greece follows the same trends as the Euro area and the EU of 27 countries, there is a remarkable shift of the curves up that shows that throughout this period and the previous years, Greece has accumulated a significant debt and is unable to control effectively its expenses. As part of the Euro, it is unable to control its own monetary and fiscal policies. The restructuring measures taken by the government and the “Troika” include increases in direct and indirect taxation, reduction in the salaries of the public sector and all pensions, further liberalization of the domestic market and lifting of protection for certain employments. These measures have – in the short term – increased inflation, increased government tax income but decreased spending and worsened the current account balance.

Figure 1: General government deficit as percentage of GDP

Figure 2: General government debt as percentage of GDP

The period after 2005 is also of importance, as it follows the Athens Olympic Games 2004 that where a significant source of debt. Figure 3 shows that government expenditure increases between 2003 and 3004 and appears to stabilize in 2005 but after 2006 there is a significant increase in government spending. Figure 4 shows the GDP growth compared to 2003 for the Greek euro area and world economies. It can be seen that the Greek economy, in terms of GDP, has been performing well until 2007 and thereafter the GDP has declined.

Figure 3: General government expenditure (100 = 2003)

Figure 4: GDP growth compared to the world and euro area (100 = 2003)

Performance over the last seven years

Figure 10 shows key figures [2], [5], [6] regarding the Greek economy plotted for the years from 2003 to 2009. Inflation is plotted on the right vertical axis while GDP, domestic demand, general government expenditure and the output gap [5] are plotted against the left axis as year-on-year per-cent change.

Table 1 shows the figures that were used for assessing the performance of Greece during the period 2003-2009.

Figure 5: performance of Greek economy during the last seven years (sources: IMF, OECD, Eurostat)

% YoY change 2003 2004 2005 2006 2007 2008 2009
Gross domestic product at market prices

10.1

7.8

5.1

7.7

7.6

5.6

-0.7

Domestic demand

8.9

5.4

4.5

9.1

8.1

4.8

-1.2

General government expenditure

9.2

9.3

1.5

6.1

12.3

9.7

6.9

Inflation, average consumer prices

3.4

3.0

3.5

3.3

3.0

4.2

1.4

Inflation, end of period consumer prices

3.1

3.1

3.5

3.2

3.9

3.1

2.0

Output gap in percent of potential GDP

0.2

1.1

0.1

1.9

4.3

4.9

1.9

Table 1: GDP, demand, government expenditure, inflation and output gap figures for the period 2003-2009.

Figure 6 shows the external balance of goods and services. On the left axis the per-cent year on year change is shown, and a positive percentage designates a reduction of the deficit. On the right axis the deficit in billions of Euros is shown. In the following, an analysis of these figures is attempted using the AS-AD model. For each year, the translation of the aggregate demand and aggregate supply curves is tracked and an explanation is given. The coloured AD1, SRAS1 and LRAS1 curves refer to the year in discussion.

Figure 6: external balance of goods and services

2003: Inflationary growth

Figure 7 shows a shift of the aggregate demand and supply to the right. This increases the GDP but the inflation is reduced (compared to 2002). However, the output gap is fairly small and there is no direct need for significant increases in imports. This is a period when in Greece, large sums of private and public investment is done in preparation of the Olympic Games. Local industries are thriving, from construction to advertising, to travel, to tourism.

Figure 7: Inflationary growth in 2003

2004: Non-Inflationary Growth

In 2004 the GDP increases but the inflation decreases slightly. Domestic demand increases but less than in 2003. The output gap opens compared to 2003. The aggregate supply and demand curves move to the right in a way that maintains inflation fairly constant or even reduces it. There is a trade deficit but it improves despite the increase in demand. Again the investments for the Olympic Games and the general positive consumer mood and spirit affect significantly the economy.

Figure 8: Non-inflationary growth in 2004

2005: Demand pull inflation

Figure 9 shows the demand pull inflation. The GDP grows steadily and the inflation increases. The output gap is small and but the trade deficit decreases. These changes are caused by the increasing aggregate demand.

In 2005 the Olympic Games are over. Historically, the legacy of the games is bad for the economies of the organising cities and nations. The population is used to increased government spending and money abundance. At the same time, during the period 2001-2004 interest rates are kept low by the ECB. This magnifies the impression that there is money, and cheap. But there is another magnifying factor, that is often overlooked, the real estate bubble. As people had more money, there was a rising demand for property and construction. The Olympic Games had increased the demand even more, for the construction of all kinds of facilities but also for providing vacation or temporary dwellings to the millions of visitors. Low interest rates prompted people to build or buy houses, which in the countries of the South is not and investment, but a security. The government made things even worse – rumour has it in coordination with local and European banks – by circulating the idea of imposing VAT to real estate transactions that were exempted until then. These factors led to the increase in demand with real estate prices even tripling in some areas and lots of people with cheap money in hand. In 2005 government expenditure is low, following a series of public investments.

Figure 9: Demand pull inflation in 2005

2006: Deflationary Growth

In 2006, the GDP increases but the inflation decreases. For the first time following a series of decrease in trade balance deficit, this starts again to increase, as people ask for more imported goods (Porsche Cayenne for example). Government spending starts increasing significantly, marking the advent of an era of government profligacy (Figure 3).

2007: Deflationary Growth

This is another year of deflationary growth, where the aggregate supply and demand move to the right. Government spending continues to grow and the output gap widens. The balance of trade worsens. This is a period where the apparent growth is probably driven by the increased government spending and the still intact housing bubble. There has been no significant improvement in production of goods or services, and many could argue for the opposite. Corporate law is still complex and cumbersome, external investment reduces, much of the economic activity moves to services for the domestic market.

Figure 10: Deflationary growth in 2006 and 2007

2008: Inflationary Growth

This is the start of the recession. The GDP race stops abruptly, domestic demand halves, inflation reduces. The deficit in the balance of trade decreases but the output gap remains large. A 15% of the economy depends on tourism which peaks in summertime and therefore is less exposed to the economic downturn after August 2008.

Figure 11: Inflationary growth in 2008

2009: Recession

In 2009 the economy starts entering into recession, with aggregate demand falling for the first time in a decade, inflation dropping significantly and the balance of trade deficit reducing. The government expenditure increases but at a smaller rate, however government borrowing and debt mount significantly (Figure 1, Figure 2 respectively).

Figure 12: Recession in 2009

Evaluation and outlook

It is probably hard to provide a reliable outlook for the Greek economy at this point. Having suffered years of bad policies and poor structure, Greece finds itself in a dire situation: it badly need the flexibility of a well-structured economy. It is not surprising that it gets a 43% probability to default. Currently there is an effort to lean towards the 57% by implementing the austerity measures agreed between the government and the IMF, ECB and EC. Much of the effort is aimed at decreasing the budget deficit by decreasing general government expenses and increasing revenues from direct and indirect taxation. As an outcome, there is a considerable shortage in cash and, as aggregate demand has not had the time to respond, there is a short term increase in inflation [3]. Economic activity in the first quarter of 2010 held up better than expected contracting by 2.5%, as opposed to a 4% envisaged by the IMF and the Ministry of Finance. There are conflicting opinions, however, on how much the economy will contract, with Greek banks suggesting a better than expected performance [3], [4].

Figure 13 and Figure 14 show the OECD projections for 2010 and 2011. The two important points to note here are the significant increase in the unemployment rate and the decrease in fiscal imbalance. As the government tightens the austerity measures and imposes higher taxation, many SMEs find themselves in the brink of extinction. Further, the government has ceased to employ temporary workers and there is a growing fear (or hope) that for the first time there is going to be redundancies in the public sector. These factors will certainly increase the unemployment rate, however, they will at the same time release valuable workforce that is currently allocated in inefficient positions. Another important aspect is the decrease in inflation in 2011 which will result from the fact that aggregate demand will react to the increased prices and push the inflation lower. Compared to the euro area, the Greek economy will not show any signs of positive GDP in 2010 or 2011.

Figure 13: OECD projections for Greece

Figure 14: OECD projections for the Euro area.

But beyond the numbers and the short term projections, Greece faces considerable challenges. In a nutshell, there are many reasons for the crisis, but these have increased gravity:

  • Greece is a country that hasn’t caught up with the rest of the EU in terms of policies and adherence to the rules. EU subsidies and Brussels political interests have not helped.
  • Economic psychology [8]. People really believed there’s someone giving money for free. The Greeks thought they could borrow indefinitely and spend on German cars. But the money came from the surpluses of Germans that thought that investing in countries like Greece will improve their retirement funds position. Further, the investment paid back as the money flowed back into the country’s industries.
  • Financial innovation. Several financial institutions have created a web of bubbles and self-fulfilling prophesies that caters itself [7]. They also seem keen on going on doing the same in the future [9]. These systems may work in some cases and Greece tried to imitate these, in effect creating an unprecedented crisis and becoming a “Black Swan” [10].

It is important to restore some sound economic thinking and dismiss ideas that a country can:

  • Survive on growing debt
  • Depend on construction and services alone for demonstrating growth
  • Depend on government spending not only to stimulate, but to drive the economy

In a state of shock, Greece has to face its severe deficiencies and disadvantages that impede its real growth and wealth:

  • The huge, expensive and inefficient public sector as well as the protection of some sectors of the economy. Besides being extraordinarily expensive, Greece’s huge government and budget deficit restrain its economic development and recovery. As salaries and conditions are better in the public sector and jobs safer, recent generations have preferred that security over the long working hours and poor wages of the private sector.
  • Greece is a small country without clear targets. It is difficult survive on services alone as these services are oriented towards the domestic market. Although the percentage of English speakers in Greece is high, the country finds it difficult to offer services outside the borders. Exports are low especially in terms of manufactured products.
  • Corruption is another big problem that has to be abolished and also stems from the profligate public sector. This creates significant problems in running honest businesses and eventually has become a kind of habit for many.

Greece is trying to improve these deficiencies and, even a modest improvement, will have a big impact. However, these will probably improve the situation in the short term, by adjusting the local market into relevant levels of consumption and prices and increasing competition. But Greece needs to focus on the future and how to improve its economy in the long run by investing in sectors where it is traditionally a good performer:

  • Shipping: Greeks have always been merchants, and merchants they should remain. Shipping is a big business for Greece, being first in ownership in the world. Including its paraphernalia, such as trading, brokering, shipbuilding and repairs can form a big industry that is there but Greece fails to tap.
  • Tourism: Greece’s touristic product is of high quality and should be traded in even higher prices than today, diversifying from the local competition from Turkey, Egypt, Croatia and Italy.
  • Transport routes: Greece is on the crossroads of Europe, Asia and Africa making it an excellent hub for commodities and energy trade. It has traditionally good relationships with the Arab world and Far East countries that it can take advantage of. Recent agreements with Qatar, Libya, Turkey and China show just that.
  • Labour productivity is extremely low. This does not mean that people don’t work but rather that people work inefficiently. This is an advantage and disadvantage at the same time, offering ample room for improvements.
  • Highly qualified personnel: for its size, Greece has a surprisingly large number of highly qualified personnel that has gone through vocational training or tertiary education. However, the lack of real growth has led many either in lower level professions, or abroad. This is a resource and investment that the country could cash in by investing more in R&D and attracting foreign investments.

The rescue package: is it worth it?

For this discussion the following form of aggregate demand or planned expenditures is used, considering an open economy:

Yh=C0+c(1-t)Y+Ip+(X-F)+G-Te

Where

  • C0 is the autonomous consumption
  • c is the marginal propensity to consume
  • t is the tax rate
  • Ip is the private investment
  • (X-F) is the net exports (exports – imports)
  • G is the government spending
  • Te are the indirect taxes

A rise in the VAT rate will increase the indirect taxes Te. However, VAT being an ad valorem tax, is acting similarly to a sales tax, and the change on the aggregate demand depends on the amount of money that households, businesses, the government and foreigners would like to spend on domestically produced goods and products, or the planned expenditures. Therefore the increase in VAT may both translate downwards the aggregate demand curve but also change its slope as seen in Figure 15. The change in slope is the result of the fact that prices go up and people are less willing to consume. However, even at zero income, as there is some spending, a VAT is applicable. The aggregate demand curve moves from T1 to T2, as the aggregate demand reduces from AD1 to AD2. The GDP drops from Y1 to Y2 and the unemployment rises as production must reduce.

Figure 15: Effect of an increase in the VAT

The effects of a tilt of the aggregate demand discussed so far, as a reaction to an exogenous stimulation, describe more accurately the short term response of the economy to that stimulus. As the stimulus may not last forever (like in the case of government spending) or even if it does, the changes are absorbed by the market, in the long run, the economy will tend to return to the optimum level of output, that is, the full employment output level. It is useful at this point to show what happens in the short and long run in the economy given a negative or positive demand shock.

Figure 16 shows an aggregate demand curve plotted against the output Y (horizontal axis) and the prices level P (vertical axis). It is claimed that in the long run, the economy will return to producing at the full employment level Y*. Suppose that due to a negative shock in demand (such as an increase in taxes) the aggregate demand curve moves from AD0 to AD1. In the short run, prices are fixed at the level of the Short Run Aggregate Supply (SRAS) plotted as a horizontal line for simplicity. As prices are fixed at this level (and wages as well) production falls from Y* to a lower level corresponding to point B as businesses respond to reduced demand by cutting down production. At point B, the economy is operating below full employment, which means that a lot of people are unemployed. This will drive costs down for businesses as well, that eventually will also reduce prices as soon as they can catch up and revise their pricing policies. In the long run, as prices fall, demand will also increase and the production will tend to return to the full employment Y* at point C. A move of the aggregate demand curve to the right (or top) has the opposite effect; in the short run, as prices and wages are sticky. The additional demand leads businesses to hire workers, pay overtime or import. All these factors drive prices up, demand down and eventually output returns to full employment.

Figure 16: Short-run and long-run responses to a negative demand shock.

The above discussion makes it almost impossible not to think on the effects that the recent IMF and EU measures will have on the Greek economy, in their effort to avoid a default and stabilise the Euro. Looking at Figure 16 what the economists that designed this package seem to aim at is to return the economy closer to its real dimensions. Increasing indirect taxes will eventually drive prices down and cause deflation and unemployment. However, as the economy will tend to return to Y*, the government borrowing and the government debt will have stabilised and the unemployment will drop. At that point, the Greek economy has the chance of becoming competitive again, both as a tourist destination and for investors as well. That can boost its growth and start reducing its debt significantly. This is the optimistic scenario though. The world economy tremors can destabilise further this small economy, in a reverberation of the troubles caused by it in the first place. Or, simply, the theory may not work at all. Deflation can strand both the businesses and the government with ever growing debts at hand. From another point of view, although the public debt may increase to 140% of the GRP by 2014 despite the austerity plans and before there is any chance to trigger investments, tackling of the black economy which accounts for 30% of the GDP will increase the revenues and favour clean businesses so that the overall debt may not look so scary after all. Further, Greek salaries and savings are relatively low indeed. But there is a cushion of private non-current assets that may prove useful to absorb some of the shock induced by salary cuts and taxation, keeping autonomous consumption to reasonable levels at least for some years. Further, it will push down the real estate market towards more reasonable prices than today.

References

  1. Bryant, R. C., Garganas, N. C., Tavlas, G.S., Greece’s Economic Performance, Bank of Greece and The Brookings Institution 2001.
  2. OECD, OECD Factbook 2010: Economic, Environmental and Social Statistics, OECD Publishing 2010.
  3. Lekkos, I., Greek Economic Review, Fiscal Policy in Greece: Discretionary and Pro-Cyclical, Piraeus Bank, 2nd Quarter 2010.
  4. ALPHA Bank, Greece and Southeastern Europe Economic & Financial Outlook, Economic Research Division, May 2010.
  5. IMF, World Economic and Outlook Database, Retrieved August 2010, (online: http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/index.aspx)
  6. European Commission, Eurostat, Statistics Database, Retrieved August 2010, (online: http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/themes).
  7. Manmohan, S., Aitken, J., The (sizable) Role of Rehypothecation in the Shadow Banking System, IMF working Paper, WP/10/172, 2010.
  8. George A. Akerlof, G.A., Shiller, R.J., Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Princeton University Press; New edition (February 21, 2010).
  9. Preston, R., Basel allows banks to play the same dangerous game, Retrieved August 2010,(online: http://www.bbc.co.uk/blogs/thereporters/robertpeston/2010/08/basel_allows_banks_to_play_the.html).
  10. Taleb, N.N., The Black Swan: The Impact of the Highly Improbable, Penguin book Ltd, 2007.
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