As Greece accepts its third bailout to the tune of $95 billion, the government and the Greek people have also been all but forced to accept additional harsh austerity measures — a tough pill to swallow given the dire straits of the country’s economy, which many believe were caused by previous austerity policies.
Greek Prime Minister Alex Tsipras and his Syriza party came to power last January by riding a wave of anti-austerity sentiment. The people of Greece have good reason to be sour on such policies — since activating an initial round of austerity measures five years ago, GDP has fallen nearly 30%, unemployment levels hover around 26% and nearly one-third of Greeks live below the poverty line. What’s more, youth unemployment has soared beyond 50% and many talented young people are leaving the country.
In the latest bailout package, Greece will have to undergo reforms to its early-pension system, get rid of tax amnesties and exemptions, and privatize shipping ports and regional airports. In one sign that the new demands might be excessive, the International Monetary Fund has said it won’t participate in the current round of bailouts unless there is debt relief built into the package, much to the dismay of the European Central Bank and the European Commission.
Though other countries, including the United Kingdom, Spain and Portugal, have undergone such fiscal tightening in the past, they have emerged with varying degrees of success. Spain’s unemployment rate, for example remains high at 22%, but it is down from about 27% during the current cycle.
So can austerity work? Or does it just make things worse? The short answer, experts say, is “it depends” — but, in Greece’s case, most agree that austerity alone won’t bring the economy back to health.
Austerity is generally considered necessary when a government overspends and subsequently needs to cut back spending in order to restore its balance sheet and economic confidence. “Governments with large public debts and deficits have limited or no choice: Continuing to run a large deficit in such circumstances risks finding it difficult or impossible to finance that deficit, requiring an even sharper fiscal contraction,” says Sir Charles Bean, economics professor at the London School of Economics and former chief economist at the Bank of England.
“The endless austerity measures have made it worse for the country. It’s been the wrong remedy for the wrong patient at the wrong time.” –Bulent Gultekin
While austerity restores financial health, it’s rare that such policies will make the economy grow faster quickly, notes Wharton finance professor Joao F. Gomes. Austerity, he adds, is used to “put the brakes on big spending.” The problem in Greece, however, was the sequencing: “They have put a lot of brakes on, and then saw a big recessionary effect,” notes Olivier Chatain, strategy and business policy professor at HEC business school in Paris and a senior fellow at Wharton’s Mack Institute for Innovation Management.
But many economists point out that while austerity might be the right prescription when an economy has been growing too fast and overheating with inflation, it does not make sense to cut spending when an economy is already in a tailspin.
Fiscal austerity has been “very counterproductive for the Greek economy, and it should be put on hold until the economy is clearly in a self-sustaining economic expansion,” says Mark Zandi, chief economist at Moody’s Analytics. “That is, the troika [the European Central Bank, the European Commission and the IMF] should not push Greece to reduce its cyclically adjusted budget deficit until the country’s unemployment rate is falling quickly and consistently.”
Adds Wharton finance professor Bulent Gultekin: “The endless austerity measures have made it worse for the country. It’s been the wrong remedy for the wrong patient at the wrong time.”
In some cases, currency devaluation is used as a tool to pump up a troubled economy. However, in the case of Greece, currency devaluation isn’t an option since it shares the same currency — the euro — with many of its trade partners. But while the countries share the same currency, they have different fiscal policies.
“Some countries have been in the fortunate position of sustaining a current account deficit over a very long period, but only because they benefit from substantial transfer payments – for example, Israel — or because they have attractive investment opportunities, [like] Australia and Canada,” says Richard Herring, Wharton finance professor and co-director of the Wharton Financial Institutions Center. “Greece is not in this fortunate position, although its membership in the EU gave it access to transfers and permitted it to borrow for a much more extended period than would have been possible if it had remained outside the EU.”
A ‘Balance Sheet’ Recession
Recently, the IMF published an analysis suggesting that it would take Greece a lot longer to repay its debt given its current economic position and that the troika should accept a debt write-down. The report also referenced an earlier IMF paper acknowledging that significant mistakes were made in calculating the effects on economic growth of the initial austerity measures imposed on Greece in 2010. The strong fiscal consolidation policy was expected to cost 50 euro for every euro cut from the Greek government’s budget, but in fact, it lost 1.50 euro for every one that was slashed, in effect underestimating the downward impact of the fiscal multiplier in an economy already in recession.
“The IMF is on board with reducing Greece’s debt burden, but it now has to convince the [European Commission’s] leadership that [doing so] is the only way to end the ongoing debt crisis,” Zandi notes. Gomes points out that if you read between the lines, everyone, including German Chancellor Angela Merkel, seems to believe that debt relief or postponement is in the cards for Greece; but they have to be careful about not establishing a precedent, or else Spain, Italy and Portugal will also want their debt written off. “This is a small tip of the iceberg. It goes way beyond Greece,” Gomes adds.
According to Richard Koo, chief economist at Nomura Research Institute, a Tokyo-based consulting firm, Greece was forced into fiscal consolidation when the country was already in “a balance sheet recession.” Everyone, he adds, the government included, was paying down debt. “When that happens, a deflationary spiral occurs, and that’s why Greece has lost almost 30% of its GDP.”
The concept of a balance sheet recession, which has been largely credited to Koo, is based on the notion that when the private sector focuses on paying down debt and saving instead of borrowing, even at zero interest rates, the economy slows down. The idea is a bit counter-intuitive because, when a single household, too deep in debt, cuts spending to pay down that debt, their balance sheet improves. However, when the entire private sector of a country deleverages, or minimizes its debt, and the government doesn’t — or can’t — spend money, the economy continuously loses demand and falls into a recession and possibly even a depression. In other words, massive cuts in spending can have the opposite of the desired effect on the overall economy. Japan’s “lost decade” can be attributed to this phenomenon, as can the U.S. recession in 2007-2009.
Koo compares the IMF’s approach to the Greek problem to the same mistakes it made with Japan in 1997. “In a bubble, private investors borrowed money to make huge sums of money. They were left with huge assets and liabilities to show for it,” Koo says. “When they went bankrupt, they had to pay down their debt. When everyone was paying down debt at [low] interest rates, the government is the borrower of last resort.” However, when everyone, including the government, is paying down debt and no one is spending money, a deflationary spiral can occur and then the economy will collapse, adds Koo.
Meanwhile, the European Central Bank (ECB) has released a paper saying that austerity measures were necessary for the medium- and long-term recovery for euro countries with a high public debt-to-GDP ratio, though the short-term fiscal consolidation efforts would be painful. John Cochrane, senior fellow at the Hoover Institution at Stanford University, says the policies are meant to reverse long-standing budget deficits, and reform out of control social spending, pensions, subsidies and state-controlled industries, together with strong structural reform, liberalizing product and labor markets, and cracking down on corruption and tax evasion. “The [initial] aim was to stop a run and chaotic default on government debt, and with long-run stability of government finances assured, interest rates would fall, allowing slow repayment of that debt,” Cochrane notes.
However, he says that “government spending is still above half of GDP. Granted both fell [since the beginning of the Greek debt crisis], but half is still half. The structural reforms basically never happened. The asset sales never happened. Taxes, or at least ‘pretend’ taxes, went up and had the predictable effect of driving more people underground or reducing economic activity.” He adds, “Lots of austerity plans relied much too much on tax increases. This is not a moment to say to people paying 50% to 70% tax rates that taxes will be sharply raised, especially if they dare to invest their money in starting new businesses and hiring people rather than squirrelling what they have left abroad.” In addition, he doesn’t think a debt write down would encourage the Greeks to carry out structural reforms, though the money would keep Greece going for a little while longer.
“What Greece needs is to commit to staying on the euro, open its banking system completely, [employ] supply-side structural reform, open up like crazy and grow like an Asian Tiger.” –John Cochrane
According to Herring, debt forgiveness can be only “a stop-gap measure unless it is accompanied by supply-side remedies.… Greece has made some relatively modest attempts to implement supply-side policies — privatization, reducing some price distortions and subsidies, etc. — but even those attempts were reversed by the Syriza government.” Gomes adds that last year, economic indicators for Greece showed growth and would have resumed if the supply-side policies had remained in place. “The elections at the beginning of this year have thrown Greece’s ability or willingness to implement anything [out the door]. The political elections threw in an extra set of issues that [will make] the next two years very difficult,” he adds.
When the U.K. experienced its crisis in 2009, “it had a large deficit and potentially faced a serious credibility problem,” explains Patrick Minford, economics professor at Cardiff University in Wales. “Declaring ‘austerity’ in the shape of getting the deficit down and debt falling again as a share of GDP was absolutely necessary to avoid a credibility shock.…” Later, some shocks occurred, he adds, including the eurozone crisis, which meant that adhering tightly to the original path of cuts would have slowed down the country’s recovery. “So the timetable was relaxed,” Minford says. “As a result, the U.K. has enjoyed a strong recovery [recently].”
What Should Have Happened
In Greece, even with the latest bailout terms, Tsipras has struggled with support within his own ruling party. “The party itself could implode with people against the way things are going” and another Greek election could happen soon, notes Gomes.
Back when the Greek debt crisis first became apparent in 2009, the Greek government wrongly hid the level of its debt. “We have the criminal act that the Greeks cheated on the books,” says Koo. “There would have to be some austerity, but I wouldn’t push for the level of austerity that the IMF pushed at the time. Some collapse in the Greek GDP was unavoidable, but a 26% [decline] of the GDP has gone way too far.” If the IMF had explained to the Greek people there would be some decline in the GDP, Koo notes, then the current distrust of the IMF would not be so severe. At that time, “the IMF apparently didn’t understand balance sheet recession and produced a rosy forecast and lost credibility as a result, causing political turmoil.”
According to Gultekin, Greece should have cut down on its military spending and decreased wages. “They could have restructured their budget differently and channeled funds and resources differently. Granted, it’s very difficult to do because there’s so much built-in inertia.”
Moreover, Cochrane says “Europe should not have bailed out German and French banks and allowed Greece to default in the first instance. In a currency union, sovereign debt is like corporate debt. Corporations default — or they should — without bailouts, and don’t leave a currency zone when they do so. Europe should not have allowed and encouraged national banks to load up on national debts.”
What Can Be Done
To stimulate a Greek recovery, Koo suggests “less austerity and more fiscal stimulus.” Francesco Caselli, an economics professor at the London School of Economics, agrees that there should be a “focus on structural reforms rather than austerity. Greece should have gotten meaningful debt relief and much more time to balance the deficit.”
Help should come from new policies outside of Greece, too. “Wages in Germany should rise and government demand for goods and services should increase,” adds Mauro Guillén, Wharton management professor and director of The Lauder Institute. Surplus economies, like Germany and the Netherlands, who can spend more should do so, he says.
Gultekin agrees, noting that Germany “has been the biggest benefiter of the EU. They have a significant current account surplus and that’s creating problems because of the fixed exchange rate.” Minford adds that it’s “unhealthy for Germany to run very large trade surpluses. They’re sabotaging the rest of Europe.” He points out that Germany has “not focused on demand shock, and insisting on rigid austerity measures is causing a sharp demand shock for the rest of Europe.”
“There’s a big chasm between what’s asked of Greece and what they can do.” –Olivier Chatain
Koo also called for Spain and Portugal to engage in stimulus efforts, as well, since both countries are sitting on significant private sector savings. Gomes notes that this increase in risk aversion and savings in the private sector is a global phenomenon caused by a lack of confidence and low productivity growth across the world.
“What Greece needs is to commit to staying on the euro, open its banking system completely, [employ] supply-side structural reform, open up like crazy and grow like an Asian Tiger. Fast growth would let it easily repay debts,” adds Cochrane.
But others believe Greece is better off leaving the eurozone. “In my view, Greece would have been justified to default unilaterally and leave the euro, and it may still be the better option for them,” says Caselli.
According to Guillén, if Greece weren’t in the euro, “they wouldn’t be having such a problem. The EU is imposing constraints they are not ready to achieve. I’m not advocating for [an exit],” but that could actually help the country, he says.
How can Greece move forward? Many experts believe that full repayment of Greek debt is not in the cards. “Greece’s debt cannot be paid back under any circumstances,” says Koo. “They need to undergo bankruptcy proceedings. We cannot move forward until the Germans and Dutch begin to realize this money will never get paid back and [austerity measures] are pushing the Greek economy further into depression.”
“There’s a big chasm between what’s asked of Greece and what it can do,” adds Chatain.
Overall, the austerity measures imposed on Greece are not just about economic reforms. With a confidence vote looming for the current Greek prime minister because the recent bailout terms were passed without the support of one-third of his own political party, the stability of the Greek government is in question. “Given the bitter negotiations that preceded the outcome and the government’s characterization of all the policy changes as punishment inflicted by heartless foreign creditors, it is questionable whether they can summon the political will and public support to implement the appropriate polices,” says Herring.
It’s important to have a balanced economy and balanced budget, but it takes a very long time for countries to recover from recession, says Guillén. “However, when countries who trade with each other and are integrated [like in Europe] are engaged in austerity measures simultaneously, it makes more sense to make adjustments,” he notes. “I agree with bringing government deficits down. I disagree that that is all we have to do.”