The Continuing Eurozone Extend and Pretend

By Marshall Auerback

The Europeans genuinely must genuinely believe that they can get blood out of a stone. Or perhaps resort to a modern day equivalent of turning lead into gold. There’s no other reason to explain the euphoria now prevalent in the markets, in light of the approval by Greece’s lawmakers to pass a key austerity bill, thereby paving the way for the country to get its next bailout loans that will prevent it from defaulting next month.

The €28 billion ($40 billion), five-year package of spending cuts and tax rises was backed by a majority of the 300-member parliament on Wednesday, including Socialist deputy Alexandros Athanassiadis, who had previously vowed to vote against. The European Union and International Monetary Fund had demanded the austerity measures pass before they approve the release of a €12 billion loan installment from last year’s rescue package.

So default is averted for now, which is clearly the main reason behind the global equity rally seen over the past few days. But will the package work? Here’s a look at the details of the Greek Medium Term Fiscal Bill.

The projections for Real GDP Growth are:

2012: 0.8%

2013: 2.1%

2014: 2.1%

2015: 2.7%

The projections for expenditures (bn euros) are:

2012: 79.491

2013: 83.467

2014: 83.363

2015: 85.39

GDP growth rising in the midst of fiscal austerity? How is this possible? Everyone knows the current planned financing of Greece is a band aid. With this new financing, Greece’s sovereign debt to GDP ratio will rise to almost 170%. It will be more bust than ever. Its real GDP may fall by another 4%. Social tolerance for such austerity — already strained — will become less. If that wasn’t evident before, it should have been today, given the sight of various reporters in front of the Greek Parliament wearing tear gas masks as they reported on the “success” of the Greek austerity vote.

Can the package passed today deliver increased revenues? The Greeks apparently think so, if one is to judge by the budget projections.

Actual projections of revenues:

2012: 60.959

2013: 62.454

2014: 63.192

2015: 64.924

Now, to be fair, much of the problem is an antiquated revenue system that supports that state, which results in a budget shortfall consistently about 10% of GDP. Greek economist George Stathakis, for example, has suggested that that the top 20% of the income distribution in Greece pay no taxes at all, which may somewhat of an exaggeration but, if only partially true, suggests that a modicum of tax compliance could perhaps generate an increase in revenues in spite of the austerity measures being introduced.

Perhaps. But it’s hard to see how the EU’s attempt to squeeze more blood out of the Greeks will generate increases of revenue of this magnitude. If one examines the Medium-Term Fiscal Strategy submitted to Parliament on June 8th 2011, it appears that the Greek authorities are basically banking on is a big rise in private consumption and investment by 2013 (both of which are negative contributors to GDP today) to reduce their deficit, even as government consumption continues to decline. So they are essentially assuming a “fiscal consolidation boom”, even though there has been no historical precedent of the kind to justify this kind of a forecast. The Canadian example does not fit because it was accompanied by a huge depreciation of the Canadian dollar, thereby generating a huge turn in Canada’s current account and largely offsetting the impact of the budget cuts. As a member of the euro zone, this option is unavailable to the Greeks.

The short term hope must therefore be ongoing debt restructuring, continued ECB purchases of Greek debt in the secondary market (allowing central banks to buy the debt), guarantees, and lending. The hope is that the financial institutions holding all the periphery government debt can either move it off their balance sheets, or use the American method of “extend and pretend” to avoid recognizing the institutions are fundamentally insolvent.

Short of a fiscal union (which is the ultimate solution to the woes of the euro zone), there are other measures which the Greeks could adopt to make their bonds more attractive to external investors, thereby preventing the markets “shutting the country down” on the grounds that they refuse to extend further credit to a fundamentally insolvent country. Warren Mosler and I have suggested one such alternative: Greece could successfully issue and place new debt at low interest rates. The trick is to insert a provision stating that in the event of default, the bearer on demand can use those defaulted securities to pay Greek government taxes. This makes it immediately obvious to investors that those new securities are ‘money good’ and will ultimately redeem for face value for as long as the Greek government levies and enforces taxes. This would not only allow Greece to fund itself at low interest rates, but it would also serve as an example for the rest of the euro zone, and thereby ease the funding pressures on the entire region.

This suggestion, of course, does not deal with the problem of aggregate demand. But it provides an attractive instrument for the Greek government (and other periphery states) to secure private funding and possibly at lower rates of interest. The bigger issue of aggregate demand, however, is still yet to be addressed, and it is hard to envisage a sustainable recovery in Greece, or, indeed, the entire euro zone, without changes to its institutional structures. Of particular concern is the absence of a fiscal authority which would allow the ECB to stick to monetary policy while giving a European Treasury the purse strings to deal with the crisis.

Opposition to a broader fiscal authority, however, is mounting in the core as the crisis has increased hostility among the members. No one wants to cede power to the center. This opposition also reflects the fact that the third convergence — between elite and public opinion — has also failed to take place. But it also reflects a failure to understand the institutional limitations at the heart of the euro zone. In fact, having lost monetary sovereignty by adopting the euro, core countries such as Germany have more to gain by stabilizing their respective domestic economies by running large deficits during a downturn and boosting consumption, rather than deflating countries like Greece into the ground. That approach is ultimately self-defeating for the prosperous core countries. As Randy Wray has argued:

If the blood-letting and crushing of wages in the periphery actually does work, the factories will be moved out of Germany seeking lower cost workers. In other words, success in the periphery would shift the burden back to Germany’s workers, who would have to accept lower wages to compete. That will be fueled by job losses if Germany cannot find sales outside the EU that will be lost as the periphery nations fall farther into depression. The result will be a nice little rush to the bottom, benefiting Europe’s elite.

Implicit in the drive to create a Germanic style “stability culture” is the belief that public debt is invariably an evil, the consequences of which must be stopped at all costs. But as events of the past decade have clearly demonstrated, excessive private sector debt build-up, notably in Asia and the United States, has played a far more destabilizing role in the global economy than fiscal profligacy, which undercuts one of the main rationales for retaining the Stability Pact in its current form.

If we say that the government can run budget surpluses for 15 years, what we are ignoring is that this means the private sector will have to run deficits for 15 years. The private sector, in this case, would be going into debt that totals trillions of dollars in order to allow the government to retire its debt. Does that make sense? Again, it is hard to see why households would be better off if they owed more debt, just so that the government would owe them less. The Eurocrats, led by the ECB, are now using this crisis to ram through their vision of Europe, which is fundamentally anti-labor and pro capital. That explains why the markets are celebrating today. But it lays the groundwork for more hostility and conflict in the future.

Wasn’t this precisely what the European Union was designed to prevent?

This post originally appeared on New Deal 2.0.

  1. jporter says

    Does anyone actually believe this will work? I’m reading a lot about European banks being very highly leveraged. Could this just be a charade designed to buy the banks some time to raise capital before taking the hit?

  2. Steve Roberts says

    It seems to me that Greece has absolutely no reason to follow through on the sale of assets and true austerity measures. Europe has shown they don’t really care and will provide further support down the line. Why sell off the assets if Germany and France are so hungry to prevent a default and when Greece knows that they will default when it is in their best interest. If you are Greece you sell the assets POST default when the proceeds are yours to keep, not before when the proceeds are just reducing the amount of support Germany and France have shown they are desperate to provide. JMO.

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