So What’s It All About, Costas?

All the recent critical attention which has been directed towards Greece of late might seem surprising to some (or part of a global anti-PIGS conspiracy, to others) since, on the face of it, the Greek economy had managed over the last decade to appear to be something of a success story. Indeed the economy did clock-up a more than respectable growth rate, and the country even seemed to be well on the road to economic convergence with its richer neighbours, with GDP growing at an average annual rate of around 4.25% between 2000 and 2007, as compared with a 2% average for the euro area as a whole.

In particular there was a sharp acceleration in the growth rate in the early years of this century, stimulated in part by preparations for the Olympic games. As a result, living standards, measured in terms of GDP per capita in purchasing power standards (PPS), rose from 84.25% of the EU-27 average in 1997 to almost 95% in 2007. But as we all now know, and as many a Greek philosopher has often told us, “seeming” is not the same thing at all as being, and the current Greek case is no exception. Behind this wonderful facade, all was far from being as it should have been.

This was the case, not only in terms of the rather questionable data which was being sent out for external consumption – although, it should be noted, not everything was completely phoney, since Greeks today are surely much better off than they were in 2000 – but also in terms of a failure to explain how this rather spectacular change in fortune was achieved, or how the sustainability of the model on which it was based was to be ensured. As Titus Maccius Plautus reputedly put it, I am a rich man for just as long as I don’t have to pay back my debts, and of debts in Greece there were plenty, especially in the public sector.

So the growth we saw in the first eight years of this century was hardly normal, since it was based on a model of growing indebtedness which was always going to fail one day or another. One consequence of this is that no one really knows what “trend” growth in Greece would look like at this point (the same goes for those other two Eurozone “star performers” Spain and Ireland) since we don’t really know how much of recent growth was valid, and how much was due to overheating, and we won’t really start to get a clear picture till we see what the downside is, and how far it runs.

In an earlier post I suggested that while Greek Sovereign Debt was far from dead at this point, in the long run it was almost surely dead. Here, and in the posts which follow I will try and explain why I think that is the case.

Twin Deficit Problem

Thus the very positive initial impression becomes rapidly tarnished when you start to think about the fact that, despite all the supercharged growth, the average Greek general government deficit remained over the EU Stability and Growth Pact 3% of GDP limit during the entire period (hitting a maximum of 7.5% of GDP in 2004, see chart below).

Given that the Stability and Growth Pact philosophy is effectively one having a 3% average target, with resources being accumulated during the good years to allow space for stimulus programmes which involve larger deficits during the bad ones, this state of affairs seems to be astonishing. The accident was just waiting to happen, since having overrun the allowance with growth which was over 2 percentage points above the average, there was no spare capacity left to be deployed during the downturn, Greece will now join a number of key East European economies – notably Hungary and Latvia – in being forced to impose a contractionary fiscal policy during what surely about to be the country’s most serious economic downturn since the early 1980s. Ouch!

But in addition to this immediate, and acutely painful, problem, the consequences of all those years of excessive government spending have most definitely not been benign, and in this post, and those that follow I will focus on three of them.

i) The accumulating government stock of debt, which according to the last EU Commission forecast is set to reach 135% of GDP by 2011.

ii) The inflationary pressures to which the Greek economy was subjected by the decision to press the fiscal accelerator right down to the floor (hit the pedal to the metal) well beyond long term sustainable capacity, with the consequent loss of competitiveness this involved. Greek inflation was seldom above the EU 16 average during the critical years, and this neglect, of course does not come free.

In particular the loss of competitiveness with Germany is very evident.

(iii) The huge external deficit (current account deficit of 15% of GDP) which was the result of this massive overheating of domestic demand, and the large external debt which has been accumulated as a consequence. It is this external debt problem which makes Greece so vulnerable to financial crisis at this point, and it is this which differentiates the Greek case (and the Portuguese and Spanish ones) from, say the Italian one, since while in Italy government debt position is not that much better than the Greek one, most of the debt is actually held by Italians, and while Italy’s savers are content to continue funding their country (that famous “home bias”) Italy will not be so vulnerable to pressure from external investors.

In fact the Greek external balance has deteriorated rapidly from 1997 onwards, with the current account deficit reaching 14% of GDP in 2007, declining slightly to 12.75% of GDP in 2008. The principal culprit was the growing deficit in the trade balance, which rose to 17% of GDP in 2008 (almost 4 percentage points over the level in 1997). In particular goods exports were disappointingly weak, while import growth was strong, in line with buoyant domestic demand. Trade in services, on the other hand, went in the opposite direction. The balance of services exports improved, attaining a surplus of more than 8% of GDP in 2008, 2 percentage points higher than in 1997. However, this improvement fell far short of compensating for the deterioration in the goods trade balance.

So let us be clear. It is this situation Greece has to correct. Greek society needs to lower the level of national indetedness, and the only way to do this is through an export surplus. But obtaining an export surplus implies the restoration of competitiveness to Greek industry. Greece needs to implement a significant internal devaluation, without this correcting the fiscal deficit will only involve playing around with the tip of the iceberg, and default in the longer term will become inevitable.

This entry was posted in A Fistful Of Euros, Economics and demography, Economics: Country briefings by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

22 thoughts on “So What’s It All About, Costas?

  1. Let’s wait for the riots then…what if Greece the government cannot/isn’t willing to orchestrate internal devaluation? From what we hear until now the Greek government tries to avoid going down that road.

    One other sidenote. German policy isn’t going to change. From what I hear from German politicians, managers and economists it seems as if they were all pressing for even more wage “moderation”, continuing the policy of real wage decline that has happened for a long time now. How on earth are all these other countries, even the ones that are not in deep trouble (like France) are ever going to claw back competitiveness against Germany if the Germans carry on like that?

  2. The chart that you haven’t included is that showing EU receipts over the relevant time period. It would be interesting to compare these figures against those for Greek Fiscal and Current Account Deficits.

    My information is that not all of this money gets to where it should.

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  4. You seem to omit the fact that the whole trade deficit is just the other side of the coin of the huge capital inflows (especially interbank lending) that has happened since Greece entered the eurozone.

    When this lending slows done (which it has!), then imports immediately fall and the economy cools down a bit.

  5. Hi SG

    “You seem to omit the fact that the whole trade deficit is just the other side of the coin of the huge capital inflows”

    Sorry, you are absolutely right. I have missed out a key link in the argument chain. The difference between Greece and Spain is that in Greece much of that money was coming in to fund government borrowing, while in Spain it was helping people to buy far too many houses.

    Now that the borrowing will have to stop, then the capital flows naturally will dry up, since there will be no counterpart for them in the national balance sheet. So then the trade deficit will fold, and living standards will suffer a sharp drop.

    “the economy cools down a bit.”

    Well it’s already cooled sufficiently to be in quite a lengthy recession, and my guess is that it will stay cold until they correct the price imbalance in their industrial sector sufficiently to get an export surplus and start to pay down all that debt. Which looking at the situation may well take a very long time. How long Greece has before something else goes bump in the night first, I really don’t know.

  6. “in Greece much of that money was coming in to fund government borrowing, while in Spain it was helping people to buy far too many houses.”

    in Greece too, lending for houses but also normal consumption was rising quite fast for many years.

    ” So then the trade deficit will fold, and living standards will suffer a sharp drop.”

    I cannot really see why this would happen. It seems people will just have to buy new cars and TVs (all imported of course) a bit less often, a reasonable drop in previously reckless consumption I reckon.

    Ps seems this spam protection thingy does not like Safari users

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  8. Hi again SG,

    “I cannot really see why this would happen.”

    OK, this is a rather technical question. Basically, GDP will fall MORE SLOWLY (following a pattern we have already seen in Spain, Hungary etc) as imports fall. In fact, for statistical reasons a fall in imports appears as an INCREASE in GDP because the net trade position improves. But unless this drop in imports is accompanied by a significant improvement in the competitiveness of domestic industry (and hence a trade surplus driven by exports) then all you have is economic stagnation and falling living standards, since, for example, house prices will continue to fall, and everyone will feel worse off. Unemployment will obviously also rise, as those involved in the retail sector selling the imports will lose their jobs. People working in the ports for domestic directed external trade trade ditto.

    I mean, the goods deficit was 17% of GDP, this is much more than simply luxury items. Basically 17% of GDPs worth of internal consumption will be lost if the deficit closes in this way. I wouldn’t call that a mere detail, and the curious thing is that, according to our accounting conventions, this will show up as GDP positive.

    According to my rough and ready calculations, total Greek debt (households, corporates and government) will be around 210% of gdp at the end of this year. This is not high compared to the US, but is more than Greece, with its ageing population legacy, can sustain into the future. That is why the spread is being hit so hard.

    The only way to reduce the debt is by having a net trade surplus, and this deleveraging problem only gets worse if prices (and hence nominal GDP have to fall) even as the economy contracts. The debt – in euro terms – stays the same, even though the interest you will have to pay on it will inevitably rise on the back of the credit downgrades.

  9. Well a fall in imports is treated as a rise in GDP because more income produced in the country stays in the country.

    So I am not sure I understand your argument. The way I see it, there are less capital inflows which leads to less imports. The net effect on the income staying in the country is zero.

    Also, I don’t see why unemployment will rise, people will just substitute foreign products with domestic product. Granted, Porsche and BMW dealers will have a problem, but supermarkets not.

    “I mean, the goods deficit was 17% of GDP, this is much more than simply luxury items.”

    Agreed. But I don’t think the whole deficit has to close completely (there will still be capital inflows, just smaller), and the adjustment does not only depend on falling imports but rising exports of goods AND services.

    And there is an important point here: Greece depends a lot on services exports, which basically because of the rise of China are having a great time. Even the effect of the global slump on this will be brief. Shipping and tourism will rise the moment the EU and America start growing again (which seems to be happening now).

    “The only way to reduce the debt is by having a net trade surplus”

    What about increased domestic saving (as is happening in the US)?

    i agree the total debt is very large and some painful adjustment has to come. But increasing saving is one way that can do the trick I think…

  10. Hello again SG,

    “Well a fall in imports is treated as a rise in GDP because more income produced in the country stays in the country. So I am not sure I understand your argument.”

    OK. Well don’t worry, since I don’t think you are the only one. The thing is, behind the whole situation lies the issue of debt, since real disposable income is the sum of actual earned income PLUS what you borrow in any given time period. So when you borrow you shift disposable income from one time period to another. This is why we have what Mogigliani called a life cycle process in saving and borrowing, since patterns change across the age groups, and naturally as whole populations age the pattern of any particular country changes. A younger country – Ireland, the US – is much more likely to be a net borrower, while an older country – Japan, Sweden, Germany – is much more likely to be a net saver. I don’t think this has much to do with “anglo saxon culture” and suchlike.

    So why is all this important. Well, during the years you borrow, you spend more. I think this is obvious. This is why you say:

    “The way I see it, there are less capital inflows which leads to less imports.”

    Definitely, since the capital flows are to finance borrowing, but borrowing improves living standards in the short term, until it has to be paid back. You know, I am a rich man till the day I have to pay my debts.

    “The net effect on the income staying in the country is zero.”

    This is only true in the very long term, since in the short term disposable income goes up (someone gives you money to spend), while later it goes down (as you have to subtract from earned income to pay back). This latter situation is where Greece is now. These capital flows will need to be reversed as the debts are paid down, and that will mean lower disposable income for the internal population as a whole, which is why domestic consumption will fall and unemployment rise. The only way to compensate for this is to export and run a trade surplus, and in this way the debt payments can be made without subtracting from current income.

    “What about increased domestic saving (as is happening in the US)?”

    But this saving hasn’t really started in the US yet, since while households and companies are saving, the government is shouldering the debt via the fiscal deficit – otherwise GDP would be falling much more sharply. Government spending here can only be a cushion easing the painful transition to export orientation. The US can (possibly) still afford to do this. Greece, unfortunately, wasted far too much fiscal ammunition during the good years, and will now be having to go into a continuing contraction with diminishing fiscal support.

    I don’t know whether that makes it all clearer. This is basically what the global imbalances are all about, and why there are no free lunches, since you can’t borrow painlessly, as you always have to pay back (unless you default).

    Of course, borrowing is not income neutral in the longer term either, since if you spend the borrowed money on infrastructure, education and new productive capacity you can raise the trajectory of GDP in the longer term, while I suspect if you only use it to finance short term consumption you simply get a destruction of internal productive capacity, massive price distortions and long term GDP on a lower trajectory. This is where Spain, Greece and much of Eastern Europe are now. Basically, for those countries who lack their own currencies there is now real alternative to a rather painful “internal devaluation” to restore export competitiveness and the trade surplus.

    “Shipping and tourism will rise the moment the EU and America start growing again (which seems to be happening now).”

    I think you are much, much to optimistic on this. The financial crisis is once more gathering momentum in Southern and Eastern Europe, Germany is having a double dip. The UK is far from “healthy”, and the global “recovery” will be a much slower and drawn out process than people imagine. Simply becuase so many people now need to export and so few are able to assume more debt to balance this out. If everyone is reducing imports it is much harder to export.

    And on services, I am sure both Greece and Spain can benefit from increases in tourist activity, but look at the current account deficit (15% nearly in Greece) during the good years. You really can’t expect much more in the way of services growth than what you had in the 2002 – 2008 period, and this won’t compensate for the manufacturing distortion. I think the whole services driven argument is fundamentally flawed. All of Southern Europe needs more manufacturing, and there is no easy way round this.

    “PS and who is Costas?”

    No one special. Just a generic Greek. The title is a pun on a 1960s UK film “What’s it all about, Alfie”.

  11. @ SG thank you for asking the sort of questions I wish I had thought of.

    @ Edward thank you for your clear and interesting reply. En route you answered my, earlier question. I just wish my old Economics lecturers had been half so lucid (and textbooks as straightforward).

  12. Hi. Well, I come to comment about that a fall in imports appears as an increase in GDP.
    Maybe I am wrong, but I think that is not true, or at least not exacly.
    I always thought that the reason to subtract imports was to avoid double account. So, if I import a thing,it would be incorporated to GDP, for example, as consumption, etc
    If this is the case, doesn´t agree whith the above. Anyway, it is a tagential comment.

  13. I will explain briefly what I said.
    Suppose that C+I+G is 105. And that NX is 10-15, that is, -5. So GDP=100.
    Now you have no imports, so NX is 10. But then, C+I+G will not be 105, but 90. And GDP 90+10, again.
    I am not sure this is correct, and I know this is static, and do not reflec reality accurately. But I think it is closer to reality.

  14. Hi Ed

    wrote a long comment but spam protection stopped me and now I can’t write it again.

    In summary, I see your point better now.

    However, I think you are underestimating the size of the Greek parallel economy, which is mostly in services and is probably still growing! In the present “crisis” prices rose 2% in November, a sign that someone is still consuming.

    If I am wrong, I doubt Greece can be saved by manufacturing which is traditionally weak and more so in the days of the Chinese ascent.

    About the US, Uk and Germany, having lived in all of them I think there is a cultural difference, people of the same age have different spending habits. However it could be the case that the more youthful population in the Us has led to a more youthful dominant culture. Such an externality has not been studied AFAIK, but might be wroth exploring.

    french derek
    you’re welcome!

  15. Hello Carlos,

    “Well, I come to comment about that a fall in imports appears as an increase in GDP. Maybe I am wrong, but I think that is not true, or at least not exacly.”

    Well, it isn’t the fall in imports as such that shows up as GDP positive, but the reduction in the trade deficit as a result of imports falling faster than exports (ie the NX in your equation goes up). Now as you say, if this change in net exports has a one-to-one correcpondence with C (consumption), then there is no change, but there is no good reason why this has to be so, since the C could remain constant due to increased domestic activity meeting a need.

    Let me explain.

    This is the whole argument for devaluation in these kind of circumstances (Greece, Spain, Latvia, Hungary etc), since the devaluation not only helps export industries (as for example Dombrovskis notes in Latvia) it also helps the domestic sector by making imports more expensive. Thus, if demand was there, then a fall in imports would be compensated by a rise in domestic supply, and your interpretation of the equation would not hold.

    The whole problem, however, in these cases is that the internal demand is now longer there, since it was based on unsustainable borrowing in the first place, borrowing that appeared to be supported by rising property values as collateral. These property prices are now falling, and are not going to rise back again anytime soon (since we had bubbles, which by definition means that property was over valued), and thus the borrowing isn’t coming back again anytime soon. So there is a fall in C.

    In fact the causal mechanism is that the absence of capital inflows leads to a drop in consumption, which in turn means there are less imports. But my big point is that the accounting mechanism (making NX a positive input) masks to some extent the actual drop in living standards, since NX was negative, and the drop in C makes it less negative.

    Lets take your example. As you say, GDP stays the same, at 100, but in fact C+I+G is no longer 105, but 90, so living standards have fallen by about 14%, even though GDP seems constant.

    Take a real example, Spain, where GDP seems to have fallen by only 4% (due to the import correction), but real living standards of the entire population (ie total domestic demand) have fallen more like 7%.

    So to go back to your orignal point, a fall in imports makes the headline GDP number fall by less than living standards, and enables a canny politician like Jose Luis Zapatero be able to claim that the recession in Spain has been milder than in Germany, since German GDP fell at one point by 7%, while Spanish GDP only fell by 4%, but of course the opposite is the case, since the recession in Spain is much more severe than the one in Germany, just look at the unemployment numbers.

  16. SG

    “However, I think you are underestimating the size of the Greek parallel economy, which is mostly in services and is probably still growing!”

    I agree the parallel economies are probably growing, not only in Greece, but in all the four economies – Greece, Hungary, Latvia and Spain – which are spearheading the present crisis. This is one knock-on effect of raising taxes, and not being sufficiently competitive to operate in the normal economy. But since the crisis in all these countries is pre-eminently a crisis in government finance, and since what characterises the informal economy is that people don’t pay taxes, but the people involved do show up at hospitals when they are ill and to collect pensions when they get old, and they do send their children to schools, this feature doesn’t help the countries in question avoid default, in fact it makes default more likely.

  17. Edward, to me you have made one of the best arguments I have read in favour of Stiglitz’s “wellbeing” index proposal (prepared for French President Sarkozy).

    NB many economic and other commentators have mistranslated from the French “bien-être as “happiness”. This is a grave disservice to a great economist. Bien-être means wellbeing or, more in context “material wellbeing”.

  18. French Derek,

    “Edward, to me you have made one of the best arguments I have read in favour of Stiglitz’s “wellbeing” index proposal (prepared for French President Sarkozy).”

    Thank you, and thank you for pointing this out to me, since I hadn’t thought about this dimension. Evidently, as we can see in this case, simple measures like GDP or GDP per capita are not rich enough to capture the real situation of a country. As I point out Greek GDP per capita was shooting upwards, but then again, as the man said, we are all rich until the day we have to pay our debts.

    Unsurprisingly José Luis Zapatero was only a year ago pointing out to the Spanish how rich they were becoming, since on housevalue based implicit wealth the Spanish overtook Italy, and were approaching France in wealth per capita. But this was all an illusion, as we can now see.

    So you need some measure of indebtedness, external and fiscal balances and sustainability if you want to get some idea of the true situation of any given country, and it would be very interesting to have an index developed along these lines – which the UN Human Development Index, for all its positive points, isn’t.

    Bien-̻tre = Bienestar (Spanish) РBenestar (Catalan).

    So we need a measure which takes into

  19. Hello everyone!
    Edward, thanks for your prompt answer.
    First of all, I have to say that I have learned a lot reading your writings. So, thank you.
    Regarding the example I put, of course, in a functioning economy things do not happen in that way. There exists an adaptation more or less abrupt. I only wanted to highlight the accounting point of view. And of course, I did not want to play down the seriousness of the situation.
    In the other hand, the situation is more complex. An economy may be in need of import in order to export, etc.
    I read the link you put, too. In general, I think there is not objection to do. But I think here could be important consider not only the GDP, but GNP. Again, it is an incidental consideration. We know the USA have a lot of foreign investments inside, and also a lot of investments abroad. They operate in other countries, pay their taxes there, the profit is income that can be used to pay their debts in any place and whoever the creditor, isn´t?
    Of course, I am not saying there is no imbalances, and the same crisis is a good example of this.
    Well, thanks for reading.

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