Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

The Resolution of the Crisis in Athens

Friday, June 26, 2015


Last week I visited Reykjavik to present the draft of a chapter on international monetary reform to the Department of Economics at the University. The city is booming, the cranes have returned and the restaurants are full. The country is more or less at full employment. Ironically, the crisis in Iceland and then the volcanic eruption has put the country as a mecca for tourists.

The global financial crisis impacted Iceland in 2008 and 2009 at about the same time as it hit the United States, Britain, Ireland, Spain, Portugal and Greece. The United States is at full employment. Britain is humming, although the government’s fiscal deficit is still too large. Spain has the highest growth rate in Europe. Portugal has been growing at a rate of 1.5 percent a year, although the unemployment rate is high. Ireland has had a remarkable recovery.

Greece is in the fifth year of its crisis, with an unemployment rate north of twenty five percent.

Why then has the performance of Greece been an outlier?

One contributing factor is that the crises in most of these countries resulted from the implosion of a real estate bubble; in contrast Greece and Portugal had sovereign debt crises–their fiscal deficits were large, and were financed by the banks in Germany and France and other countries in Northern Europe. Moreover, Greece entered the Euro in 2002 at an implicit price for the drachma that was too high–that is, given the level of costs in Greece, the country would have a current account deficit because foreign goods were less expensive. The anecdote is that the tomatoes served in the salads at the Hotel Gran Bretagne were grown in the greenhouses in the Netherlands rather than in the countryside around Athens.

Five years of austerity has led to a modest decline in costs and prices, but Greece is far from competitive.

The issue is not whether Greece will default; there already have been two rounds of debt write-downs. Greece has defaulted. “Everyone” knows that if the owners of the IOUs of the Government of Greece were to “mark to market,” the haircuts would be sixty or seventy percent or more. The Government of Greece can pay interest to the owners of its IOUs only if the country has a trade surplus that leads to a flow of Euros to the country.

If Santa Claus were to wave his magic wand and forgive all of the debt of the Greek government, the country would still have an unemployment rate north of twenty five percent. If the unemployment rate in Greece were lower, the country’s GDP and its demand for imports would be higher; the country would not have the ability to pay for these imports because its exports of goods and services would still be much too small.

Five questions remain. The first is why the authorities in Brussels, Frankfurt, and Washington have failed to recognize that the primary cause of the fiscal deficit in Greece is the lack of competitiveness. The second is why five years of austerity has not led to a decline in costs and an increase in competitiveness. The third is how much longer will this charade continue. The fourth is why leadership in Europe continues to be diddled by the maniacs in the Government in Athens. The fifth is what will happen when Greece leaves the Euro.

One of the peculiar aspects of contemporary analysis of international imbalances is that there is general acknowledgement that the globe has shrunk (remember Tom Friedman’s The World is Flat), and yet there is relatively little recognition of the impacts of an increase in the size of a country’s trade deficit on its fiscal balance. The general view is that increases in government spending lead to increases in imports and a larger trade deficit. This view is correct. But an increase in the country’s trade deficit can lead to an increase in its fiscal deficit. If residents of Greece increase their spending on foreign goods and reduce their spending on domestic goods, domestic employment and profits decline and the country’s fiscal deficit increases. Because costs and prices in Greece are high, the spending on imports is much larger than the receipts from export sales. If Santa once again were to wave his wand so that spending on imports declined and export earnings increased so that the country had a sustainable current account balance, GDP in Greece would increase by eight to ten percent, and the fiscal deficit would decline by eight to ten percent of GDP.

One of the stylized facts is that Greeks are talented entrepreneurs. Which leads to the question of why the economy has not expanded as costs have declined. One possible answer is that the costs in Greece are still too high relative to those in other countries in the Mediterranean Basin. A second is that the austerity has led to a shrinkage in the balance sheets of banks, and would-be entrepreneurs with clever ideas can’t obtain the credit they need to develop a business because the banks need to reduce their loans as their deposits decline. The third is that these entrepreneurs feel stifled by the regulators; the creditors’ countries are asking the Greek government to increase the corporate income tax and the value added tax to reduce the fiscal deficit–a marvelous strategy for shrinking the private sector in Greece.

The likelihood that this charade between the creditors in Northern Europe and that the Greek government will continue for several more months is low. The current Prime Minister in Athens has been successful in alienating the authorities in Northern Europe. One view is that the Prime Minister knows that Greece has to leave the Euro, and since his political future is in Athens, he needs to be able to show the voters that the separation or divorce has been caused by the niggardliness of the Finns and the Austrians and the Germans.

Few of those in the governments in Northern Europe want to be tagged as the villains in this morality play. They have tried to position themselves so that they will appear relatively faultless compared with the arrogant and the strident political leaders in Athens.

Greece’s departure from the Euro is more or less like a devaluation of the currency under the Bretton Woods arrangement of adjustable parities–or like Argentina’s abrogation of its currency board arrangement in 2001, or the decision of the U.S Treasury to close its gold window in 1971. The modest additional complication is that the Government of Greece will have to introduce the new drachma. The sun will shine on the Acropolis the day after Greece leaves the Euro. Prices of imported goods will increase by twenty or thirty percent and the price of assets in the export industries will leave markets in Athens in turmoil for two or three months. The tens of millions of Euros that have been stashed in foreign banks by Greeks will be repatriated, and spending will surge. The unemployment rate will decline. The likelihood that Portugal or any other member of the European Monetary Union–other than Cyprus–will leave the Euro is trivially small. And after Greece leaves, Mrs. Merkel can turn her attention to Putin’s challenge and to how the Eurozone countries should reconcile the large current account surpluses of Germany and the Netherlands with the large current account deficits of France, Italy and Spain.