Monday, 30 April 2012

"Redistributive austerity"

I ran across an interesting quote the other day on Economix (NY Times economics blog). It’s from a text by Casey Mulligan of the University of Chicago, entitled “The varying impact of austerity and stimulus”:
The interplay of the social good of helping the poor and providing them incentives creates tough policy choices for governments looking to reduce their deficits. The more resources available to those living below the poverty line, the less incentive they have to raise their income above that line. 
More research is needed to quantify work incentives in various countries, but I suspect that Western European nations have been pursuing exactly such redistributive austerity and will continue to do so, which means that they can expect austerity to depress their economies.
He makes an excellent point on Eurozone dependency, coining a phrase 'redistributive austerity'. The welfare state strategy pursued by a majority of Europe’s economies before the onset of the crisis resulted in reducing incentives for low income groups to earn the additional income. This pan-European welfare state model was partially responsible for the current sovereign debt problem, since many nations’ governments offered concessions to various targeted voter groups in order to remain in power longer. The system of high debts, unbalanced budgets and rising CA deficits (inducing the so-called twin deficit problem) was used to increase domestic consumption instead of production which increased the vulnerability of the system to outside shocks. In addition, banking regulations that steered EU banks into financing the debts of peripheral nations, and thereby indirectly supporting this consumption culture, further increased the systemic risk of these economies (as I have pointed out in numerous occasions before). As for the redistribution point, one could argue of a misplaced set of incentives offered to the people, all under the scope of buying votes. This systemic dependency (domestic governments on foreign assets, population on government) added much to a decrease of productivity. And it is this decrease of worker productivity that needs to be addressed at in Europe. While most have called either for devaluation or internal devaluation (downward adjustment of real wages), productivity is best restored by a labour market reform that will rebuild the proper system of incentives in the labour market. 

Mulligan’s viewpoint is that Western EU nations are still pursuing the same redistributive strategy, whereby nothing is being done to address the rouge incentives created to a large number of Europe’s population. Fixing these incentives is a painful solution indeed, but it is a necessary one in order to restore the right market signals that will guide private sector incentives towards growth creation. Any attempt of a stimulus or ‘redistributive austerity’ will only restore the pre-crisis status quo without addressing the fundamental institutional issues in Europe. The model applied in Europe so far has proved painfully wrong. It’s time to change it, and it’s best to do so during already miserable times. Why? Simple – have you ever heard of anyone attempting an institutional reform when the economy is growing rapidly? No one knows that this growth is unsustainable, and frankly, the short-term politicians don’t really care.

Friday, 27 April 2012

John Bates Clark Medal awarded

The winner of this year's AEA John Bates Clark Medal (as of 2010 awarded annually) is MIT economist Amy Finkelstein, for her contributions in the research on health insurance markets, in particular on "the presence of selection and asymmetric information in insurance markets."

The John Bates Clark Medal is the second most prestigious award in the field of economics. It is awarded only to American economists under the age of 40, who were already able to make a great contribution to the economics science. It is said to be a good predictor of future Nobel Prize winners. In fact, 12 Clark Medal winners  (out of 34) went on to become Nobel laureates (including Friedman, Samuelson, Arrow, Sollow, Tobin, Stiglitz, Spence, Krugman etc.). The average lag for these economists to win the Nobel Prize was 22 years. Among the non-winners stand out some impressive names like Acemoglu, Feldstein, Shleifer, Summers, Murphy, Grossman, Levitt or Saez, many of which carry a high probability of achieving the Nobel status. 

38-year-old Finkelstein is thought to be one of the leading scholars in health economics, a rapidly expanding field in the past few years. She is a micro-economist with a strong orientation on empirical and experimental research, focusing on policy-relevant issues such as the analysis of public intervention in health insurance markets.

WSJ summarizes her most prominent experimental research on health insurance:
"...she and other researchers tracked a group of low-income, uninsured adults in Oregon who were randomly picked to get — or not get — the chance to apply for public health insurance. Because it was a randomized controlled trial, the experiment sidestepped common pitfalls that researchers examining the effects of insurance face, including the tendency of sicker people — or unusually healthy people — to seek insurance.
The result: A year later, those selected by the lottery to be able to apply for Medicaid were more likely to have Medicaid, used more health care, had lower out-of-pocket medical expenditures and reported better physical and mental health."
Read about the rest of her research here, or on her MIT webpage.

Wednesday, 25 April 2012

If something is repeated loud and frequent enough, it’s bound to be true

The same reasoning goes for the bond purchases and monetary easing of the ECB. 

By the beginning of the year, the ECB provided unlimited funds for the next 36 months under the newly adjusted 1% interest rate. The first December auction released €489bn of funds (even though the net increase in liquidity was reported to be lower according to the ECB) which reduced long term bond yields for every Eurozone country apart from Greece and Portugal. Banks used the released cash to buy government bonds which kept long term interest rates low.

But EU banks still have around €500bn on overnight deposits with the ECB, on an interest of 0.25% (this means, as I noted earlier in October, that banks would rather accept a loss by borrowing at 1% and depositing at 0.25%, then to take a risk and lend to the private sector). On the other hand these banks are facing higher capital ratios enforced by the EBA, when the value of their still held peripheral sovereign debt is falling (especially after the Greek default). 

However, the policy did have an effect as Europe experienced a slightly better first quarter of 2012 than expected. What the policy did is that it created positive expectations among investors, proving once again that this crisis has a lot to do with confidence.

Source: European Commission: Business and Consumer Surveys
But even after a quick increase of confidence in January and February, in March things were starting to deteriorate again. The EC’s sentiment index reports: 
“After improving in January and February, the Economic Sentiment Indicator (ESI) decreased in March by 0.8 points in the EU and by a marginal 0.1 points in the euro area... The decline was mainly driven by decreasing confidence in the industry and construction sectors. By contrast, confidence increased among consumers and in the services and retail sectors.”
As is noticeable on the following two graphs, while consumer confidence was seen slightly improving, business confidence again started to decrease.
 

Source: Trading Economics
Throughout the final quarter of 2011, more and more prominent analysts, economists and investors called for the ECB do step in and do more to save the euro and the entire Union. As a result a lot of investors were waiting what the ECB will do, as if the ECB is the only thing that can save them form losses. It is no surprise that its auction and the announcement of another, even larger one helped increase confidence among investors and, along with liquidity, released a bit of optimism.

But with all this liquidity released, who did the ECB really help? It helped the governments and their banks. The biggest problem is that investors will again start looking at the ECB as the investor confidence goes down again (just look at the recent Spanish bond auction), and this is not a good thing. More and more pressure will be put on the ECB to become the lender of last resort to governments.

But it won’t be able to withhold that pressure. All it can do is provide a temporary liquidity offer and easing to governments, but it won’t do any direct or indirect good for the businesses or the consumers. It won’t increase their confidence and it won’t help them grow or spend more. It is a strikingly narrow solution proposed by many as the main recipe for solving the eurozone crisis.

Here's an excerpt from a text by DeLong on that point (he makes it as a call for fiscal stimulus but the reasoning is clear and straightforward): 
"The ECB could induce banks to make more loans, and fund more investment and consumption spending by credibly promising to raise its permanent inflation target – but it will not so promise, and it would not be believed if it did. The ECB cannot induce banks to make more loans and fund more investment and consumption spending by swapping bonds for reserves as long as the value of pure liquidity is zero and reserves are as good as – nay, better than – short-term bonds. The ECB could induce banks to make more loans and fund more investment and consumption spending by taking risk onto its balance sheet and so freeing-up scarce private risk-bearing capacity – but is that monetary policy? No, that is fiscal policy, albeit non-standard fiscal policy." DeLong, April 2012, VoxEU
The actual solution didn’t and won’t come from the ECB; it will come from pro-growth reforms enacted by the peripheral governments. Political stability, market liberalization, labour market reform, removing regulation and reducing the tax burden are policies much more likely to restore consumer confidence than anything the ECB is prepared to do. 

Or else, you're stuck with this - starting a business in Greece
"It took 10 months, a fat bundle of paperwork, countless certificates, long hours of haggling with bureaucrats and overcoming myriad other inconceivable obstacles for one group of young entrepreneurs to open an online store."
10 months for an online store?! These are the real issues the reforms must deal with: how to help business grow, how to restore confidence and let the market signals do their magic. Nothing that ECB does will help this country or any country with similar anti-business climate (recall my previous post on Hungary) to achieve economic growth.

Monday, 23 April 2012

IEA: "After default: options for recovery in Greece"

My blog post on the recovery options for Greece is published at the Institute of Economic Affairs blog.

Here's an excerpt:
"Institutional reform starts with political stability. Greeks have little confidence in their government. In order to address this, the politicians need to restore belief in the system and the rule of law. The government must act as an enforcer of contracts to signal greater stability to both domestic businesses and foreign investors. After this, it has to continue with public sector reforms and liberalisation of the labour market (both are closely tied since the public sector unions are the ones with the highest level of rigidity). It must show strength in the bargaining process and create favourable incentives for businesses. Signals for new specialisation, trade and production should be left to the market - to bring about the necessary restructuring process supported by the new institutional setting. This is the only way to enable an efficient allocation of resources, removed from any distorting signals and able to attract capital. The banking system will benefit from positive signs of confidence and stability in the economy, which will reduce capital flight and slowly but gradually improve balance sheets. A euro exit could threaten this process by making it harder to achieve political stability. It would take Greece much longer to consolidate. 
Greece should turn to pro-market institutional reforms that will reduce distorting signals in the economy and create space for market led specialisation and investment. And these institutional reforms should not be limited to Greece. They are applicable to a series of countries which find themselves constrained by their unsustainable welfare state models of debt accumulation, high current account deficits, fiscal profligacy, corruption and high levels of state intervention."

Read the whole thing here.

Friday, 20 April 2012

Graph of the week: Eurozone dependency

This week's graph comes from the Economist as another verification of my earlier ideas on the causes of eurozone contagion.


Here's what it says:
"Borrowing too much from foreigners can imperil your nation's health
LOTS of countries in the rich world ran pro-cyclical current-account deficits before the financial crisis hit, which is to say they borrowed heavily when times were good. Yet only a handful have seen yields on their sovereign debt spike to alarming levels. One reason for this, as the chart below shows, may be an over-reliance on fickle foreigners to finance those deficits. Italy, which has a high rate of domestic savings (and thus is less reliant on finance from abroad) and yet also suffers from high yields on its debt, is an outlier."
(Daily chart, The Economist, 13th April 2012)
I would add that the key reason why foreigners financed the CA deficit is linked to the common currency and the banking regulations which led to a levelling of spreads across the eurozone. This essentially meant that Greece and Germany for example, could borrow at the same cost. Despite having the same zero-risk status and low interest rates, investing in the periphery became more attractive than investing in the North simply due to an attractiveness of a new market. And when this new market is considered to be risk-free, all the better! 


Tuesday, 17 April 2012

Beware of real-life analogies

Readers usually enjoy it when economists (or experts in other fields) use real-life analogies to try and explain things more clearly. You will very often hear of economists using medical terminology in trying to explain the situation in the economy ("the medicine is harsh, but the patient requires it" - this one is actually from Margaret Thatcher), or automotive analogies ("pulling the economy into the faster gear"), sporting analogies (numerous examples, usually referring to boxing but also first halfs and second halfs) and so on.

I ran into another interesting one a few months back but I completley forgot about it before I read today's post by Scott Sumner, quoting George Soros. I meant to write something about it back then on the essence of Soros plans to fix the eurozone but I was preoccupied with other subjects. Besides, since then I covered the eurozone topic quite thoroughly (see here, here and here).

What I'm drawing my attention to now is this part of the quote (pay attention to the underlined bit):
"To be a little more specific, let me suggest the outlines of a European solution to the euro crisis. It involves a delicate two-phase maneuver, similar to the one that got us out of the crash of 2008. When a car is skidding, you first have to turn the steering wheel in the direction of the skid, and only after you have regained control can you correct your direction. In this case, you must first impose strict fiscal discipline on the deficit countries and encourage structural reforms; but then you must find some stimulus to get you out of the deflationary vicious circle—because structural reforms alone will not do it. The stimulus will have to come from the European Union and it will have to be guaranteed jointly and severally. It is likely to involve eurobonds in one guise or another. It is important, however, to spell out the solution in advance. Without a clear game plan Europe will remain mired in a larger vicious circle in which economic decline and political disintegration mutually reinforce each other." "How to Save the Euro", 23/02/12
So the crisis is like a car skidding, and we need to know how to control it both in the short run ("immediate turning of the steering wheel") and in the long run (steer normally once control is regained). The analogy implies that the economy would stand still unless there is someone (presumably the government or any other form of central authority) to steer it properly. If you really think a central authority needs to steer an economy like you do with a car, then this analogy may even work. But for those who don't understand how the economy works (e.g. politicians), this can be quite confusing. 

One needs to be very careful when using real-life analogies as they can very often backfire.

For example, take this analogy: When fixing an economic system you need to treat it like a sick part of a plant (do some pruning every now and then). You need to cut off all the infected branches in order to leave room for the healthy ones to grow on their own out of the new tissue. Even if you have to cut down a lot, you are doing so to help the plant by removing the malign parts. Even when it isn't infected you still need to cut out some dying branches every year (in spring) in order to leave space for new ones to grow. The result is you get more and better fruit next season (by the summer).

Another analogy in the same level is when a person is sick - sometimes doctors amputate limbs in order to save the rest of the body, i.e. to save a life. This analogy is much harder to grasp since limbs unlike branches in a plant don't grow back. Using this analogy to call for austerity would clearly backfire, as leaving an economy crippled isn't quite the solution everyone is hoping for. 

Using analogies this way only creates confusions among people who don't understand the subject very well and can likely lead to an increase in their biases. In the example of steering a vehicle by Soros or my example of gardening both arguments could make perfect sense to someone with an upfront biased belief on how an economy works (or is supposed to work). Just for the record I think the gardening example is much more realistic to describe an economy since it looks at it as a natural dynamic system (like human behavior) - unlike a car which is static and man made. 

In conclusion, be vary of using real-life analogies to explain theoretical assumptions. Rather, use real-life data and apply it to logic - this strategy never fails. 

Sunday, 15 April 2012

Are you a Social Darwinist?


Note: This article was first published on the Adam Smith Institute blog (April 13th) in a modified form. For all my other ASI writings see here.

In a recent exchange of compliments on the American political scene, the US President Barack Obama accused the GOP budget commissioner Paul Ryan as well as the supporter of his budget proposal and Obama’s likely Presidential opponent Mitt Romney, of being “Social Darwinists”. The severe budget cuts called for by the Republicans enraged the President as he feels that the government must take an active role in supporting education, R&D, and infrastructural investments, which are not only important in restoring short-run recovery, but also for creating a long run, sustainable, government-led dynamism of the US economy. However, government investments will always fail the assumptions of the Smithian market signalization and specialization and will never be robust enough to produce the optimal outcome in the economy. 

Anyone opposing this civilizational aspiration of humanity to be led and controlled by the government is apparently a Social Darwinist. Let me just clarify that the GOP is far from Social Darwinism in terms of government intervention in an economy. But I do understand why the President would use this term to describe them. 

The term will always be considered in a pejorative fashion. Why? Because Social Darwinism implies survival of the fittest; an application of Darwin’s natural selection law into a society. In the animal kingdom struggle for existence the strong survive and succeed, while the weak fail and are left to die. The stigma of Social Darwinism in a society implies that the poor shouldn’t be aided in a system where wealth is a sign of success. 

I feel this definition needs a bit of clarification. Survival of the fittest doesn’t mean that those who fail should die. This means that those who fail should undergo a trial and error process until they do succeed. No one reaches success immediately; we all undergo a trial and error process, whether through looking for jobs, applying for schools or looking for a place to live. Our experience gained through a series of trials and errors ensures a process of constant cognitive learning. 

Social Darwinism has much more examples in real life situations than one could think of.

In sports, every sporting competitor strives on proving he or she is stronger than the competition. Strong teams and strong players will defeat the weaker ones, and we will celebrate the strong ones while bantering on the weaker ones. And for some reason this behaviour is perfectly acceptable. And why shouldn’t it be? 

In Premier League football, one team wins the league, three teams fall out of the league. Unfair? Better call up the lefties to fix this: “We cannot have anyone dropping out of the league. It isn’t fair to those who came in last. It’s the society’s fault they came in last, so we should help them. Maybe the players instead of practice went on watching mindless shows on TV – that’s society’s fault for letting the ‘free market’ ruin good television with their quests for ratings.” How many times have you heard this argument? 

Another example is higher education – who gets admitted, those with best SAT/GRE/GMAT scores or those with the worse? Opportunity to study is given to anyone who proves his or her worth with hard work and competence. In schools kids learn that success in a society should be based on merit. This is how they distinct themselves from others and ensure a better life further on. 

Finally, in a competitive marketplace, this is more than welcomed behaviour. Firms that treat their customers poorly will be considered weak and will go under, while those who offer an extra service and value to the customer will be considered strong and will be able to prosper. Trial and error means that good companies which offer an added value will succeed while bad ones will fail. Bear in mind, this doesn’t include bailouts and socialization of the costs. Under Social Darwinism this is strictly forbidden. Under common sense this is forbidden as well. 

But unlike my ‘imaginary’ aforementioned examples, the competitive marketplace does get unfair intervention. Why is that? Why we chose to accept the educational system to produce experts based on merit, sports to produce results based on merit, while companies aren’t allowed to do so? If it produces Messi, Jordan, Federer, many brilliant Nobel prize winners or companies like Facebook, Google or Apple, why shouldn’t it be allowed to produce more companies that behave like Messi, Jordan or Federer in their respective fields? 

In the animal kingdom, natural selection ensures only the strongest of the species survive. In a society, a competitive marketplace will yield the same outcome. This doesn’t mean that those left behind due to natural congenital disadvantages should be left to die. I don’t think anyone within a society thinks this way and I don’t think this is implied in the definition of Social Darwinism. When it comes to human beings everyone should get an equal opportunity to prove him or herself based on merit. When it comes to companies the same rule should be applied. Call it Social Darwinism or call it competitive meritocracy, unlike its ideological opposite - socialism, at least it hasn’t killed anyone. 

P.S. As for the Ryan budget, I think it’s highly hypocritical of the Republicans to cut everything apart from defence and national security spending. They fail to realize that economic freedom cannot fully express itself without individual freedom. One cannot go without the other.

Thursday, 12 April 2012

Modern consumption theory - temporary vs permanent income

One of the main arguments in favour of a fiscal stimulus include the idea that tax rebates will work towards encouraging consumption, and hence aggregate demand. If the people suddenly gain unanticipated funds which will increase their disposable income, this should encourage them to spend this money immediately. On the supply side the argument is to cut personal income taxes in order to increase the disposable income and then consumption. The real problem is that both of these policies won't do much help to temporary consumption especially if confidence in the economy is low. Even though a tax decrease has a positive effect on disposable income, it will yield the same effect on consumption only if the tax decrease is considered to be credible. 

The distinction between temporary and permanent income is an important parameter in determining the real effects of tax policy. If citizens find themselves suddenly with more cash back than they expected, logic permits that they spend this temporary increased disposable income on durable goods that will initiate a temporary spike in consumption.

Figure 1. Changes in US Real Disposable Personal Income (blue) and
Real Personal Consumption Expenditures (red) 1958 - 2011.
Source: St. Louis Fed, FRED database

However, this might not be true in the real world. According to Figure 1. above, spikes in p/c disposable income didn't result in much rise in consumption. On the graph, several of these are noticeable - 1975, 1987, 1993, 2001 along with some others. For the 2008 tax rebate, Christina Romer claimed it had a big effect in not letting consumption fall any further, while John Taylor claims there was no effect at all and that it all went into savings. 

Taylor's argument could be true, especially if we look at the change in the savings rate during the crisis years.

Figure 2. US Personal Savings Rate 1958 - 2011. Source: St. Louis Fed.
FRED Database 
According to Figure 2, people increased their savings during the crisis years. This is, of course, an expected effect. In uncertain times people chose to put away their money and 'play it safe'. Tax rebates or even tax cuts (unless they are considered credible which takes time) won't initiate consumers to spend more, as they are currently in the process of deleveraging. They will use the money to pay off debt and save more in accordance to an uncertain future.

The reason is the distinction between temporary and permanent income. If people anticipate a rise in tax rebates or any other form of stimuli (this is true for companies as well, not just consumers) to be temporary, they will save this money instead of spend or invest it. But when they anticipate a permanent rise in income (like getting a new or better paid job) they are much more likely to spend or invest now as they anticipate a certain future stream of income. With a temporary cut or rebate, they know that next year this won't happen so they better put the money away for now. 

This is why the policy shift must come from a different angle - restoring confidence and pro-market structural reforms

Monday, 9 April 2012

Why Nations Fail

Here is a lecture by Prof. Daron Acemoglu on his new book co-authored with Prof. James Robinson; "Why Nations Fail", for which I am preparing a book review on. 


The book is an excellent read and I highly recommend it to anyone interested in the role of institutions in comparative development. It answers the central question that interests anyone studying economics: 'why some nations are rich while others are poor?' In praising the book I even came across opinions that its contribution is as important as Smith's "Wealth of Nations". 

Here is Acemoglu and Robinson's blog on the book and other issues covered in it, here is a podcast of Acemoglu talking to Russ Roberts on Econlog, and here is a good review from the NYT's Thomas Friedman. 

Thursday, 5 April 2012

Graph of the week: A crisis of confidence driven by policy decisions

Following up on the Economic policy uncertainty research done by Baker, Bloom and Davis (on which I wrote about earlier), here is a graph from them on the movements in the S&P 500 index:

Source: Baker, Bloom and Davis (2012) "Measuring Economic Policy Uncertainty" 

Notice how the majority of movements in the last period (both upwards and downwards) were policy-related. A possible conclusion from this could be that bad policy-making decisions (particularly towards the end of last year - see here, here and here) are the main drivers behind high levels of uncertainty. In the years during the crisis, it was obvious that other events were driving stock market swings much more than political decisions. But the sluggishness of the recovery can only be blamed on inadequate policy measures and misplaced signals sent by politicians to the market (such as the debt ceiling quarrel in August in America, or the eurozone faulty attempts to reform). 

On the methodological point, the way the authors come up with these movements is by reviewing newspaper articles, where they find an article that explains previous day movements. The 'movers' are alocated into categories such as macroeconomic variables (unemployment or GDP growth data), profit and earnings reports or policy-related movements such as announcements of new regulations, laws, or actions done by the FED, however excluding interest rate changes. Having to include for the FED interest rate decisions I would dare to say that policy oriented decisions would consist of an even larger part of the total movements (both upwards and downwards). 

The authors find the increase in the proportion of stock movements driven by policy decisions rather interesting: 
"...this does not seem to simply be a symptom of the recession. Looking at the other recessions in our sample, we see no jump in policy-related stock movements, with the large movements being driven primarily by macroeconomic data or, in the case of the 1990-1991 recession, by news of the first Gulf War. Plotting these numbers over time, you can see a tremendous surge in absolute numbers of large movements since 2007. Furthermore, the increase in policy-related movements, including European  and domestic policy-related events, is also apparent. The recent experience stands in stark contrast to the mid-1990s and the mid-2000s, where there were several years in a row without a single large stock movement of greater than 2.5% and even longer periods without a large movement driven by policy."
Point of the story - the crisis of confidence we experienced last year (and which is threatening to continue into 2012) had too much to do with politicians. It's never a good thing for businesses to eagerly anticipate what policy makers have to say before making allocation decisions. They should receive their signals elsewhere - among the consumers for example.

Read here about their further attempts of trying to make a new economic indicator of policy uncertainty

Monday, 2 April 2012

To Greece and back

In the last month I briefly drifted apart from the eurozone and its problems (amid some interesting graphs), and by doing so I overlooked the Greek default situation. For those who are unsure, Greece did actually default on its debt. After agreeing on the second bailout in February (€130bn) and forcing private holders of Greek debt to accept a larger haircut, in March Greece experienced the largest sovereign-debt restructuring in history (€100bn of its total debt of €350bn will be included in the debt restructuring deal). The debt swap means that current debt holders (mostly EU banks) will exchange their existing debt for new bonds, which pay a lower interest and have a lower face value. This made Moody’s declare that Greece did actually negotiate a default, since that's what a debt swap implies. Another reason why this clearly was a default is that it wasn’t voluntary, as those private holders of debt that didn’t sign up for the bond swap were forced to do so. Anyway, this made Greece open to take in the €130bn bailout, pledging of course to continue with its austere reforms.

The markets seem to have reacted positively to this news, but the story is far from over. This temporary restructuring isn’t likely to do any good to the country if other steps are taken into account. 

Economy in dire straits 

If you look at the current situation there is no sign of improvement: consumer confidence is hitting a new low, unemployment is reaching a new high, industrial production is still falling as is the manufacturing PMI, while the growth outlook never looked worse. The only two things showing improvement are government gross debt and the budget deficit, both due to the foreign enforced austerity reforms and as a part of the recovery strategy of the Troika (ECB, IMF, EC). Well, as anticipated it doesn't seem the enforced austerity did much help so far.
The program of debt restructuring is that Greece needs to do a whole bunch of austere reforms which aren’t likely to jump start the economy or create a sustainable path for growth. They are expected to decrease their debt-to-GDP ratio from 160% to 120% in 2020, which is still a burden far too heavy for Greece, or anybody for that matter. The 120% threshold is too high, and has no economic justification. It’s a politically chosen goal made up to resemble the current Italian debt-to-GDP ratio, which is still deemed to be sustainable. If this were to be proclaimed too high, Italy would risk further destabilization ignited by ratings decreases and another increase in bond yields. So that's why 120% was chosen, but it is by no means a guarantee of stability. Furthermore, as I noted in October, this set of enforced policy measures will mean that Greece won’t experience any growth or recovery until 2020. It is a lost decade indeed for Greece and a potential danger of a lost generation. 

In light of such a catastrophic economic picture, some have called for an immediate exit from the eurozone characterized by currency depreciation and capital controls to stop capital flight out of the country and to quickly restore competitiveness (without the need to renegotiate wages down). However, leaving the eurozone is not an option - the public is against it, and the politicians are overwhelmingly in favour of staying. The costs of leaving are simply too big and no one has the courage or the strength to bear them. The realistic scenario is the one laid out by Blanchard in this text, where the focus will be on reducing debt and the CA deficit in line with trying to restore competitiveness. 

But what both approaches omit to realize is that the economy won’t grow based on the mixed and distorted signals it is being subdued into at the moment. 

Call for a proper institutional reform 

The depreciation argument assumes that the central Greek issue are relative prices not productivity, implying that the depreciation is the quickest possible solution, just like what happened in Iceland. But Greece isn’t Iceland – Greece doesn’t have the productive capacity to be solved simply by currency depreciation. Its culture is consumption (as is shown in its CA deficit structure – see figure 2 on the link), its labour markets are corrosive and state dependent, its state is inefficient (even in basic tasks of collecting revenue), its banking and business sectors are destroyed with lack of confidence and uncertainty. To fight all this Greece doesn’t need a fiscal stimulus and it doesn’t need fake austerity with no institutional support; rather it needs structural reforms and it needs strong pro-market institutions that it seriously lacks. 

An institutional reform starts with political stability. The confidence of the Greek people in their government is close to nothing, and who can blame them – every single government so far has left a taste of betrayal. The fundamental principle that the politicians need to restore to address this lack of confidence is belief in the system and its rule of law. The government must act as an enforcer of contracts to signal greater stability to both domestic businesses and foreign investors. After this, it has to continue with  public sector reforms and the crucial labour market reform (both are closely tied since the public sector unions are the ones with the highest level of rigidity). It must show strength in the bargaining process (in which I believe they have gained much experience by now) and create favourable incentives for businesses. The patterns of sustainable trade and specialization can once again be applicable in a slow, yet successful restructuring process Greece desperately needs. This is the only way to enable a productive resource allocation, removed from any distortion signals and able to attract capital. The banking system will follow upon the positive signs of confidence and stability in the economy, reducing capital flight and slowly but gradually improving their balance sheets and preparing more money to foster economic activity. 

The euro exit would reverse this process by not allowing political stability to be achieved, and it would take Greece much, much longer to consolidate. 

I want to believe that the European policymakers have recognized this, which is why they won’t allow the euro exit, capital controls or a devalued drachma, and call for necessary long overdue reforms, but unfortunately this isn’t the case. European policymakers are slowly beginning to let Greece go (as I anticipated earlier in October), they realize that the danger of Greece pulling with it Spain and Italy is now much less than it was before. They are better equipped now to cope with pressure if such a scenario should occur. But they are also risk-averse and careful in designing a politically optimal strategy as they need to justify to their taxpayers all the bailouts made so far. This is the only thing that's making eurozone leaders still put pressure on Greeks to carry on with debt and deficit reduction and austerity reforms. Even though the current set of policies is clearly backfiring. 

Greece should turn to pro-market institutional reforms that will reduce distortive signals in the economy and create scope for market led specialization and investment. This set of institutional reforms isn’t limited only to Greece; they are applicable to a series of countries which found themselves constrained by their existing unsustainable welfare state models of debt accumulation, high CA deficits that were used to finance consumption instead of production, fiscal profligacy, corruption and high levels of state intervention (any country in particular comes to mind? I can think of more than a few).