Saturday, 14 February 2015

Greek game theory: You can fool the voters but not the financial markets

Back in November 2011 an increase of Italian bond yields for the third time in three months and for the first time above the critical boundary of 7%, resulted in an abrupt and surprising resignation of Italy's controversial PM Silvio Berlusconi. All of his corruption affairs, political blunders, and even the infamous bunga bunga parties could not hurt him. It was the financial markets that punished his reckless behavior of buying time for reforms by playing with the patience of investors.

The financial markets will be crucial once more in the case of the newly elected Syriza government in Greece, led by the radical leftist Alexis Tsipras. After having read his op-ed for the Financial Times published but a few days before the elections, it seems Tsipras realizes the gravity of the situation he and his country are in. Apart from the general anti-austerity rhetoric which won him the elections, Tsipras clearly stated that Syriza will respect the constraints given to them by the Troika (IMF, ECB, EC) and that Greece will, as a fully pledged eurozone member, aim towards reaching a balanced budget and will fulfill all other quantitative goals set by the European Commission. Tsipras emphasizes, however, that austerity imposed upon Greece by the Troika as part of the bailout deal, ruined the country and that such policies aren't the only way to balance the budget.

It's hard not to agree with him. In fact, back in October 2011 I wrote a blog post expressing deepest concerns over the bailout plan designed for Greece. Here's an excerpt from that text:
"...the Greek ‘rescue’ plan. It’s hard to see how this plan can actually help Greece stabilize. Keeping the status quo is not going to make investors ready to invest into the Greece economy. Pushing more money into an insolvent country and keeping it on ‘life support’ will make its economy more and more vulnerable and dependent on foreign aid. The policymakers are turning Greece into a long term problem for Europe. This will have negative implications on all fronts – it will ruin confidence around Greece for a long time, disabling it to achieve any growth whatsoever, it will create massive social instability in the country, and it will give further rise to euro-scepticism around the continent. The country’s future seems to be a lock-down in debt, social turmoil and inability to create growth. Greece at this point doesn't only need a debt restructuring, it needs a restructuring of its entire economy, starting from the labour market, public sector, industrial policy and so on. This is what the policymakers should have focused on, instead they choose to short-fix Greece until 2020. According to all of this, I fail to see how Greece will be able to grow at all until 2020.
But austerity in itself is not the cause of Greek problems. The complete picture of the demise of the Greek economy has to be traced back to decades of unsustainable, populist political concessions which were used to 'buy votes' by increasing pensions and public sector wages, extending public sector jobs to maintain a perception of high employment, and satisfying a plethora of budget-dependent interest groups. They used cheep borrowing on international markets, when Greece could borrow at the same rate Germany did (see here), to fund political concessions which increased their public debt-to-GDP ratio to above 100% (bank bailouts during the crisis coupled with rising budget deficits brought it to the current 175%). A consequence of this is the systemic unsustainability of the Greek public finances.


But it wasn’t all bad. The debt-fuelled growth model led to a rise in living standards as Greek citizens experienced the largest increase of personal income among eurozone countries (particularly the bottom income groups) during the first decade since the introduction of the euro. Due to cheep borrowing, enabled partially by the introduction of the euro, it seemed that the Greeks found a loophole in the system and that there was no ending to this model of debt-led growth. This obvious fallacy reached its painful and bitter end in 2009 when the external shock and the subsequent credit stop brought the domestic instabilities of the Eurozone economies onto the surface and created the final trigger for the sovereign debt crisis, both in Greece and across the euro periphery, which used the same debt-led growth model and political populism. 

There is no doubt that the responsibility for orchestrating such a debt-led growth model lies primarily on the political leadership of the old elites, PASOK and New Democracy. In fact their negligence and misconduct go even further after the discovery that the government’s official financial data has been falsified. The demise of their growth model and corrupt practices was coupled with social turmoil amid an extended crisis for which even Europe’s leaders hold a partial blame. And so the stage was set for Syriza to win the elections and make a genuine attempt to revoke the austerity commitment.  

However, despite high expectations of leftists worldwide, Tsipras and his finance minister Varoufakis, upon taking office have started changing their rhetoric. On their recent European tour they offered policies which the Commission has already asked Greece to do, such as closing down tax evasion (the tax authority fails to collect almost 30bn euros per year), and balancing the budget, but with firm promises that new debts are intolerable. They advocate Greece staying in the eurozone and are asking Europe for more time to implement the reforms which would put an end to the clientelistic and kleptocratic practices of their predecessors.

The main point of disagreement is the negotiation over the debt repayment. In particular, the 240bn euros which the Troika has used to bailout Greece on several occasions during the crisis, imposing strict austerity as a requirement. Varoufakis asks for part of the existing debt to be swapped for new bonds which would be linked to the growth of nominal GDP, achieved with a crackdown on tax evasion and subsequent budget surpluses.

The ECB, however, reacted by forbidding the Greek banks to access ECB credit lines by using Greek government bonds as collateral, thereby exposing the Greek banks to the risk of illiquidity. This created additional pressure for the government to respect the deal imposed in the bailout conditions, which would see them receive another payment rate of 7.2bn euros by the end of February. With deposits fleeing the country and without the help of Europe, Greece could literally find itself insolvent by the beginning of March. The ECB has later allowed the Greek central bank to extend up to 60bn euros to the domestic banks in case of emergency, but this still doesn't make much of a difference for the Greek government.

Greek 10-year government bond yields. Source: Bloomberg
Prime Minister Tsipras therefore has two options; one is to follow the rules of the Troika and respect the realistic constraints of financial markets. This would necessitate entering into various compromises which could be interpreted as a betrayal of his voters. The other option is to use the same populist policies responsible for the crisis in the first place, and descend the country into bankruptcy and subsequently an even bigger recession. This would surely result in a political downfall of Syriza and the ascent of right-wing nationalism, with which Tsipras is already scaring Europe. This seems to be the central strategy of minister Varoufakis, a game theory professor, in his negotiations with the Commission and Germany - a credible threat of national-socialism which should force Europe to cave in. So far the strategy hasn't been too effective; capital is still fleeing the country, liquidity is endangered, risk of bankruptcy is increasing and stock markets are in decline. By the end of February Tsipras will probably choose the first option, coupled with a few benign populist decisions such as rehiring cleaning ladies and firing ministerial advisers, in order to maintain a signal of intransigency towards his voters.

Contrary to ideological illusions, the key to a Greek recovery is the recovery of its private sector. This will not happen by maintaining and even furthering concessions to various budget-dependent interest groups. The budget must be released of such expensive concessions in order to open the scope for tax cuts (particularly on labour) and the removal of various obstacles for businesses. It is of crucial importance for Greece to restore confidence and credibility of its government and its rule of law. Enforcement of contracts is another key area that needs to be strengthened in order to signal greater stability to both domestic 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 and create favourable incentives for businesses. 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. Restoring national pride can help, but the only solution Greece has are proper reforms, not empty populist promises like Berlusconi's. 

Wednesday, 11 February 2015

'Good hunches': Predictions on Greece

On a few previous occasions I've found myself praising 'good hunches' of certain economists on being right about a number of predictions for the future (see here and here for example). There's also been a few not so good hunches (like when Paul Krugman asked Alan Greenspan to create a housing bubble in 2002 to offset the IT bubble) and a few downright terrible ones (like when Paul Samuelson predicted that the Soviet Union GDP will surpass that of the US by 1984(!), but more realistically by 1997). 

Now it's time to blow my own horn. I've been covering the eurozone sovereign debt crisis and in particular the Greek situation since I started writing this blog. After all, the crisis was a sort of an inspiration.

I was rather content to see how precise I was back in October 2011 to describe the possible outlook for Greece in the next few years, after the policymakers have devised their first draft of the Greek bailout plan. Here is what I wrote back then: 
"First of all is the Greek ‘rescue’ plan. It’s hard to see how this plan can actually help Greece stabilize. Keeping the status quo is not going to make investors ready to invest into the Greece economy. Pushing more money into an insolvent country and keeping it on ‘life support’ will make its economy more and more vulnerable and dependent on foreign aid. The policymakers are turning Greece into a long term problem for Europe. This will have negative implications on all fronts – it will ruin confidence around Greece for a long time, disabling it to achieve any growth whatsoever, it will create massive social instability in the country, and it will give further rise to euro-scepticism around the continent. The country’s future seems to be a lock-down in debt, social turmoil and inability to create growth. Greece at this point doesn’t only need a debt restructuring, it needs a restructuring of its entire economy, starting from the labour market, public sector, industrial policy and so on. This is what the policymakers should have focused on, instead they choose to short-fix Greece until 2020. According to all of this, I fail to see how Greece will be able to grow at all until 2020." (28th October 2011)
 In April of the following year, when Greece made the infamous debt swap the situation was even worse:
"...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." (2nd April 2012)
And in the same month I proposed which reforms in particular Greece should focus on:
"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." (23rd April 2012)
Pleas such as this one, advocated by many economists at the time, went unnoticed unfortunately.

In January 2013, I discussed why I don't think the euro will perish, despite Greek woes:
"Even though some are still not convinced that Greece will stay much longer in the euro (Roubini has given them a deadline sometimes in the next 5 years - a much careful prediction this time), nor that the euro itself would survive. Some see austerity, some see lack of real reforms as an eventual end to the euro project. It's hard to argue against this, since austerity is done in a completely wrong fashion, without any emphasis on labour market rigidities (sacking public sector workers just won't do it) or the regulatory and bureaucratic burdens. However, investor sentiment is a delicate creature, and an event such as a euro failure may destroy all hopes for recovery for as much as a few decades. In an ageing continent, with a risingly unsustainable welfare state system, this could be a trigger for a great deal of social unrest and new (old) conflicts. Political stability of the Eurozone, a system that became irreversible, is crucial in sustaining it. This is why it will never perish no matter how faulty were its initial foundations." (27th January 2013)
So far so good (in terms of the predictions that is). However the Greek woes continue. In the next few days I'll have a comment on the recent developments. Stay tuned.