Between Default and Reform: The Night and Day Options for the Greek Economy

The obvious alternative to the catastrophe that the government is contemplating is to implement real structural reforms. This would first require a deal with the creditors to keep Greece afloat.
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Greek Prime Minister Alexis Tsipras, left, is greeted by European Commission President Jean-Claude Juncker prior to a meeting at EU headquarters in Brussels on Wednesday, June 24, 2015. Eurozone finance ministers meet Wednesday to discuss the Greek bailout. (Julien Warnand/Pool Photo via AP)
Greek Prime Minister Alexis Tsipras, left, is greeted by European Commission President Jean-Claude Juncker prior to a meeting at EU headquarters in Brussels on Wednesday, June 24, 2015. Eurozone finance ministers meet Wednesday to discuss the Greek bailout. (Julien Warnand/Pool Photo via AP)

In these moments of extreme danger for Greece it is important to take stock and understand what the real issues are and what the alternatives might be. We arrived at this point following decades of bad governance during which the governing parties (particularly PASOK with New Democracy having a share of the blame) established themselves by distributing favors either in the form of appointments in the public sector or unfunded increases in pensions, or legislation that would protect vested interests, such as barriers to entry in certain professions and extreme regulations in the formal labor market. They accompanied this by a tacit acceptance of tax evasion. The end result was a massive decline in productivity relative to our trading partners (it stood at 70 percent of average EU productivity in 2009), and a huge increase in the budget and trade deficits funded mainly by unprecedented increases in internal and eventually in external debt (when Greece was accepted into the Euro). The unprecedented debt levels were caused by the clientelist policies and fed an artificial level of growth. The Greek economy was built around the state, which became the most important employer and on which an important part of the private sector depended on for contracts. While PASOK started the Greek economy on this road to perdition, New Democracy followed suit with massive amounts of appointments in the public sector and huge increases in the debt to GDP ratio, even while the latter was growing fast.

The result is that Greece has no tradable goods sector to speak of. In other words Greece cannot export much except for some agricultural products and, of course, tourism. Both are low value added and belong to sectors exposed to intense international competition. Witness to this is the fact that ¾ of the adjustment of the trade deficit (from 15 percent of GDP in 2009) was achieved by a reduction in imports despite the fact that Greek private wages fell at least 25 percent, which should make Greece much more competitive. However there is no serious export sector to respond to this decline in costs because overregulation of the Greek economy, corruption and bureaucracy prevents serious investment from taking place. The absence of a dynamic tradable sector is at the heart of the crisis and no amount of fiscal stimulus can correct this fundamental problem.

With these facts in mind let us return to the endless negotiations of the Greek government with the troika of creditors (ECB, EU and IMF). They have already cost huge harm because thy have destabilized the Greek economy, which has reentered recession and have introduced massive uncertainty, inhibiting investment. Nevertheless, this is where we are. The position of the Greek government, as far as one can discern a position at all, is that debt should be somehow restructured, but structural reforms opening up markets to competition and liberalizing the labor market should not take place. Moreover, they have refused reforms to the pension system (which is completely unsustainable) and to current levels of pensions despite the fact they are currently over 15 percent of GDP. Instead they have proposed increases in corporation tax from 26 percent to 29 percent (which will further depress output) and other dubious tax measures, such as taxing online gambling, while at the same time promising to rehire public sector workers and offering no reforms that could possibly stimulate growth. They have also suggested that if their demands are not met they will allow Greece to default and leave the Euro. Understanding the aims and position of the government has become all the more difficult because of the absence of hard figures and fully costed proposals. In the remainder of the article, I outline the economic consequences of the two real alternatives that are on the table: either default and exit from the Euro or market based reforms with some possible debt restructuring.

Suppose the Greek government carries through its threat to default. At that point, Greek bonds may not be considered valid collateral anymore and since they form an important part of the capitalization of Greek banks, the ECB may consider the Greek banks insolvent. In this case, the emergency liquidity assistance (ELA), on which the banking sector has been relying on to satisfy the demands for withdrawals, may have to cease. This would mean a collapse of the banking sector and would result in an immediate withdrawal of credit from the private sector and a default on the remaining deposits. Most trading activity would stop and the importation of even the most basic goods, such as food, medical supplies and fuel would be halted and would have to rely on foreign aid.

Since trading would stop, government revenues would disappear and no pensions or public sector salaries would be payable. Since borrowing will be impossible, the austerity of the past five years will be remembered with nostalgia as a period of plenty. At this point the government would have no option but to exit the Euro and print its own currency, which would trade at a much lower exchange rate than 347 drachmas to the Euro, as was the case in 2000. This massive devaluation would not lead to an export boom (as many commentators have suggested) because there is no export sector to speak of -- indeed despite the large decline in labor costs over the past 5 years exports are still not responding substantially, and the credit crunch resulting from the collapse of the banking system would not allow for any new investment. The result will be inflation, a huge reduction in purchasing power and a complete wiping out of individual savings.

The insistence of the Greek government on leaving pensions unchanged will sound laughable once the purchasing power of these pensions adjusts to this reality. In the longer run, growth will be sluggish both because we will have reintroduced massive currency and policy uncertainty and because in all likelihood the future governments will continue to refuse to implement structural reforms. Access to credit may eventually be restored after a few years (although the example of Argentina is not encouraging), but the lack policy credibility means it will be expensive. Moreover, the creditors are likely to continue to pursue Greece for at least partial repayment of the debt, which now will have mushroomed because of the devaluation (the Greek debt is denominated in Euros). But even if this does not happen and the creditors forget about their assets, the dysfunctionality of the Greek economy with its huge web of regulations will prevent serious investments. So Greece will continue to rely on the low value added informal economy. Greece will be trapped in a low growth state and its standards of living will continue to slip.

The obvious alternative to the catastrophe that the government is contemplating is to implement real structural reforms. This would first require a deal with the creditors to keep Greece afloat. Achieving the fiscal targets was not much of a problem in January, but because of the confrontation, which the government initiated with Greece's partners, revenues have collapsed and the economy has entered into recession. Nevertheless the creditors have already reduced their demands to a primary surplus to just 1 percent of GDP for this year. They may even be willing to move to a lower surplus if Greece implemented real reforms. So suspending disbelief for a moment and supposing that the Greek government wished to negotiate in good will, this is what it should do.

First, it should openly recognize that the source of the debt and the reason for the resulting huge recession was not the bailout agreement but the Greek economic governance and institutions (for which the current government cannot yet be held responsible -- although it seems to want to perpetuate them). Indeed, it's a fact that all the austerity we have seen up to now in Greece was required for balancing the budget from its 16 percent deficit in 2009 to a primary surplus so that Greece would not need to borrow even more -- it does not reflect repayments of capital or interest. All talk of illegal debt should stop because it only succeeds in undermining the credibility of the Greek government now and in the future.

Second, it should immediately implement structural reforms that would open up professions, remove protections from sectors, such as pharmacies, road haulage, mobility of lawyers and numerous others, opening them up to competition and removing restrictions from trading. Most importantly, all bureaucratic impediments to starting and running a business (some of the worst in the OECD) should be removed. Corruption should be stamped out and tax evasion should be credibly pursued across all income and professional groups. The labor market should be completely deregulated (beyond the basic rules ensuring health and safety and non‐ discrimination) and unions should no longer have a role in collective bargaining, other than at the workplace and then only if the majority of employees have voted for representation. Deregulation would ensure more formal businesses and a decline in the low growth informal sector, which is an impediment to growth.

Third, it should announce a radical overhaul of the tax code and of course reduce the corporation tax, making Greece an attractive place to invest. Part of the overhaul of the tax system should be the creation of a welfare program with a minimum income guarantee and tax incentives to work, subsidizing low pay and removing the need for a minimum wage. As we have shown in another paper this is possible to do now without extra expenditure, and would help people adjust to the new market conditions. Because of rampant tax evasion, this system will have to become contributory after a short phase-in period. However, a well-functioning social insurance system should be a priority to enable the transition to a genuine free market economy and would provide a well‐targeted stimulus.

Fourth, the overhaul of the public sector should continue with primary aim to reduce its size and improve accountability. Part of this reform, but also linked to increasing competitiveness directly, is the privatization of numerous public utilities, including the electricity company (DEH) and continuing the hugely successful privatization of the Piraeus Port Authority (OLP). With a view to the longer run, the education system needs systematic overhaul, introducing high quality education from the early years to University and introducing a system of accountability of all those working there. At the same time research and development should be allowed to flourish, both to support innovative industry and to support local policy‐making. Finally, the judiciary is completely dysfunctional with commercial cases taking on average five years to be resolved -- this needs radical change.

With this reform program in place, the government should then negotiate some debt restructuring, which could be based on lengthening debt maturity and fixing interest rates to the current low levels. Given a commitment to such reforms, the creditors would be happy to oblige, since Greece, instead of being the sick lady of Europe, would be one of its most dynamic economies. Such restructuring would be important in spurring growth so long as the increased funding was appropriately spent to support the reforms. With the resulting increase in growth, repaying the debt would be much less onerous, since repayments are fixed, while GDP will be growing.

Despite 35 years of mismanagement, Greece still has reserves of human capital. The post war success story, which was based on expansion of education and entrepreneurship, despite all its well‐known faults, left a country with a solid human infrastructure that, in part at least, persists today. Moreover, there are numerous entrepreneurial Greeks living abroad who are prepared to return and pursue successful businesses, both because they love their country and because Greece can offer amazing opportunities due to its location and its culture: part of western Europe but with a broader understanding of the Balkans and the Middle East. In other words, Greece can compete at the top tier in both financial and high-tech industries if only the current statist system would be dismantled.

This post originally appeared on HuffPost Greece and was translated into English.