Kick The Greeks Out?

A small majority of German voters apparently now want to kick the Greeks out of the Euro. That won’t happen, of course, due to the enormous consequences of exposing the Greek economy and its new non-Euro currency to the fury of the world markets. Going solo right now would be a one way ticket to oblivion.

I have not yet commented at all about the big mess that has surfaced in Europe, but since it seems to get top billing in the financial media it’s worth taking a look at. In particular we need to compare the crises in various Euro countries with the very similar crises in various US states.

In many ways the problems faced by California, Florida, and New Jersey – to name the obvious suspects – are very similar to the crisis that is currently engulfing Greece, Portugal and Ireland. Notice I leave Spain off of this list, an omission I will explain in a moment. Each of these countries or states has run profligate and reckless budgets in the recent past, the consequences of which are now coming due. The easiest example to lampoon is Greece, where the government has run massive deficits, the tax system is so corrupt that revenues are never collected, and the nation is knee deep in over-paid and under-worked civil servants. There is nothing positive to say about the way in which the Greeks ran their economy over the last decade or so. They are due for a nasty and brutal adjustment.

In some ways the Greek problems are a classic example of what we call ‘the tragedy of the commons’. This is a circumstance where a group of individuals – such as a nation – make decisions that collectively impose a cost on society, of which they are a member. In many ways this is the diametric opposite to Adam Smith’s fabled ‘invisible hand’ where individual greed produces a collectively superior and beneficial result.

The example in Greece is non-payment of taxes. The Greeks, like the Italians, are culturally so averse to payment of taxes that it is normal for them to keep two sets of books: one for cash and one for all other payments. Naturally cash payments go unreported for tax purposes. The size of this cash, market is so large a piece of the entire economy that it significantly alters the tax rates necessary to levy on the taxable part in order to raise sufficient revenues to pay for the Greek equivalent of Social Security and so on. It gets worse: because tax rates are so high, many people evade paying them, which just makes the revenue shortfall worse.

None of this would matter were it not for the fact that the people who are avoiding and evading taxes still want to receive their state pensions. That plunges the state into debt. A fiscal crisis soon follows, and unemployment rises rapidly. In other words the culture of cheating simply boomerangs and damages those who cheat as well as those who don’t.

That’s a simple case of a ‘tregedy of the commons’.

The comparison between the Euro and the US states like California breaks down at a macro-economic level. The two situations provide valuable lessons in economics.

Let’s go back and look at Spain.

The Spanish economy was run in exemplary fashion. It had very conservative fiscal policies and tight management all around. The Spanish, however, are cursed with glorious weather, so in the real estate boom times of the last decade cash flooded into Spain from other European countries, in particular Germany. So far the analogy with Florida is fairly good, but the analogy with California and New Jersey has already broken down due to their profligate budgeting and fiddling of expenses. The Spanish experience gets unique after the bursting of the real estate bubble. Prices had been driven up by that flood of incoming cash, so after the bubble broke Spain found itself hopelessly uncompetitive. Its labor market was overpriced, and it was left as an outlier in terms of prices, and productivity.

The big divergence between the Euro and US state experience is now exposed: whereas the failed US states still benefitted from massive inflows of Federal cash in the form of Social Security, Medicare, and other program payments, Spain is self contained at the fiscal policy level. That means it receives no fiscal aid from some source outside itself, there are no ongoing payments to provide stimulus. Worse: Euro monetary policy is centralized. This means that Spain’s interest rate and currency exchange rates are outside its control. The combination of having no control over its currency and yet no sources of fiscal aid, reduces Spanish options to virtually nil. The entire burden of getting their local economy going falls on the Spanish budget. Consequently they have to institute extremely harsh measures to stop the rot. Spanish unemployment has shot up to near 20%, they are experiencing severe deflation, and there is no real prospect of a near term recovery. Had Spain not ben part of the Euro it could simply have devalued its currency and allowed a much softer adjustment to take place. Instead is is stuck in a rigidly and externally imposed currency regime.

Contrast that with Florida. There the process of adjustment is much easier: its local real estate and labor markets are linked more freely with the general US economy. Stimulus cash flows in easily and monetary policy is a non-issue. Florida, although it suffered a bigger bubble will adjust more quickly because other parts of the US are sending cash in via the Federal budget – Florida doesn’t have to slash its own budget as much as a result.

This is the big lesson to take away from the Euro crisis. The euro experiment was half baked. Monetary policy was unified, but each country kept its own fiscal policy. That has now been shown to be a foolish mistake. There are two solutions: ditch the Euro or unify national budgets into one Pan-Euro fiscal policy.

I have already mentioned that I don’t think the Euro will be ditched. The economic consequences for laggards like Greece, Portugal and Ireland would be devastating. The political consequences would be equally incalculable. So I expect the Euro area to fudge and muddle its way through the crisis. The cost will be massive in terms of slow economic growth and high unemployment, but both will probably be better than the alternative. Oddly though I see the long run being very different: eventually this crisis will provide impetus to tighter fiscal union. The Euro experiment has gone too far down the road to turn back, so logically it must plunge on forwards. I doubt there will be any greater union in the next few years, but such a union is now almost inevitable.

So it is very dangerous to compare the crisis in the Euro region with the crises unfolding at the state level here. Decrepit US states like California and Florida can survive because they they are not independent and are subsumed into Federal monetary and fiscal policies. They are bailed out through the backdoor rather than through the front door.

Poor Spain has to suffer despite having done everything correctly because it has no control over monetary and currency policies. That throws the burden onto its local fiscal policy which has to be draconian because it is the only lever available locally.

As for Greece: they deserve what they get. Fortunately they are so small in terms of the entire Euro economy that their failure should not prove too disruptive. I expect them to suffer through regular crises and wild swings from growth to collapse until they establish a more modern economic infrastructure to support the level of expenditure they seem to demand of their government.

You have to pay taxes if you want the government to give you a pension and health care.

Hmmm. What an interesting concept!