Tuesday, July 12, 2011

Athens forgot a country isn't a company...

Athens forgot a country isn’t a company

Greece knocking on the doors of IMF and the EU for another 60 billion euros of assistance feels like déjà vu. About a year ago, these two institutions had jointly structured a bailout package of a whopping 110 billion euros for Athens. Bailout packages in the absence of structural adjustment treat only the symptoms and not the underlying disease. What Greece needs is serious restructuring that will necessarily involve major and tough lifestyle changes.
How did Greece come to such a pass? Available evidence has confirmed that Greece raised high levels of debt through fraudulent practices and misrepresentation of public data under the benign supervision, indeed connivance of the EU. It violated the EU Stability and Growth Pact’s budget deficit criterion (of no more than 3% of GDP) for the majority of the last decade, except in 2007-08. In order to cover its initial error of admitting Greece into the European Monetary Union (EMU), the EU has been compelled to humour Greece and often looked the other way when censure would have been the more appropriate response.
There are striking similarities between Greece and the few large and disgraced financial institutions that were the fountainhead of the recent economic meltdown. Many years ago, Nobel Prize winner Paul Krugman had warned us of the dangers of running a country like a company in his celebrated Harvard article “a country is not a company”. The Greek crisis brings this debate to the forefront again. Is Greece being run like one of those collapsed corporations and if so, what dangers does this present?
We now have enough evidence to implicate a few of the large US-based financial institutions in the global financial crisis of 2008. The modus operandi, while not exactly a Ponzi scheme, used a series of questionable methods of misrepresenting financial statements and inflating profits to justify higher bonuses and compensation for company executives. Not only were the auditors hand in glove, as is usually the case in financial scams, so was the ‘revered’ economic policy establishment. Charles Ferguson has taken enormous pain and flack to demonstrate the involvement of key US economic decision-makers in the scam in his popular and frightening documentary Inside Job.
Long before the financial crisis, Greece had similarly manipulated national statistics (public debt, budget deficit, etc) to secure entry to the coveted EU in 1981 and to the EMU in 2001. On both occasions, it was frugal with ‘truth in reporting’ and concealed the dangerous levels of debt it had accumulated. The EU could have, but chose not to dig deeper into the quality of Greece’s statistics. Greece is one of the poorest members of the EU, with services contributing the lion’s share of its GDP (close to 75%), especially tourism, which accounts for about 15% of GDP. Despite its lack of diversity and competitive advantage, Greece has prospered due to subsidisation from other EU members (EU aid equals about 3.3% of its annual GDP) to boost its standard of living, which is much higher than what its current GDP would suggest. Perhaps, a decline of 30-40% in standard of living will generate adequate resources to repay the outstanding debt.
That ‘moral hazard’ played a critical role in both episodes is now a given. Greece and the financial institutions were reasonably confident of escaping in case of a default. Predictably, after the crisis the too-big-to-fail institutions were either bought or bailed out. Greece took advantage of its association with the EU, which in consultation with the IMF doled out a structured bailout package to relieve the government’s debt burden within days of the crisis being declared. In both cases, the inherent security of being rescued by a giant institution at the time of a crisis encouraged gluttony.
It is, of course, easier to gamble with someone else’s money. Most of the troubled financial institutions participated actively during the financial boom years of 2003-07, piling up huge amounts of subprime mortgages including bad loans. Company executives prospered while the companies sank. Similarly Greece, with the powerful EU backing it, improved its credibility and attracted vast amounts of foreign institutional investment. The profligacy of the Greek government increased when the EU membership gave it the luxury to raise new debt without worrying about higher interest rates.
Engaging in short-term profit maximisation is arguably a strategic and legitimate goal for a company, but clearly not for a country. Although borrowed billions allowed some Greeks to live beyond their means, it ultimately compromised economic stability, an indisputable objective of nation states. In a closed system that an economy is, excesses in one component quickly show up elsewhere, corroborating Krugman’s thesis that one cannot run a country as you would a company.
If Greece defaults on sovereign debt, as seems imminent, it will trigger a deep crisis in the world economy. CM Reinhart and K Rogoff note in This Time Is Different that Greece has spent half of the past two centuries in default. As against the US where only 3% of sovereign debt is held by financial institutions, in Europe almost 30% is held by European banks (including European central banks), insurance companies and pension funds. Following the European Bank Capital Regulation, these institutions treated the Greek sovereign debt as riskless reserves to hedge against riskier high-yielding assets. Such concentration of sovereign assets has raised alarms that banks may be undercapitalised to bear the losses in case of default, and generate a need for government recapitalisation. The Greek crisis will not only have a direct impact on the European countries but an additional indirect impact on emerging economies that trade extensively with the Eurozone. This not only threatens the future of EU but also increases the possibility of relapse into a global recessionary phase.
Given its history, it is unlikely that a second bailout will be adequate to address the problems facing Greece, unless packaged with austere regulatory and implementation measures to reduce the fiscal deficit. Moreover, it may trigger a domino effect where other failing countries like Portugal, Ireland will also approach EU for financial aid and, in turn, set poor precedence for other nations in the longer run. Whatever the outcome of this crisis, an enduring lesson is that while moral hazard plagues both countries and companies, the implications are vastly different. A company’s profligacy could end with its demise, whereas fiscal irregularities of governments could have profound social and economic ramifications on its own current and future generations. The crisis in Greece, hence, needs a much more serious intervention than that for bankrupt institutions but, much more importantly, the economy needs to be run with a deeper understanding of a closed system.
The authors are researchers at ICRIER

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