We need to talk about Greece and other spendthrifts

Neoliberals and fiscal conservatives, look away now …

In response to my last blog posting a few people raised the following argument in relation to state spending: if you spend more than you consume, at some point you have to cut back and live within your means. After all, as an individual or company, if you don’t pay your debts at some point your creditors will take legal action against you and seize your property.

The same logic, according to these people, applies to states.

States, however, are different. When faced with economic problems, like having to repay excessive debt, states have choices available to them that individuals and companies don’t. A state’s choice is not binary (i.e. either cut or spend).

Typically, states have four policy choices:

Induce inflation by printing money;
Deflate the economy through austerity measures;
Devalue their currency; or
Default.

The classic example of inducing inflation to repay debt is that of the German Weimar Republic in the 1920s. In order to repay their war debts, which were denominated in Marks, the Weimar government decided to allow inflation to get out of control.

To try circumvent the “inflation solution” available to states, creditors typically now require that loan agreements be denominated in US Dollars. Debtor states can’t devalue the US Dollar. Only the Federal Reserve can do that.

Politicians have, of course, found one way to circumvent the problem of having their debts denominated in US Dollars. The solution is for a state to devalue its currency. This has the effect of making exports cheaper and imports more expensive. Technically speaking, this should make it easier for a state to repay its creditors as they build up excess foreign reserves.

The success of devaluation as solution to paying off state debt hinges on a few critical factors:

Is there a demand for a state’s exports? Many coffee producers ran into this problem in the 1980s when the price of coffee collapsed. Several African states devalued their currencies in response to the collapse in the coffee price (at the behest of the IMF). But the policy failed, as the success of this policy choice depends on a state being the only one to devalue its currency. If several other states are simultaneously devaluing their currencies, a state has little “comparative advantage”.

So that leaves the last two options – deflation (i.e. austerity) and default.

None of these four options are problem-free. Each, if not handled properly, can prove to be very messy (to put it nicely). The best option remains for states to proactively manage their finances.

So what options are available to Greece?

Because Greek monetary policy is handled by the European Central Bank (i.e. the ECB controls the printing presses and sets the interest rates) it can neither induce inflation, nor devalue its currency. That leaves two options open to Greece (and other Eurozone member states):

Default; or
Deflate the economy.

Clearly Greece’s creditors, the European Commission and the European Central Bank would never allow it to default. There may be some talk of allowing Greece to default, but the ramifications for German, British and French banks would be too horrendous to realistically contemplate. This leaves Greece with only one option: it has to cut its way out of the slump.

This is not to say that there weren’t structural problems in the Greek economy that could justify some cuts and readjustments. Two often-cited examples are the bloated Greek civil service and the lack of income tax recoveries. Interestingly, in terms of the Greek constitution, Greek shipping companies exempt from paying tax.

For me, an easy win (never discussed) would be to cut Greek military spending. Greece is one of the few EU countries that spends in excess of 2.5% of GDP on its military. Indeed, in 2012 alone, Greece spent over €5-billion on its military. In 2011 Greece spent over €6-billion on its military. That kind of spending in the middle of an economic crisis is foolish.

But who are the primary sources of Greek armaments? Germany and France. Why has no one suggested cutting Greek military spending? Well, why upset your creditors even more by threatening not only their banking but also their military industries?

So if you were looking for some “easy wins” to reform the Greek economy, there are some options right there. These “easy wins” could all be implemented (if sequenced correctly) with minimal impact on social spending (such as health and welfare spending).

So why not just continue cutting, cutting and cutting again? You know, live within your means?

As the example of Greece (the rest of the PIIGS, the UK and the SAP countries) has shown, simply cutting welfare spending, or any spending for that matter, without giving due consideration to getting the economy going again (and getting people back to work) is going to have consequences – including more welfare spending to try help people who are out of work because you, um, cut spending.

The problem is compounded when (as what is currently happening in the EU) the private sector and the state are both cutting spending at the same time. Where is growth supposed to come from if no one is prepared to spend? Governments deficits should, in a recession, allow corporate profits to keep growing. When the economy is back to growth, then the government can start cutting back its spending.

Unfortunately any solution of this nature is, for Greece, too little too late. So Germans now own a second property. It’s called Greece.