Greece's Deal with the Devil

The Greek crisis is a toxic mixture of politics and economics. The showcase euro zone project is in jeopardy from a looming sovereign default of one of its members.

 

Greece made a Faustian pact with the European Union that allowed its political elite to freeload the system, using EU transfer money and cheap credit for local political patronage instead of building a sound goods and services economy.

The euro destabilized the balance of payments. Local production waned and imports soared. Price inflation led to pressure for wage increases. Greece lost competitiveness. Public debt mushroomed to finance never-ending public sector deficits. For many years the EU blinked.

The EU elite, fearful of the Lehman precedent and protective of their scandalously undercapitalized banking system, have chosen a contradictory approach of debt bailouts to cover creditors by musical chairs and wage and price deflation austerity.

The Devil is now seeking his due. Greece is locked into an ever-growing debtor's prison with a shrinking GDP causing its tax base to implode. The rising mountain of debt is currently 150% of GDP, shortly to rise to 170% with the next bailout loan on the pyramid. Unemployment is skyrocketing; shops and businesses are closing. The government cracks the whip, cursing its own people every time unrealistic tax revenue projections fall short, creating ever more draconian penalties for tax evasion. This climate seeds an increasing flight of capital and lack of investor confidence.

EU policies are terrorizing periphery countries with deep recessions and mounting unemployment, creating disorderly default risk from rising social unrest. Northern European taxpayers are also growing restless and upset over ever-growing demands for bailout money from Brussels, as the periphery sinks under the growing debt overhang. They are concerned that these are stealth transfers with growing doubts that the periphery has the capacity ever to repay the money.

Nobody in the EU is happy. The more EU voters see Brussels asking for taxpayer money to bail out banks and socialize losses, the angrier they get. This causes growing discontent with the whole EU system. The EU elite seem smugly sure of themselves, appointed with secure positions rather than democratically elected. Politicians in member countries face a rising storm. Few have the courage to openly express their discontent for fear of ostracism from the Brussels elite for daring to question them.

So far the EU elite refuse to discuss successful restructuring techniques in past emerging market crises. The markets presently see 80% prospects of a Greek default. Their emotional outbursts against default or debt restructuring are directly related to their exposure to sovereign toxic debt and weak balance sheets. After their own meltdown in 2008, the U.S. authorities want to keep this mess under the rug as long as possible, basically turning over the IMF to them as a European bad bank.

As it stands presently, there are basically two trends of thought. The EU elite seem intent on the EU public sector picking up an ever-increasing share of Greek sovereign debt. In a few years’ time, there will be one sole public creditor with the private creditors paid off and Greece will have a very high debt to GDP ratio, likely in excess of 200%. There is no clear plan thereafter what to do about this mountain of debt. There is a vague hope that somehow Greece will grow its way out of the debt. Structural reforms have been discussed for the last 20 years in Greece, but the many stakeholders in the present system create substantial resistance to change. Locked into a hard euro and compulsory wage and price deflation, it is hard to see from where this growth will come.

The other school of thought comes mainly from American economists like Simon Johnson, Nouriel Roubini, and Paul Krugman, heavily influenced by the disorderly Argentine debt default and emerging market debt restructuring. They have support from German economists concerned about Greek debt sustainability and capacity to repay. They call for orderly and coercive debt restructuring as soon as possible to remove the default risk and provide relief from the huge debt overhang.  Such action may make the structural reforms more palatable, gaining the good will of the Greek public with burden sharing and allowing more gradual adjustment. Both structural reforms and debt renegotiation are necessary conditions to resolve the Greek debt crisis.

Unless the EU elite realize that they must meet periphery needs, the divergence between the core and periphery will grow so large that it may lead to a breakup of the currency zone. It may take generations to restore the credibility of EU institutions after such an aftermath. Moody's in the latest downgrade of Portugal cited poor EU crisis management as a major risk factor, angering many EU politicians. The truth frequently hurts.