Greece Is a Test World Economists are Failing

The situation in Greece means one thing to the Greeks, and another to the world financial and economic community.  To the Greeks, the bailout they received by the IMF and the European community represents two things.

1. A humiliating receipt of “charity” by their neighbors.

2. A humiliating imposition of austerity by the international financial community that provided the bailout.

Let’s make clear that both of these things were brought on by the Greeks themselves.  They joined the Euro, giving up their own currency for the benefits being a part of the European Economic Community would bring.  After doing so, they continued to utilize their public sector in an economically inefficient manner.  The public sector subsidized non-economic performance by state owned industries, supported regulations which strangled innovative entrepreneurs and economic growth, failed to collect statutory tax revenues and ran substantial budget deficits.  When it became clear they could not pay their debt, the bailout was required.

Why the bailout was required is an interesting story.  It seems that non Greek banks have huge holdings of Greek government debt.  Failure of the Greek government to pay that debt, a sovereign default, would have severely damaged those banks and endangered the economic recovery of Europe.  Germany stepped into the leadership in small part to help Greece and in large part to help its own banks.

The deal with Greece was for the IMF and the Europeans to provide Greece with short term loans so that Greece could get its economic house in order.  Under this plan Greece would return to borrowing from private sources in 2012, pay back the short term loans and be on its way.  It has been clear to everyone, except those directly involved, that this will not happen.

The reason Greece cannot return to private markets in the near term is that the IMF and the Europeans imposed a strict contractionary austerity program on Greece.  This resulted in exactly what those programs always result in, a contracting economy.  Taxes go down, unemployment goes up and economic growth turns negative.  The economic condition of Greece has not improved and now decisions must be made with respect to bailout money and Greece’s inability to repay its debts as they come due next year and beyond.

There are several scenarios that can take place.

1. A “hard restructuring” takes place in which the Greek loans held by private institutions are written down from face value.  Since this would endanger European banks and possibly produce a second recession, which is what the bailout was designed to prevent in the first place, this option is not being heavily considered.

2. A “soft restructuring” takes place in which the maturities of the Greek loans are extended.  This would enable lenders to maintain the chimera that the loans will someday be paid, and they can be carried on the books at full value.

3. The IMF and/or Europe replaces loans held by private organizations with their money.  This means that the IMF and European nations become Greek creditors.  This option does not have much support among the taxpayers of the European nations that would provide the new funding.

The most likely outcome is number 2, as it gives the appearance of solving the problem without incurring any new money.  There is just one problem.  In return for implementing that solution European countries will demand even greater austerity and contractionary fiscal policy on the Greek economy.  In other words, in order to salvage Greece, Europe will implement policies to continue the decline of the nation.  This article in the Financial Times says it all

EU Looks at Greece

Greece needs to realize the power of the debtor.  Yes, contrary to most beliefs, a debtor does have power.  The debtor can threaten to not pay.  This power is low when the debts are low, but paradoxically, this power increases when the debt increases.  Greece’s debts are so large that if they wanted to, they can threaten to leave the Euro, default on Euro debts by replacing those debts with their own currency and there is nothing Europe can do about it.  See  How Greece Could Leave the Euro.

The economics and financial communities need to produce a realistic plan for Greece before the Greeks realize the power they have.  If they did decide to invoke their option of leaving the Euro, it would be like a financial bomb, and would rain great destruction down upon both the Greek and European economies.  This does not mean, that it could not happen, and the financial analysts and economic thinkers need to see that it does not happen.