Greece and Germany I: the issue is fiscal union

Published 6th February 2015

The Eurozone will not be stable until there is fiscal union. All German politicians know this. But Germans and others will not agree to fiscal union until they are confident that they will not be obliged to subsidise public spending in other Eurozone states. And like it or not Southern Europe, and Greece in particular, has a problem on this front. So I don’t buy the argument that German politicians think that it is in their interests to keep Greece in the Eurozone come what may. Greece’s exit from the Euro has to be seriously contemplated.

The plain fact is that Greece has failed to undertake the kind of reforms that are needed to improve its productivity — which on some measures has barely changed in almost 30 years and the new Government has shown no interest — at least not in public — in reforms to address this issue or in the broader issue of convincing Germans that Greece will be a reliable partner in a fiscal union.

Greece’s failure to improve productivity

Take a look at the facts: in 1981 when Greece joined the EU, its GDP per head relative to the US was about 50%. That was the same as Ireland’s. By 2002, its GDP per capita had fallen to 45% of US levels while Ireland’s had rocketed to over 82%.

Some of this reflects the fact that Greece’s overall dependency ratio was higher than Ireland’s: there were fewer workers as a proportion of the population in Greece than in Ireland but it should be noted Greek workers worked longer hours than Irish ones. The main explanation, however, is that labour productivity in Greece fell from 60% of US levels in 1981 to 53% by 2002 whereas in Ireland, it rose from 60% of US levels to over 90% by 2002.

Why did labour productivity in Greece fail to rise? Well, it wasn’t a shortage of capital. Capital inputs per worker in Greece were higher than in Ireland from 1981 to 2002. The real explanation for its poor labour productivity is that total factor productivity in Greece fell from 70% of US levels in 1981 to 60% in 2002 whereas in Ireland it rose sharply to reach US levels by 2002. Remember that total factor productivity is efficiency that comes from experience, know-how, education, technical skill, technology and innovation.

Even after 2011 when the credit boom in the periphery started, Greece underperformed Ireland.

There is broad agreement that total factor productivity increases as economies become more educated, flexible and more open. Greece is a very closed economy. Lots of research shows that it has (1) very low levels of competition, (2) very inflexible labour markets and (3) weak institutions. This shows up in OECD and EU studies and in many studies carried out in the Greek universities. These studies also reveal that Greece also has (4) high costs of setting up and shutting down businesses; (5) poor levels of infrastructure and particularly poor internet connectivity; (6) tolerance of tax avoidance; (7) poor capital and resource allocation decisions because of the influence that well-connected parties can bring to bear on banks and the public officials; (8) significant regulation with respect to, and high taxes on, employment and (10) poor standards in education.

… the future horizon is darkening

And this matters now more than ever because the Greek population is ageing fast, the number of people of working age is falling and pension and healthcare are rising. Unless there is a large and sustainable increase in its productivity, the country will struggle to maintain its living standards.

Take a look at the ageing profile of Greece and some other European states. We can see that while Germany is likely to have a serious problem, Greece (and Italy) are not far behind.

When you look at what these means for the age dependency ratio i.e. the burden on the working age population of maintaining the aged one can see how dramatic the issues are likely to be:

What these figures tell us, if things remain the same, is that long run trend rates of growth in Europe are going to be lower in the future than in the past because there are going to be fewer workers and fewer consumers.

But things are not all gloomy. Since Europe has much lower levels of productivity than the US, there is tremendous room for improvement. Europe will have to learn to produce more goods and services with fewer people. It is a challenge for everyone in Europe — and a bigger challenge for Europe than for the US, China or the emerging markets. Of course Greece is not at bad as Germany in terms of its demographic profile but Germany has taken steps to reform to deal with these issues in the past 30 years through big reforms in labour markets, deregulation, privatisation and taxation. Greece has done very little by comparison.

What kind of reform is needed?

The evidence suggests that competition in the economy and labour market flexibility are the two main routes through which countries can improve total factor productivity.

Competition in this context means simplifying regulations to allow people to set up and wind up new businesses quickly and easily, rules to prevent monopolies and oligopolies, rules that allow new firms, especially foreign firms, to enter the market quickly through start ups or by acquiring existing Greek businesses. Privatisation is important because state owned firms tend to be monopolies or have connections that allow them to gain an unfair advantage over their competitors by pulling political strings. In fact the real value of privatisations is often the impact on total factor productivity and not the proceeds from sale. Foreign firms have transformed total factor productivity in many industries globally, including manufacturing in China, technology in India, retail distribution in the Middle East, the car industry in the UK and the mobile phone industry in Brazil. There is every reason to think that this can happen in Greece as well.

The other key requirement is a flexible labour market. That means the laws that give businesses, especially small businesses, the right to hire and fire staff with ease so they can increase hiring in good times and reduce staff quickly in bad times. If business cannot reduce labour in bad times, they will hesitate to hire staff in good times. A flexible labour market also means openness to international workers. The evidence shows that this openness has been one of the main reasons why the asset management industry in the Middle East, the pharmaceutical industry in Switzerland and in almost all sectors in Singapore have become so successful. And a flexible labour market needs high quality education.

What about the demands for austerity from the Troika?

Let me start by clearing up a big misunderstanding here. Greece’s public sector deficit before the crisis was over 15% of GDP. If the Troika had not bailed Greece out, the market would have stopped financing this deficit and the Greek Government would have had to reduce spending and increase taxes to close this gap immediately. Under the Troika plan’s Greece’s deficit fell from 15% in 2009, to 10% in 2010 and 9% in 2011 and today the deficit is roughly in balance.

That is a slower pace of deficit reduction than would have been the case if the Troika had not intervened and it has meant — let’s face it — less austerity that would otherwise have been the case. So let’s not blame the Troika for Greece’s problems. That’s just wrong.

The Troika had expected that with reforms, Greek exports would have picked up sharply as they have in Ireland and Spain for example. That didn’t happen. Its hard to say whether this objective was realistic given the difficult conditions in most international markets but it is easy to say that the plan was never implemented — 13 out of 14 reforms required by the Troika were never implemented according to the IMF. In other words, the chances of an export-led recovery was doomed by policy failures.

Yes the plans now call for a primary surplus of 4.5% by 2020 and that is a bit crazy so a deal will have to be done to reduce that. There is no question that output is way below trend in Greece. But the Greek Government cannot borrow in the markets at any level of interest rates that would make any sense and that means that any deficit will have to be financed by official creditors. So its hard to see how stimulus can be introduced without a deal between Greece and the international partners. And when you consider the long term context discussed above, you can see that even a balanced budget today is likely to mean austerity tomorrow as demand for higher spending on the old rises.

What this means is that Greece’s best option for the future is export-led growth and as Greece cannot devalue its currency, cost competitiveness can only be restored through falling nominal wages, hard as that maybe. Note that what is needed for Greece is not true for the rest of Europe, where fiscal stimulus would indeed make sense and could even help Greece if it increased demand for its exports. But remember that even with fiscal stimulus in the rest of Europe, Greece will struggle if its exports are more expensive than Spain’s or Mexico’s. So this is not the time to be raising the minimum wage.

German citizens will not allow their leaders to agree to fiscal union unless they are satisfied that there is reform and that it is likely to be successful. If the new Greek Government commits to reform and prepares a plan that seeks to raise productivity to Irish levels within a decade then clearly the prospect of fiscal union between Germany and Greece will increase. But people in other Eurozone countries will need confidence that reform is being implemented. That means that if Greece is to remain in the Euro, it will have to accept some kind of international supervision of its reform programme. The amount of debt service or debt write off is a red herring — what is not, it appears, is the existence of some kind of conditionality between reform and Greece’s place in the Eurozone.

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