An unavoidable disaster – the lesson that no one seems willing to learn

Among aviators there is what they call V1. It is essentially the speed the aircraft builds up during the process of takeoff, above which there is not enough runway ahead to stop should a major malfunction occur.  

It is the point of no return; or at least not without grave consequences. Different in every aircraft and varying according to a multitude of parameters including the airstrip length, the payload, weather conditions etc. it is not as far out a notion of what should different economies be keeping track of, with regards to their own policies, to always have enough runway ahead in order to safely reconsider before it is just too late. 

In the case of Greece, V1 was persistently ignored throughout a number of years and when the brakes were finally hit it was way too late. Greece priced itself out of the public debt markets in 2010. Its sizable debt of 113 percent over GDP the previous year was one reason; the most important being its unwillingness to take any immediate measures to rectify the situation which had fueled longstanding structural deficits on both its budget and its current account. Its public debt had simply become unsustainable and thus non-fundable.

The country today is just barely registering its first positive growth quarter after more than 20 consecutive quarters of serious contraction, which in aggregate has reached 25 percent over its peak GDP in 2008. Unemployment has soared to 27 percent and among the youth surpassed 65 percent. For the last four years Greece has, and is still living its own Great Depression. Effective income tax has increased with the introduction of fewer tax brackets and higher rates which are more punitive to the middle and lower earning families and as incomes have been dropping so fast, property taxes have soared sevenfold to plug some holes in the public tax revenue side.

For a large part of the society, including by definition all of the unemployed, it is not anymore about being taxed according to their income but rather on what they own. Savings built over the previous years – and indeed often over a lifetime – are quickly depleted in an effort to keep an acceptable standard of living but most importantly to pay for non income related taxation. Wages in the public sector have been cut but with all of the unemployed coming from the private sector, the private payrolls have plummeted even more. Since 1911 to this day, public employees are constitutionally protected against lay-offs. The local banking sector is facing an unprecedented almost 50 percent non-performing loan to total loans ratio and even without the recently imposed capital adequacy Basel III rules new credit would look more scarce than a droplet of rain in the middle of Sahara.

But just how did Greece end up in such a mess? What was the core reason that such a privileged in many aspects country, allowed itself to be ridiculed by its European partners at the same time they were footing the largest restructuring bill ever in history? In search of yield and superior returns on equity, a large number of systemic European banks had already been exposed to the toxicity of the housing crisis in the U.S. On top of this, Greece had been funding a large portion of its debt through the international bond markets and a good portion of its issues was taken up by such European banks and their clients.

If Greece had uncontrollably defaulted the house of cards would have crumbled along with grave consequences stemming from what still to this date is feared to be a contagion link; one that would spread from the little republic in Europe’s periphery to the much larger economies of Spain and Italy, who were also viewed as weak and overleveraged at the time. Primarily in this context and less under the auspices of European solidarity, Greece was saved from an imminent meltdown which would have shut down its banking system within days and sent a European country member into a tailspin of chaos with food and energy shortages similar to those of the Eastern European countries under communism and the disarray they went through during the early years after the fall of the iron curtain.

Greece did not come to this point because of the euro but because of the mismanagement of the great opportunity that the common currency represented. The country had come face to face with grave challenges in its recent history. World War II was immediately followed by a four year civil conflict that proved to be even more destructive of its frail asset base than the war itself. It also reopened old rifts of political and ideological divisions that survive to this day.

The Marshall Plan gave the country a chance under the sun but it was the devaluation of the drachma in 1953 against the U.S. dollar which cut its value by half that marked the beginning of an almost 20 year long period of very high growth with very low inflation and low unemployment rates. Despite the sizable wake of the civil conflict Greeks managed to arrive on a “social contract”, accepted by both left and the right that provided the base for a peaceful focus on economic growth, away from political ferment that had torn the country apart. Necessity stemming from extreme poverty had worked its magic.

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The first evidence to a slowdown was seen in the mid-70s. The oil crisis and the Turkish-Cypriot conflict changed the risk profile of the region. Inflation started kicking in, primary deficits became the order of the day – mostly as a result of increased defense spending – and in the 80s unemployment started to register as a meaningful number. In 1981, the newly elected socialist government set its eyes on the thus far low sovereign leverage – it was just 25 percent over GDP. It is this point that things start going off track. Social transfers, wage increases in the public sector and ever increasing public expenditure, all were financed mainly through public debt. The corruptive power of power itself kept the socialists from credibly reversing fiscally unsound policies but most disappointingly infected the right as well.

Populism was well in the order of the day and regrettably is going on even stronger following the controlled default of Greece. In pursuit of political power, populism had a corrosive effect in all the political parties and worked much like Gresham’s law does for money. Policies and their adoption relied on the way they were perceived by the electorate in a context of a very short term perspective. The four year re-election period was often never reached because elections were called earlier, often dictated by the incumbent’s perception on when would the best time be to tactically call for a national vote. In the meantime the public sector was pampered as it provided a steady and easily manipulated part of the electorate, which would vote according to the highest bidder. Unions in the public sector mushroomed and with them their demands. Needless to underline that such demands were primarily centered on higher pay and maximizing public labor force.

Greece was flirting with V1 throughout the 90s and in addition to the wrong expansionary and consumer driven policies, the collapse of the iron curtain created a massive influx of low paid workforce, which substituted native hands in most of the labor-intensive low skilled positions. The euro was not around yet and sovereign borrowing was done on the back of a drachma economy. Borrowing was driven by domestic funds but also by international sources. The spreads were naturally kept higher and while hot money was increasing feeding domestic short term expansionary objectives spreads also reflected a real risk premium associated with Greece, which was higher than that of any other larger European economy.

With higher spreads, the market kept the domestic policy makers in some kind of check and in turn they were aware of the limitations of borrowed wealth. However, the increasing wages of public employees and the growing public sector, the shift of the younger generation to seeking public paid jobs and the ever increasing bureaucracy and taxation that made private enterprise and risk taking investments less and less attractive to the general population, kept suppressing the overall productivity levels of the economy.

Before an ever expanding government sector which had assumed its ill-conceived role as a shelter for a persisting cluster of unemployed in return of their only really valuable asset; their vote, national borrowing further expanded as the euro was adopted – only now all debt was denominated in a currency that neither the Central Bank nor the Treasury had any control over it. The markets mispriced the Greek sovereign risk for European risk and the premiums decreased to become similar to those of Germany and France. Native politicians saw this as a windfall not to pass unexploited. Further expansionary consumer driven policies were deployed in a competitive upward bidding for the vote and many more thousands were welcomed to join the great public force.

So, in all, the result was that public employment increased by fivefold since the early 70s while the everlasting inner-circle union pressures supported an average wage differential between the public and the private sector of 1.5 times in favor of the bureaucrats, not to mention other perks and the blanket protection against layoffs. No wonder such an offer attracted and finally devoured so much of the human capital!

Greece lost a unique opportunity to climb up the ladder on its own sustainable powers. The adoption of the common currency allowed for low cost funding. Regrettably instead of borrowing to invest it borrowed to consume. This simple but grave mistake was so huge that it has now thrown more than 27 percent of the workforce in complete desperation with the rest of it sleeping every night in fear that unemployment may ring the doorbell before the milkman does in the morning. Yet one would think that unemployment is a rightful punishment for the excesses of the past and the array of wrong policies followed for years before the door was finally shut flat in Greece’s face. Not the case.

The reality is that the vast majority of those unemployed do not come from the public sector but from the liquidity choked private enterprises, which anyway were never as competitive as one would have liked, but were definitely never the shelter of those who sold their vote for a place under the extended public umbrella.

Meanwhile, the public sector refuses to contract by means of lay-offs and cutbacks of unwanted personnel, leaving reform on public employment to natural attrition. Unwillingness by the government and extreme pushback from the interested parties have made the reform of the public sector a sought after objective only on paper insofar that it pacifies the sovereign creditors.

In reality what’s happening is an increasing pressure, by those who fueled the low productivity and even lower competitiveness of the Greek economy, on the unemployed of the private sector to chose emigration over a chance to find a job domestically. Should enough resources be freed by meaningful reduction of the largely unproductive and corrupt public sector bubble, taxes could be reduced and the private economy could kick start once again, but that would initially entail the gradual substitution of private unemployment with unemployed from the public sector.

And this is the hard choice that one needs to make. Wealth is not produced by the public sector. And it has been proven time and again that even if the public sector controls productive industries, the level of efficiency is way lower than if these were run by free enterprise. It is in the private sector that the decision maker ultimately coincides with the one who risks his own recourses and this is true even in large corporate structures. The disassociation between the decision maker and the responsibility of own capital risking can most clearly be found in the public side of the economy. Tax payers feed the public sector with equity flows which are leveraged by borrowed funds.

The decision on investment or outright expenditure rests with the government but the political parties behind the governments focus on re-electability, which in turn is based on short term tangible results for the majority of the electorate. While in most well governed places across the globe racketeering is punishable, overspending public money is not. Yielding to short term sirens of popularity, likability and re-electability over the longer term wellbeing of the community and securing its future as a going concern, is not considered a crime, and in the name of democracy advocates of this kind of freedom in the hands of any elected party recognize the election process as the only one that can rectify any such imbalances.

That may be true but it only kicks in once the real damage has been done and the cost of rectifying the economy is very high. Frequently, playing on the general ignorance of the average voter over fiscal matters and macroeconomic issues, the time of reckoning, when it comes – and it does – is blamed on external events and “supposedly” unforeseen changes in the international scene, allowing the same politicians who led the economy into the ground to even perhaps get a second chance in office. Very clearly this is what has happened in Greece. While the names have changed somewhat, the political pantheon is still inhabited by more or less known quantities who definitely know only one way in life.

Any hard choices still have to be enforced by the creditors instead of self imposing them before the clear and present danger of a complete meltdown. As Greece is reaching an inflection point the sentiment is improving; but what about the fundamentals? It is true that Greece has rectified its huge double deficits of the recent past – mostly with the excruciating taxation of its people and the across the board reduction of payrolls and social transfers, but have any structural reforms really taken place?

The answerer is that while legislation has been introduced to deal with certain problems of this nature that have been prevailing and burdening free enterprise for too long, the implementation is getting significant pushback from all those groups who have a misconceived interest to keep things the old way.

Preventing the disease is far better than curing it. Greece should never have allowed public debt to climb to these levels. Today it is still way over 170 percent over GDP despite the recent restructuring. V1 speed is different for every country. Greece found out that its V1 laid around the 110 percent debt over GDP mark.

Not more than 15 years ago Argentina woke up to the fact that with debt far less than that of Greece’s in both absolute and relative to its GDP numbers it had no other choice but to default, still to this day grappling with the consequences. But it is unfair to simplify things to only one indicator. Reality is far more complex and regrettably often elected officials’ view of the risks involved with unsound policies resembles a game of musical chairs. They just have to make sure not to be left standing when the music stops. Out of power before the day of reckoning is sometimes quite an effective hedge.

There is a point beyond which populism and expanding public expenses require more taxes and more debt than an economy can sustain; a story that regrettably can only end in blood and tears.

In public finances, loss of credibility is a gradual process of feeding expectations that one day credit may cease to be available to the country that misbehaves. The higher they build up, the higher the debt spreads become, until one day, like the marginal drop that makes the glass of water overflow, credit vanishes.

It is the moment of unavoidable default. The inflection point comes in an instant but the process that leads to this unstable balance and the ultimate reversal of fortunes is a long one. One that sometimes is so slow that it is very hard to detect and properly evaluate as it unfolds. It is a process through which (borrowed) wealth is also probably spread over wide clusters of society, which makes it almost impossible to fight against the immorality that hides behind the choice to burden future generations over today’s consumption.

Today, it is easy for someone to look back and see what the mistakes were in the case of Greece. The problem is that when the mistakes were taking place very few had the immediate incentive to act beforehand and the political process that favored expenses over investment, excessive social transfers and structural cumbrances over prudence and free markets, favoritism, vote fishing and cronyism over meritocracy and long term objectives, equality in opportunities over equality in rewards, led the country into the corner, way past its V1speed. The crash was the only option left on the table.

 

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