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Marshall Auerback: Greece – A Default is Better Than the Deal on Offer

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By Marshall Auerback, a portfolio strategist and hedge fund manager

Pick your poison. In the words of Greek Finance Minister Evangelos Venizelos, the choice facing Greece today in the wake of its deal with the so-called “Troika” (the ECB, IMF, and EU) is “to choose between difficult decisions and decisions even more difficult. We unfortunately have to choose between sacrifice and even greater sacrifices in incomparably more dearly.” Of course, Venizelos implied that failure to accept the latest offer by the Troika is the lesser of two sacrifices. And the markets appeared to agree, selling off on news that the deal struck between the two parties was coming unstuck after weeks of building up expectations of an imminent conclusion.

In our view, the market’s judgment is wrong: an outright default might ultimately prove the better tonic for both Greece and the euro zone.

The only questions that remain to be resolved are these: have all of the parties begun preparations to mitigate the ultimate impact of an outright default by Athens? And will the ECB be sufficiently aggressive in combating the inevitable speculative attacks on the other members of the euro zone periphery, which are almost certain to ensue, once Greece is “resolved” one way or the other.

Within the Troika, the Germans in particular have been the champions of taking the toughest line possible against the Greeks and other “Mediterranean profligates”. But however stubborn Berlin appears to be, the Merkel Administration is certainly not stupid. At this juncture, it seems more rational to view their ongoing promotion of fiscal austerity as a political smokescreen: In reality, what Germany likely wants to do in the case of Greece is trigger is an involuntary default so that the other PIIGS don’t get the wrong idea and ask for a similarly large haircut on their debts. They realize the consequences that might follow, as the others gear up for similar treatment. Far easier were Greece to move toward involuntary default, in the eyes of Berlin.

Politically, of course, the Merkel government can’t actually come out and advocate a Greek default or, indeed, outright expulsion from the euro zone. Far more politically astute to promote fiscal austerity on top of yet more fiscal austerity, (even though that is certainly not winning Mrs. Merkel any popularity points in Greece), until the Greeks themselves scream “Uncle!” and default outright.

It helps domestically as well. According to polls, Angela Merkel is now the most popular politician in Germany, which is why she persists with this pernicious narrative that the problems of Greece all stem from fiscal profligacy and laziness, in contrast to the responsible and hard-working German people.

Ultimately, though an involuntary default carries risks for the stability of the euro payments system, a deal, per the terms outlined in the press, is bad for Greece. And probably even worse for global markets, especially the bond markets.

Either eventuality creates problems but default is probably the less bad option longer term. Let me elaborate:

Greece is a hopelessly uncompetitive economy that probably shouldn’t be in the euro zone. But can you surgically detach Greece if it defaults, without some sort of impact on the entire euro payments system?

And what will the impact be on Greece itself? The country currently runs a primary budget deficit (excluding interest payments on debt) of around 5% of GDP. Were it to default, Athens would be forced to go cold turkey (“cold Greece”?) until the primary fiscal deficit (now around 5% of GDP) is balanced. Maybe the government could suspend all military expenditures as a first pass? At the very least, they can stop buying German military equipment!

No question, that under a default, a lot of public sector employees will be sacked, pensions will be at risk, and unemployment will almost certainly go higher. However, were the country to revert to the drachma, they would likely be left with a substantially weaker currency, which could ultimately provide the country with the wherewithal to compete in the global economy. With a super-cheap exchange rate, Greece would be a Mecca for retirement homes, research hospitals, trans-European liberal arts colleges, and maybe low-overhead software startups. Plus, a permanent home for the Olympics. It could live happily ever after, as Florida does, on the pension income of the elderly and the beer money of the young.

This would be the source of the foreign transfers that the private banking sector won’t make anymore. In Greece’s case that credit went to the public sector and a lot of it built useful infrastructure, so it’s not a waste, but the first step is surely to cancel the debts and stop the illusion that they can be paid. And it would end the “death by 1000 cuts” currently being imposed on the Troika, which will serve no useful economic, political or social purpose.

Of course, there will be a slew of defaults and an endless series of court cases, litigation, etc., much as there was when Argentina defaulted in 2001. But it would force the issue of debt restructuring on the table in a meaningful way and at least provide Greece with light at the end of the tunnel.

To ensure some sort of viability of the drachma, the Greek government would have to find a more credible means of ensuring tax compliance. Most Greeks with money have presumably already moved it beyond the reach of the Greek banking system, so that savings would not be wiped out. As the tide of repossessions begins, many of these oligarchs would likely start to buy back the Greek assets on the cheap, as it is doubtful that the euro banks will want anything to with them.

Beyond that, it would be important for Athens to establish a new tax system that minimises tax evasion, so as to create demand for the new drachma immediately, and mitigate the formation of an extensive parallel transactions currency. After all, it is possible that many Greeks might prefer to use the existing stock of euros in the country and there is very little the EU authorities could do to stop this (much as the US government could not prevent Panama from dollarising its economy). But in order to establish a long-lasting demand for drachmas, two things would have to happen:

1. The Greek government would announce that it will begin taxing exclusively in the new currency.

2. The Greek government would announce that it will make all payments in the new currency.

Given the country’s history of tax evasion on income tax, a national real estate tax would likely work better than a new income tax.
(See here for more details)

On the other hand, the challenge for the European Union authorities is to ensure that speculative capital is not unleashed on the next weakest link in the chain – say, Portugal – to ensure that there is an adequate firewall established and to minimise disruptions to the entire euro payments system. It’s unclear to me whether the euro zone authorities have truly thought this aspect through and considered the best means to prevent a major disruption of the EMU payments system. Then again, perhaps this is what the ECB’s new programs are really all about.

On the other hand, I happen to think a rescue of the sort that is now being publicly mooted is worse for both sides. The imposition of yet more fiscal austerity on Greece will exacerbate the debt deflation dynamics which are destroying the country and will provide Greece with ZERO means of servicing even the reduced levels of debt. The country will still remain uncompetitive and depression like conditions will continue, with the ongoing burden of more euro denominated debt servicing.

More dangerous is the risk that comes if there is a “successful” deal: It come with the pending question- ‘if Greece doesn’t have to pay, why do I’- The Irish are asking that question already, and I’m sure the Portuguese and Spanish will soon be asking the same thing. As my friend Warren Mosler has noted:

Possible immediate consequences of that discussion include a sharp spike in gold, silver, and other commodities in a flight from currency, falling equity and debt valuations, a banking crisis, and a tightening of ‘financial conditions’ in general from portfolio shifting, even as it’s fundamentally highly deflationary. And while it probably won’t last all that long, it will be long enough to seriously shake things up.

Longer term, a Greek default could well provoke the question, “What on earth do governments issue bonds for anyway?” That might well provoke a far more provocative debate on the nature of modern money and the self-imposed legal constraints with which sovereign governments bind themselves in their conduct of fiscal policy. But that’s probably best left to the pages of another blog post!

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65 comments

  1. Francois T

    As long as Greece refuses to tackle their scandalous tax collection problem, there is no hope. One cannot build a solid society on chronic mistrust and sleaze.

    1. YankeeFrank

      Marshall raised this topic in his post — suggesting a real estate tax to replace the income tax as it is easier to identify real estate holdings than income. Sounds good to me. Also, that bond question at the end was quite good. Let’s have that post okay Marshall?

      1. psychohistorian

        It will get very real to define exactly what government services Greece wants and what it is willing to do to get money to pay for those things.

        Maybe Greece just needs to hire a better tax collection organization, write tighter tax laws or both. If adherence at the top to rule of law is on the same trajectory as here in the US then join the new international brotherhood of subjects.

      2. Very Serious Sam

        “as it is easier to identify real estate holdings than income”

        Normally yes, but not in Greece. The public sector in Greece is as dysfunct as it is oversized: there is as of today still no reliable land-registry system. One wonders hat the huge system of ‘public servants’ there did during the past decades.

        1. JTFaraday

          They did what “public servants” everywhere do. They facilitated what their “social betters” wanted them to facilitate. Should their “social betters” decide they want something else, the public servants will then facilitate something else.

    2. C

      That have begun already. That is why a part of the last deal was a new property tax that is collected not by the Greek tax authorities but by the power company via their meter-readers. The goal was to sidestep the corruption within the tax authority and its existing rules against checking homes with an agency that already does.

      Its the kind of baby step that shouldn’t be necessary but a baby step nonetheless.

    3. ECON

      The Greeks have “a tax collection problem” while USA has a “tax revenue problem” in need of a Value Added Tax.

  2. someone

    The idea of a flourishing Greece after default is ridiculous. It won’t be able to pay for oil medicine and other essential stuff, so there will be riots as well. Great stage for a pensioners paradise. lol. The Balkans will become very uneasy in the next years and the Arab spring will get copied.
    L’insurrection qui vient…

    1. j.grmwd

      Croatians saw GDP grow from $2000 p.c. to $16,000 between 1992 and 2008. No balance of payments crisis. No fuel shortages. No shortages of critical medicines. Even though their trade deficit is bigger as a percentage of GDP. Tourism does most of the work of balancing the trade deficit. So why is Greece doomed and a country like Croatia apparently not ? There’ll be a tough couple of years and probably temporary shortages but with decent pro-growth policies Greece will bounce back.

      1. someone

        As long the credit folws the stuff will follow, but don’t delude yourself Croatia is on the same road as Greece with the single difference that they entered the game later and with almost no debt in the beginning. It has also a twin deficit and an indebted population, ask any austrian bank. They all dreamt a lot of k.u.k. in the last decade, you know?

      2. j.grmwd

        I agree that many Eastern European countries have significant quantities of euro-dominated private debt. A very bad idea. But private debts do not have to be taken on to the public balance sheet.

        1. someone

          Yes. But it is quite a bad situation, if a third of your taxpayer’s and/or business base can go bankrupt. And in addition, I have problems with the comparison between the bankruptcies of Russia/Argentine/Indonesia and Greece. All the former are resource-rich countries and all of them enjoyed the apreciation of raw material prices in the last decade.
          And not everything is alright there:
          http://en.wikipedia.org/wiki/Piquetero

          Bancrupt countries tend to clientelism.

          States can fail… like Yougoslavia.

          Although I am also quite annoyed by humiliation of the Mediterranean people, but it was the English speaking world which established abbreviations like pigs. UK is no better shape.

        2. j.grmwd

          And with a sovereign currency those governments can, if they have the political will, mitigate the effects by ensuring that the fallout doesn’t destroy the real productive economy too.

        3. j.grmwd

          If you don’t like the example of Argentina et al., how about Iceland ? It recently returned to growth. No mountain of exportable natural resources there. No global boom to help.

          1. someone

            How about Mexico? What if your primary products of exports are not wanted drugs and people. Then you have lost. I am a quite left wing german, if you’re anglo you would call me communist,I expect bankrupticy of Greece , but i see no point of leaving the euro, even they socialise some production. There is no sdvantage.

  3. Economic Maverick

    Great post Marshall.

    One of my thoughts today from listening to Soros on Fareed Zakaria’s CNN GPS saying that “The peripheries are in a similar position to developing countries in the 80s/90s because their foreign debt is not denominated in a domestic currency”, I was thinking that in some ways, it seems like the EU Peripheries are perhaps in WORSE state because they have not domestic currency to speak of. Atleast when Argentina defaulted in 2001, people could still keep using their pesos, but the Greeks OTOH are acutally using Euros, so moving to the Drachma would involve to 2 steps that you, Mosler, and other MMTers point out (start taxing and spending in Drachmas), which is an extra step that Argentina perhaps didn’t have to do in 2001 (though I’m not sure if there was an extensive parallel economy in dollars?) . Most importantly, the population is ecologically tied to the Euro, so introducing Drachmas may be (or perceived to be) difficult. Thoughts on this?

  4. bmeisen

    Cheap shot that one about German military equipment. Greece should suspend all defense related buying and Merkel is not IMHO going to the floor about minor amounts.

    I can’t explain the continued buying – OK contractual commitments or maybe a secret report that the Turks will attack at the blink of an eye. I don’t see it happening – what would the Turks gain? A sultanic erection and then decades of mega-trouble. Anyway, didn’t Erdogan recently force almost the entire Turkish general staff to resign, because he feared a putsch? Greece must stop arms purchases.

    1. Very Serious Sam

      “Cheap shot that one about German military equipment”

      There is no piece by Auerback in which he does not let his hatred against Germany and the Germans take over control of his keyboard.

      1. Marshall Auerback

        Very Serious Sam,

        To be clear, I do not have a “hatred” of Germany. I do have an intense dislike of what their government is doing and I also think they deserve to be called out on their hypocrisy. I’m sorry if that offends you. See my response to bmeisen, which I think explicitly addresses the point on German military equipment. That’s from a GERMAN paper. On the broader point, those who accept the pervasive German narrative that they are being punished for being “fiscally responsible” and hard-working, as well as accepting that the Greeks are lazy and incorrigibly corrupt. I don’t go around with the canard, “You obviously hate the Greeks,” but instead try to address the substance of the argument, which the defenders of Germany never seem prepared to do. The gist is this: Germany chastises its neighbors for
        their “profligacy” but relies on their “living beyond their
        means” to produce a trade surplus that allows its government
        to run smaller budget deficits. Europe runs an approximately
        balanced current account with the rest of the world. Hence,
        within Euroland it is a zero-sum game: one nation’s current
        account surplus is offset by a deficit run by a neighbor. And given triple constraints—an inability to devalue the euro, a global downturn, and a powerful neighbor committed to running its own trade surpluses—how does a nation like Greece move to fiscal balance? Why don’t you try to answer that question rather than resort to red herrings that I am “anti-German” for pointing out a basic accounting identity? That’s the oldest rhetorical trick in the book, and you seem more interested in taking cheap shots than addressing the substantive issues.

        1. someone

          Ever thought of the current account balance of Europe with the rest of the world without Germany, Netherlands and Belgium? It would be quite disturbing, almost as disturbing as the UK’s despite the avoidance of the Eurotrap of the insidious Germans.

          1. Leverage

            Not so bad, again, most of the problem is oil-dependency, and trade within european nations is quite balanced (some periphery nations have surplus with the core).

            The trade chain imbalance goes like this:

            Core -> EEM/Oil producers-> Credit-to-Periphery (=Chronic deficits) to buy Core/EEM/Oil-producers imports -> Periphery exports necessary lower value-added production goods to Core.

            The model is unsustainable obviously, and as always is created by extended credit by merchantilistic nations to sustain the status-quo.

            Take in mind that the welfare of nations like Arabia Saudi depends on high oil prices and demand, and the welfare of nations like China depends on the consumer demand from developed nations. Both are built on the consumption-industry model of oil-based economy with high prices (but not too high or economic contraction happens, optimal price around 80-90 USD/barrel) & demand (but that can’t be sustained in the long term because credit can’t be allowed indefinitely). This is a very delicate equilibria that no longer works.

    2. Marshall Auerback

      bmeisen,

      Not a cheap shot at all:

      http://www.zerohedge.com/news/greece-spends-bailout-cash-european-military-purchases

      http://www.spiegel.de/fotostrecke/fotostrecke-61566-3.html

      These state-of-the-art U-boats in the picture are equipped with fuel cell technology : Despite the financial crisis, the Greeks have ordered a total of six boats of the Class 214 from the German company HDW, which is owned by ThyssenKrupp Marine Systems, according to Der Spiegel.

      1. bmeisen

        Thanks for the link – the Zeit article that is the basis for zerohedge report is also very helpful. Several billion could flow back to German weapons makers.

  5. Middle Seaman

    The Greek tax collection problem cannot be fixed by a better collector. This problem afflicts too many countries, mostly underdeveloped, and in particular countries in the eastern Mediterranean. The US suffers from the same problem with a twist. We decided to exempt the rich from most income tax; we legalized theft of taxes.

    Marshall, as usual, is clear, to the point, bright and probably correct. (I am not a financial expert.) Morally, what the German and the French are trying to do to the Greek population is a total and complete outrage. When the Germany was bankrupt after 1945, the Marshall Plan and a lot of hand holding helped the country recover.

    You don’t have to kill tens of millions of people to be treated without abuse.

  6. mmckinl

    “”Longer term, a Greek default could well provoke the question, “What on earth do governments issue bonds for anyway?” “”

    Bingo !!!

  7. Bill G

    Its all kabuki – the Greeks will never really do anything austere but it looks so scary, Merkel et al can get away with funneling more dough to the banks. It might get more interesting once she has been re-elected though. I wouldn’t take any of this seriously except for the cruel game that’s being played on the Greek peasants er people. For that cruelty there is probably a very warm place in Hell for the German and European leadership.

  8. foosion

    Greece can default now and get the benefit of wiping out a fair amount of foreign debt or it can default later and default on much less foreign debt.

    It has no reasonable means of cutting its deficit while its on the Euro. Austerity will cut GDP at least as much as it cuts debt, continuing its downward spiral. The standard cure is to devalue its currency, which it can’t do while on the Euro.

    Other Euro countries were running primary surpluses (fiscal surpluses not counting interest on debt), so there’s hope for them. Greece is uniquely bad.

  9. Pat

    A transition back to the drachma would be much more painful and difficult than Auerbach and Ed Harrison suggest, which is no doubt the main reason why Greeks, including Varoufakis, see this as the least palatable option.
    The Greeks would not just need to tax in drachma, they would have to impose capital controls, completely support the drachma with hard currency (which they don’t have), and impose wage and price controls to deal with inflation. Plus somehow deal with the “black market” economy in Euros.
    After drachmatization, the Greek government would have to prevent capital flight by prohibiting foreign accounts by Greeks, limit transfers out to, say, 10000 Euros per year, stop offshore transfers of Greek goods, impose wage and price controls to keep inflation under, say 5% a year, prop up the new drachma with very large amounts of hard currency (i.e. Euros), and establish a new bureaucracy to limit the new black market in foreign money. Plus guarantee bank deposits and recapitalize Greek banks to prevent bank runs and bank bankruptcies.
    Given the present dysfunctional government system, how are they supposed to do all this? They would need a small army of civil servants to check all the businesses for use of undeclared Euros and to search the border crossings. They would somehow need to force all Greek exporters to sell their goods in Euros and then convert their sales proceeds into Euros, in order to provide the Greek government Euros required to support the new currency.
    And all this is made even more difficult by what appears to be a slow-motion process of Greek exit from the Eurozone (something like two years), which would allow Greeks to send every last Euro out of the country. A conversion can only really work if it is done suddenly and unexpectedly.
    I’m not saying that the Greeks won’t ultimately adopt this plan, but they will do so only as a last resort.

    1. j.grmwd

      Why on Earth would the Greek government need Euros to support the drachma ? The only reason they would need Euros is if they were attempting to peg the drachma to the Euro. Which needless to say they should not attempt to do.

      1. Pat

        The Greek government absolutely must support the currency, otherwise there will be a total collapse of the drachma and internal hyperinflation. If there was no support and the drachma floated freely, the currency would decline precipitously, say 50%, and the cost of living for Greeks would go way up.
        All those bondholders who hold debt in drachmas will want to cash out immediately for Euros or dollars. Who will supply the Euros and dollars?
        The only solution is to peg the drachma at a high rate, and institute currency controls, thus trapping the bondholders’ money inside Greece.

      2. j.grmwd

        A one time currency devaluation is not total collapse and hyper-inflation. Argentina, Russia, Mexico, and Indonesia for example all saw currency devaluations of more than 50% during the first year of their respective financial crises. None showed any further devaluation after three years. I think the currency is going to find it’s natural level whatever you do, although capital controls can probably ease the shock by slowing down the flows.

    1. craazyman

      You can pick your friends and you can pick your nose, but you can’t pick your friends nose.

      That’s a law of society.

      It seems, however, that somebody is trying to pick Greece’s nose, other than the Greeks.

      What if this was your nose and somebody’s finger in it? That would require a lot of self-restraint, I think, to endure being picked. I guess if they were a doctor you could tolerate it, but there’s not much evidence right now that a doctor is in the house.

  10. Linus Huber

    From an earlier discussion:

    Quote

    I am no economist but often when I mention that we have too much debt in the system, some well educated guy will reply that I have no clue as debt equals savings.

    It is exactly the point that seems to be missed that debt MUST remain serviceable and be repayable within a reasonable period of time. Default is not part of their thinking and the creative destruction as tought by Schumpeter is not acceptable anymore. This led to the present statism that tries to maintain the status quo with all means available which in itself is an unsustainable proposition.

    Anyway that is the way I see it. Comments are welcome.

    Marshall Auerback says:
    September 21, 2011 at 3:49 am
    Linus,

    You are over simplifying. The idea is that PUBLIC debt equals private savings. You are conflating two distinct concepts when you group private and public debt together. That’s where you make a crucial mistake. For households and businesses, paying back debt means they have to sacrifice current consumption (spending), as you rightly note. For the government, no such financial constraint is imposed operationally (although there are clearly LEGAL constraints, as the recent debt ceiling fiasco demonstrated). But operationally speaking, the government’s ability to spend now is independent of how much debt it holds and what it spent yesterday.

    Unquote

    Coming back to today’s situation, would you, Mr. Auerbach, still consider that the total level of debt within a country (government, business, banks, private) has in itself no meaning but that government’s debt is not a real problem? I mean this in the context that total debt levels in most western countries nowadays exceed 350% of gdp and that a default by a government may have various forms including the intentional debasement of a currency which in my eyes is simply another form of default.

    1. Marshall Auerback

      Linus,

      I never said public debt didn’t matter, because too much government spending can obviously lead to real resource constraints and can be inflationary. But, yes, when a country issues debt in its own free floating non-convertible currency, then there is never a solvency issue. I stick with that statement. Now what I’d like you to consider is this:
      If households attempt to net save by spending less than they are earning, and businesses attempt to net save (reinvesting less than their retained earnings), then nominal incomes and real output will be likely to fall. Money incomes and economic activity will tend to contract until private savings preferences are reduced (with essential goods and services taking up a larger share of household income as incomes fall), or until depreciation leaves businesses and households inclined to invest once again in durable assets. Common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and widespread insolvencies – that is, unless creditors are generously willing to renegotiate existing debt contracts en masse, OR THE GOVERNMENT BEGINS TO OFFSET THE IMPACT OF THAT PRIVATE DELEVERAGING VIA GREATER FISCAL EXPANSION. For the current post bubble period, reeling fiscal deficit spending back in before the business sector is headed back toward its more “natural” deficit spending position, could prove disruptive.

      1. Linus Huber

        I think I do understand what you are saying Mr. Auerbach BUT, have we not done that all the time since many years and as a consequence increased the government’s debt continuously and do you really believe that we can continue with the idea of fiscal measures for ever with the obvious result of higher and higher government debt OR are you willing to accept the possibility that at one point it might be impossible to increase government debt further due to reasons that the population might lose confidence in the prospects of the future which may alter the mindset and produce some kind of political backlash? Please do not use Japan as an example how far we might be able to go with increasing government debt as those increases mainly happened while the world’s economy was still expanding at reasonable rates while we, in my opinion, presently have a slightly different environment.

        1. Alex R.

          What we’ve done is to reduce taxes on the wealthy, even in time of war, (Iraq, Afghanistan) while continually borrowing to pay for government programs which previousy had been paid for by taxes. We’ve done this while reducing regulation (and enforcement of those regulations which remain) upon the finance sector. This has resulted in a giant debt and a giant economic cataclysm.

        2. Marshall Auerback

          Linus,

          You might “believe” this to be different, but you don’t support this belief with an argument, merely an assertion. In many instances, public debt levels are more a symptom of the problem anything else reflecting poor economic activity (and therefore lower tax revenues, higher social welfare expenditures and correspondingly larger public deficits). A sovereign national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a budget surplus will be possible.

          But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the budget outcome towards increasing deficits.

          Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The budget will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.

          So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment – which I define as 2 per cent unemployment and zero underemployment.

          Fiscal sustainability cannot be defined independently of full employment. Of course, a government can proactively fill a private sector spending gap to generate growth (and reduce deficits) or it can continue to frustrate the private sector attempts to net save (as is the case in the EU today), which gives you yet higher deficits. Each time the government tried to push its budget into surplus, a major recession followed which forced the budget via the automatic stabilisers back into deficit.

          These deficits have provided support for private domestic saving over most of this period. That is what is happening to some degree in the US today, which is why that economy is performing better than most of the EU (yes, because of those “horribly irresponsible” fiscal deficits)!

          There are only 3 broad sectors in the economy: (a) the private domestic sector; (b) the external sector; and (c) the government sector.

          Each of those sectors contributes one way or another to aggregate demand. Domestic economic activity (real GDP) is determined by aggregate demand. Further while historical appreciation is very important, it is also crucial to understanding scale. It is never sensible to react to statements like “record levels of debt” or “massive budget deficits” or “unprecendented levels of spending”. If levels mattered then how would you compare the US deficits (trillions) to Australia (billions)?

          You always have to judge these things in terms of scale and what the movements in the other significant and interlinked aggregates are.

          If spending from the private domestic sector and the external sector is insufficient to generate enough output consistent with full employment then there is only one other source of aggregate spending possible in any economy, no matter how open it is to the external sector.

          All the supply chain developments, all the changes in labour mobility, all the changes in patterns of world production, all the new product innovations, do not alter these basic macroeconomic facts

          1. Ralf T

            Hi Marshall,

            interesting points you make and I very much doubt that anyone who has read at least a bit into the matter would seriously disagree with you that government expenditure can and should attempt to counteract sudden shocks.
            The interesting question though seems to be what is the timeframe you have in mind for such an adjustment to occur?

            To give you an example: when the telegrapgh was invented, for how long should the government still have provided demand for the pony-express, when email was invented how long should surplus delivery structures have been supported? When the spinning jenny came along, how long should the government have commited to still purchasing hand woven goods? (…)
            I do agree with your point that “All the supply chain developments, all the changes in labour mobility, all the changes in patterns of world production, all the new product innovations, do not alter these basic macroeconomic facts” ; the sectors ultimately balance, the question only seems to be if that will be on a level constistent with living standards comparable to Switzerland or Bangladesh.
            So my question is: what´s your time frame for the necessity of adjustment measures by the government? 5 years? 10 years? half a generation? a generation?
            Or do you believe, that the US/UK/… would be better off if it had chosen to keep up demand for manually woven cloth to ensure full employment to the present day?

          2. Linus Huber

            Mr. Auerbach, thank you for the time you take to explain me these aspects of economic theory.

            It is not easy for me to put my words into logic counter arguments, still I do try.

            1. The described economical relationship may be correct; however have we not probably reached the present situation exactly due to this repeated interference by the government into the free functioning of economic activity over the past 30 years or so?

            2. With all means available, the present crew in charge is trying to avoid the write-offs required as a result of mal-investments in the past. We are rather working with fiction (asset values as per model instead of market) in order to avoid the creative destruction as proposed by Schumpeter. Yes, the people in charge are trying to gain time for letting the banks heal, but this sucks out enormous value from the economy.

            3. You seem to consider money as a means to manipulate the economy and do not think for it to have the function of store of value at all. The diminishing value of the currency however, in my opinion, should be considered theft and those responsible for this should rot in jail. The result of these manipulations are the increase in speculation as safe investments do have a negative return. It certainly creates enormous uncertainty. As it affects property rights in some way (transferring money from savers to debtors and from the 99% to the 1%) it represents a violation of the spirit of the rule of law which is an essential part of the capitalistic system and the western countries success in the past.

            4. I do define debt levels specifically in relation to gdp when I mention overall debt levels in most western countries to be mostly in excess of 350% of gdp. Has past positive economic performance not been arrived at due to the build up of exactly these increased levels of debt?

            In short, I strongly do feel, that the present policies compare to trying to heal an alcoholic with a bottle of Jack Daniels; sure he will feel better for a while but is that a real cure?

            The reason I mentioned to not compare Japan is based on the fact that while Japan was building up its enormous government debt levels, we were generally still in a period when the credit bubble did build up whereas we, in my opinion, now are in a period when the bubble had burst and therefore deflationary forces are in play.

            I hope that my arguments make some sense.

          3. Linus Huber

            By the way, I definitely do agree with you that the default of Greece is better than the present actions, as these actions are simply delaying the eminent result. It would have been even better if economists would have done a proper job a long time ago and recognised that these debt levels are simply unsustainable and a default like 2 years ago would have been considerably easier to handle. With each delay the problem is going to increase. But as it seems, the only real resolution will have to be forced upon the holders of power by democratic/political means in the form that the electorate will finally reach the conclusion that it is better to have an end with horror than horror without end.

            One important aspect to the whole mess is the way how the media was able to change the focus from the actual culprits (namely the banks who again did fail miserable in their core function in evaluating a debtor’s economic ability to maintain a debt and pay it back within a reasonable period of time before providing credit. The 1% will even start using nationalistic feelings in order to avoid the populace pointing the finger in their direction.

  11. wolverine

    There are still open borders in the EU ,unfortunately.
    In order for the fascist EU empire to fold we must return to robust and energetic Nationalism.
    So maybe a default will be followed by an exodus of Greeks to the North who may throw themselves at the mercy of the German social welfare system.
    This will bring back border controls which will be welcomed by the vast majority of ordinary citizens who hate the EU.
    Here in Ireland we are third in line behind the Greeks and the Portuguese waiting in dread for the Troika’s Fiscal Wermacht to invade and asset strip our country.

  12. docG

    Would someone be good enough to explain why a Greek default would necessarily require them to drop the Euro in favor of the Drachma? Also, I’m puzzled as to why something as simple and common as bankruptcy, which happens all the time, has morphed into such a world shaking possibility that it cannot even be considered? Huge businesses have gone bankrupt and survived. Greece is a small country with a small economy, so why can’t it simply go bankrupt, stiff its creditors like any other bankrupt entity, and start over, while continuing with its usual currency, just as any other bankrupt entity?

    Naturally the creditors are going to be upset. They always are. Too bad. That’s what bankruptcy is all about, isn’t it? Maybe the difference is that in this case the creditors are much more powerful than usual and unwilling to accept reality.

  13. Lafayette

    NEW RULE

    MA: In our view, the market’s judgment is wrong: an outright default might ultimately prove the better tonic for both Greece and the euro zone.

    I cannot see how.

    The Greek economy exports incoming-tourism. Which is its major ecurrency earner. It’s other money-spinner is Maritime Services, but those who own these companies have learned to offshore their profits a long-time ago. (Why did Onassis start investing heavily in Monaco in the 1970s?)

    What will happen if Greece is shoved out of the Euro? Like most European countries it has an Energy Bill, meaning petroleum bought in from the Middle East. Overnight, when they have to start paying dollars for oil, the New Drachma will hit the pits.

    Only a small percentage of the population actually works in Tourism. They will have jobs maintained. But with the price of oil skyrocketing, what is left of the Greek economy could well crumble.

    JUST THE FACTS, PLEASE

    WikiP:

    * Greece’s main industries are tourism, shipping, industrial products, food and tobacco processing, textiles, chemicals, metal products, mining and petroleum.
    * The service sector contributes 78.3% of GDP, industry 18%, and agriculture 3.6%. The public sector accounts for about 40% of total economic output.
    * Greece has the EU’s second worst Corruption Perceptions Index after Bulgaria, ranking 80th in the world, and lowest Index of Economic Freedom and Global Competitiveness Index, ranking 119th and 90th respectively

    Just what, in heaven’s name, is the Greek economy going to fall back on to sustain employment? Forty-percent is governmental – meaning paid out of its tax revenue base. Of the other sixty percent, only Tourism and Maritime Services can sustain employment levels. But they are insufficient to maintain economic buoyancy with a New Drachma in such poor condition.

    MY POINT

    And finally, the most important component of any decision to let loose the Greeks is this: They are full members of the EU. It would be morally abject to let them go to their own devices, which are wholly unable to maintain a decent standard of living. (Even if they deserve well that punishment for having trusted an inept political class that got Greece into this present mess.)

    As it stands, with the austerity measures that it must accept, living standards would diminish considerably. Kicking the Greeks out of the EU is tantamount to feeding the country to the sharks.

    So, it just wont happen.

    POST SCRIPTUM

    And the next time an American state, say California, hits up against its debt-limit, shall we hear the same dire advice as a solution? Yeah, right – let’s sell California to the Chinese and pay of the National Debt!

    What a Great Idea! Believe me, Bernanke will be doing some “Quantitative Easing” of California’s debt lonnnnnggg before it goes bankrupt.

    New Rule for our Global New Economy: When the fit hits the shan, just print money …

    1. docG

      Lafayette, you are lacking in imagination. The Greeks could:

      1. Nationalize all the banks.

      2. Expropriate all the major industries, including shipping.

      3. Place all multi-millionaires and billionaires under house arrest until they pay all owed back taxes, and if that isn’t enough then let them cough up ALL their wealth before they are allowed to once again roam the Greek earth.

      4. Declare a socialist (or communist) state, and call on Hugo Chavez for petrol supplies and the Castros for medical assistance.

      For starters.

      I’m not advocating the above, but hey, in a national emergency, NOTHING should be off the table (to quote a recent US policy statement regarding Iran).

      1. Lafayette

        MIRROR IMAGES

        And you are lacking in understanding of some simple facts.

        Whether the Greeks go to a New Drachma or not, their debt remains an albatross around their collective necks since it remains to be paid in Euros. So, after the depreciation, the Greek debt is even greater.

        The change in the aggregate debt-burden is TIPOTA (nothing). Thus the Greeks are worse off, because they must also add to the debt burden the cost of currency exchange to buy Euros, from an economic-base that barely allows them to service the debt.

        I’m not advocating the above, but hey, in a national emergency, NOTHING should be off the table

        I should hope not, they are hallucinatory. They call for an autocratic police state that nationalizes everything willy-nilly. It’s a sure recipe for death of the Greek economy.

        Besides, all those companies nationalized have already dislocated their home offices (and stock ownership) abroad. Their asset-values are fore the most part not in Greek-ports but on the high seas and cannot be seized.

        Really, the Greek Business Class is a lot smarter than the average Greek Politician, especially the Socialist variety. Frankly, it doesn’t take much in intellectual capacity to do so.

        I will blame both sides (the Left and the Right) for the present Greek debacle. The Greeks deserve a better political class. But, I could make the same remark about our American political class as well.

        The dogmatic stupidity of the Left in Greece is just as baneful as the dogmatic stupidity of the Right in the US. They are mirror images of one another.

        Which is why, reason is usually found somewhere in the middle between the two.

      2. Lafayette

        MIRROR IMAGES

        And you are lacking in understanding of some simple facts.

        Whether the Greeks go to a New Drachma or not, their debt remains an albatross around their collective necks since it remains to be paid in Euros. So, after the depreciation, the Greek debt is even greater.

        The change in the aggregate debt-burden is TIPOTA (nothing). Thus the Greeks are worse off, because they must also add to the debt burden the cost of currency exchange to buy Euros, from an economic-base that barely allows them to service the debt.

        I’m not advocating the above, but hey, in a national emergency, NOTHING should be off the table

        I should hope not, they are hallucinatory. They call for an autocratic police state that nationalizes everything willy-nilly. It’s a sure recipe for death of the Greek economy.

        Besides, all those companies nationalized have already dislocated their home offices (and stock ownership) abroad. Their asset-values are fore the most part not in Greek-ports but on the high seas and cannot be seized.

        Really, the Greek Business Class is a lot smarter than the average Greek Politician, especially the Socialist variety. Frankly, it doesn’t take much in intellectual capacity to do so.

        I will blame both sides (the Left and the Right) for the present Greek debacle. The Greeks deserve a better political class. But, I could make the same remark about our American political class as well.

        The dogmatic stupidity of the Left in Greece is just as baneful as the dogmatic stupidity of the Right in the US. They are mirror images of one another.

        Which is why, good-reason is usually found somewhere in the middle between the two extremes.

  14. HS

    It seems obvious to me that default is best for the Greeks. This seems very simple. If Greece takes the bailout it will be expected to pay down its debt. This means that the government of Greece will have to run at a budget surplus even after interest on the debt is billed. If Greece defaults on the debt, it will be unable to effectively borrow money. This means that the government of Greece would have to maintain a balanced budget with no interest payments. The second is a much lower burden on the citizenry.

    Seems obvious which is better for the Greek citizen.

  15. Ed

    “Longer term, a Greek default could well provoke the question, “What on earth do governments issue bonds for anyway?” That might well provoke a far more provocative debate on the nature of modern money and the self-imposed legal constraints with which sovereign governments bind themselves in their conduct of fiscal policy. But that’s probably best left to the pages of another blog post!”

    Basically, if there is a deficit between taxes collected and government expenditures, just print! that’s what you’re implying. The problem is, history has been less than kind to governments that have done this. We’ll run out of tally-sticks eventually (ask Charles II)

  16. dcblogger

    No question, that under a default, a lot of public sector employees will be sacked, pensions will be at risk, and unemployment will almost certainly go higher.

    Why would sacking public employees be necessary? If Greece returns to a fiat currency, surely meeting public payroll would be no problem.

  17. steelhead23

    “But that’s probably best left to the pages of another blog post!” Marshall, please discuss sovereign coinage sooner, rather than later. I hope you have noticed that the left-right divide is becoming weird in the aftermath of the financial crisis. The only presidential candidate talking about sovereign coinage is Ron Paul, the libertarian. Obama seems to believe that the only problem with the current kleptocracy is that it needs nurturing. The remainder of the Republican field seems to believe that the financial crisis was immaculately conceived, that no laws were broken and the real failing was the decision by Obama to bail out the banks and car companies. You see, sovereign coinage and meeting government expenses through a combination of morally-guided taxation and printing would eliminate the government’s need for “primary dealers” and stick at least one nail in the TBTF bank’s coffins. From where I sit, there are two great changes needed in America – an end to corporate personhood and sovereign coinage. The rest, including all those financial regulatory reforms, is window dressing.

  18. be'emet

    missing in action? can anyone give us info on the insurance, swaps, etc, that default may bring into play. what scale of sums, who pays and how, who gets the money…?

  19. docG

    I lived in Yugoslavia during the Tito era. It was a poor country with a seriously discounted currency. At that time you could get 1000 dinars for a US dollar. I lived there for roughly 2 dollars a day. And yet there were NO signs of poverty, no beggars, no slums, everyone appeared to be employed, everyone had enough to eat, everyone had a decent place to live. And also, by the way, no one ever had a problem discussing politics with me or offering their honest opinion on any question.

  20. kris

    I cannot believe how little is known about the north and south europe, mentality wise, life style wise. How narrow the conversation is played. How finance is understood as numbers only.
    Clue: North over-produces Siemens turbines, Volkswagen cars and Leopard tanks(http://www.fprado.com/armorsite/leo2.htm)
    There are no buyers and the northeners do not spend. What to do? Beg the southeners to borrow money at the condition of buying the high end stuff that north produces.
    It works pretty well until south can’t afford the interest on the debt. Hence, north has to stop over-producing and buy more stuff from south.
    Same thing happens between Japan+China vs US+Canada+Europe.
    Verstehen sie? Tutto capito?
    It’s as simple as this.

  21. kris

    More clues:
    If Germany didn’t over-produce, it would not have begged greece, italy, spain, portugal etc to borrow their money and buy their stuff, so as to avoid german unemployment.
    By receiving borrowed money without a sweat, clubmed countries just gave it to the pensioners and expanded public employment. Easy money, what do you expect.
    All these countries would not have had higher standard of living if germany, netherlands, finland didn’t beg them to borrow.

    Hence: Source of problem – north europe overproduction and stinginess – those guys do not spend.
    Suckers: clubmed
    Currently: suckers – germany and north. Pension funds must take a loss. Can’t get more from squeezing greek, italian, spanish and portugeese blood.

  22. WorldisMorphing

    I disagree. Greece is *not* Argentina.
    ———————

    ["Longer term, a Greek default could well provoke the question, “What on earth do governments issue bonds for anyway?” That might well provoke a far more provocative debate on the nature of modern money and the self-imposed legal constraints with which sovereign governments bind themselves in their conduct of fiscal policy."]

    That I agree with…the debate is on.
    …but this time, more people should join in…to make sure it isn’t hacked…

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