CREDIT AND CROCODILE HEARTS

Written by Professor Herakles Polemarchakis, originally featured in the Bulletin of the Economics Research Institute.

The financial crisis in Greece was well-publicised by the mainstream media, but there are aspects of the situation that remain unexplained. Professor Herakles Polemarchakis, Warwick Professor and economic adviser to the Greek government, examines what he has learned in confronting the financial crisis in Greece.

By the end of 2009, Greek public debt stood at 127 per cent, the deficit at 15.5 per cent and the current account deficit at 11 per cent of GDP. In addition, the outgoing conservative government had failed to address these long standing problems and had succeeded in driving the country to the brink of bankruptcy. At the same time, it had consistently misreported statistics to European authorities, compromising the credibility of the country at a time when it needed it most. [NB: The first paragraph of this article has been amended, as the statistics quoted have been found to be inaccurate].

The country finds itself in a sorry state that is the outcome of easy money, the legacy of the enormous credit available to both the public and private sectors after the 2001 integration of Greece into the euro zone. This combined with many factors, among them, corruption, a failed political culture and an educational system that failed to provide citizens with needed skills.

During recent weeks, violent and escalating riots against laws that, among others, reduce salaries in public and semi-public enterprises have brought Greece to a standstill. The economic adjustments require extremely painful measures and the public’s willingness to suffer the consequences is not a given. When workers and pensioners already on a financial edge face cuts, one never knows whether the response will be stoic acceptance or the angry recrimination of rioting and voting out political leaders.

The value of mortgage defaults underlying the crisis was modest, but the fiscal stimulus needed to offset them was large.

A year ago, when I arrived in Greece to work for the government, then just confronting the enormity of the crisis, I was told to brace for the worst. “You don’t understand how terrible things are,” a man who greeted me insisted. With panic, he said, “It is so bad that we no longer have any comparative advantage.”

His comments offer a wry punch line to economists, for whom a comparative advantage, the ability of a place to produce a certain good or provide certain services more cheaply than another, cannot in theory or in practice simply evaporate. But the man’s remarks underscore the extraordinarily bleak outlook pervasive in Greece, and the need for the best economic tools our profession can wield.

In the spring of 2010, the situation for Greece became untenable. The steady and rapid rise in the interest rates faced by Greece to finance its deficit or to refinance its debt resulted in an inevitable appeal to the support mechanism set up by the European Commission, the European Central Bank and the International Monetary Fund. The support provided by the mechanism amounts to €110 billion over a three-year period, during which Greece enjoys full protection in the fulfilment of its financial obligations.

According to the Memorandum of Understanding signed with the European and international authorities in May 2010, Greece has implemented severe deficit reduction measures: among them, a 15 per cent decrease in public sector salaries and pensions (some already painfully low), and a four percentage point increase in the VAT. But, problems remain: sustainability of the public finances is still uncertain. The debt to GDP ratio is expected to peak at about 150 percent in 2014-15. The severe reductions in public expenditures, public investment among them, may plunge the country into a prolonged recession, with adverse consequences for long-term growth as well as for fiscal stabilization. The structural reforms required are extensive.

Public support for painful economic measures that are needed cannot be taken for granted.

Following Greece, Ireland next had to appeal to the international support mechanism. The Irish crisis was not a public debt crisis as its Greek predecessor. The Irish crisis grew out of the decision of the Irish government to bail out a banking sector that had faltered. This situation resembles events in the United States, where the financial crisis was the outgrowth of defaults in the subprime mortgage markets and the failure of financial institutions. There is fear that Portugal, and even Spain and Belgium are next in line.

As the economy uncertainty spreads, European politicians and technocrats are busy setting up a permanent support mechanism to avoid the ad hoc intervention the Greek crisis required. In this context, they have to address fundamental, difficult and divisive problems: the trade-off between stimulus and restraint, with its implications for inflation, taboo from the German point of view, or the participation of the private sector in future bail outs. Such a 'bail in' implies that different members of the euro zone would face different interest rates, with evident complications for the conduct of a common monetary policy.

But in economics, so often buffeted by politics and public opinion, the temptation to find someone who offers fast and easy solutions, the economic equivalent of the medicine man, proves almost irresistible at times.

Meanwhile, mainstream academic economists have been conspicuously absent from the policy deliberations and public debates that the debt and the financial crises have required and generated.

A good starting point for the practice and teaching of economics to address for the public good at this time would be the consumption-savings problem. Asset markets and the ability of individuals and firms to borrow and lend determine the allocation of value and goods over time. Two major obstacles, however, prevent the optimal operation of asset markets. First, market participants do not know the prices of commodities and assets that will prevail in the future. Ponzi schemes may allow market participants to evade budget constraints; collateral requirements in asset markets or the excessive deficit restrictions in the Stability and Growth Pact of the euro zone are at best imperfect rules of thumb. Neither the practice nor the theory of economics has figured out how to cope with mistakes in the allocation of value and goods and how to contain their multiplier effects.

This is not a time to abandon academic economics for quack 'cures'.

For example, the value of the mortgage default that led to the financial crisis was modest. But the fiscal stimulus required to offset the economic default was many times larger, and quite substantial. The current system exaggerates the size of the default. Someone who has defaulted on a $1 million house may be able to pay $750,000.

Academic economics was not able to predict the financial crisis or to offer a way out. At times, it does not even seem to possess the categories required to comprehend the problem. But, what options are there?

The situation has a parallel in medicine. One can recall a time when modern medicine, despite its research in biology and chemistry, could not treat or cure illnesses that have since been conquered. When modern medicine failed, desperate patients turned to the village medicine man and his promises. A Western doctor visiting Egypt a few years ago, for instance, was shocked to find that villagers preserved and nibbled on crocodile heart as a cure for impotence, as the local medicine man had advised.

When medical research falls short, few argue that one should turn to the village medicine man rather than to further study of chemistry and biology. But in economics, buffeted by politics and public opinion, the temptation to find someone who offers fast and easy solutions, the economic equivalent of the medicine man, proves almost irresistible in promising to cure suffering and loss.

These crises of our times create an urgent call for good economics: the intellectually demanding, hard core theory and empirical work that provide the underpinnings for sound economic policies. These policies will not offer quick, painless solutions to the world’s economic woes. Alas, for Greece and other nations, there is no viable crocodile heart cure.

Professor Herakles Polemarchakis is a Professor of Economics at the University of Warwick who specializes in the theory of economic policy. For the past year, he has also served as the head of the Greek Prime Minister’s Economy Office. He has previously held posts at Harvard University, Brown University and Columbia University.

This article was originally published in the Bulletin of the Economics Research Institute.