Austerity: A German Prescription for a Greek Tragedy
By: Benjamin Locks
Due to Germany’s weight in the Eurozone, it has an outsized role in policy prescriptions for the region. It is imposing a reform package that it itself passed in the early 2000s, which is widely credited with turning around the German economy. However, these reforms are suited for the export-driven economy of Germany, not the demand-driven economy of Greece. In Greece, the reforms have led to a massive drop in GDP, high youth unemployment, and a rise in debt to GDP. Meanwhile, the Greek government is becoming less capable of enacting the reforms demanded of them. As a result, citizens are turning towards more extremist political parties that want to end austerity. All of this will make it harder for Greece to pay back its debt and remain in the Eurozone at an acceptable cost to society. If things do not change soon, the troika may be creating conditions for the same Greek exit that it has been trying to prevent.
“Your empire is now like a tyranny: it may have been wrong to take it; it is certainly dangerous to let it go.” - Pericles
Ten years after the introduction of the euro, several countries face bankruptcy, threatening the very existence of the currency union. Greece has had a particularly hard time and was forced to turn to the European Commission (EC), European Central Bank (ECB), and the International Monetary Fund (IMF), commonly referred to as the troika, for a bailout to keep the country solvent. As the richest country in the Eurozone, Germany’s financial and political support has been essential for any bailout to move forward. Germany’s prescription for the crisis is an austerity package closely modeled after the reforms it implemented in the early 2000s, when it faced high unemployment and stagnant growth. The “Agenda 2010” reforms were designed to reduce government expenditures and open labor markets and have largely been successful in transforming its moribund economy into a world-beating exporter. However, these reforms are suited for the export driven German economy, not the domestic demand driven Greek economy. Applied to the Greek economy, these reforms are creating terrible side effects. Greece’s debt-to-GDP ratio and unemployment figures are rising. Greek institutions are becoming less capable of enacting reforms, and pro-austerity parties are losing ground to the far-left and far-right, making it more difficult for reforms to be politically sustainable and for the Greek economy to grow and remain within the Eurozone.
An exit from the Eurozone might give Greece more flexibility, but it must be managed in an orderly fashion over an extended period of time. Spain, Italy, other peripheral countries, and European banks are in such a weak position that a premature Greek exit could threaten their ability to borrow from financial markets and with economies many times larger than Greece’s, the rest of the Eurozone is not in a position to offer them a similar bailout. Without the commitment to a perpetual transfer union or Eurobond system, which seems unlikely given current German sentiment, the troika must redirect some of the bailout funds toward improving the economic prospects of ordinary Greeks. This would give the current Greek coalition some breathing room to survive the next election, while making preparations for other institutions to withstand a Greek exit. If the troika does not adapt, it could be creating the very conditions for the Greek exit that it has been trying to avoid.
Original Sin
The purpose of economic integration in Europe has always been about the prevention of another destructive war. As French foreign minister Robert Schuman declared on May 9, 1950 in setting up the European Coal and Steel Community (ECSC), the forerunner of today’s European Union (EU), economic integration will make war “not merely unthinkable but materially impossible”.1 In this sense, the euro is politics by other means, or an economic tool being used for the purpose of political integration. In 1998, Spanish President Felipe Gonzalez admitted as much when he said “The single currency is a decision of an essentially political character... We need a united Europe. We must never forget that the euro is an instrument for this project”.2
The decision to let Greece into the euro was accordingly based on political rather than economic grounds. Greece’s initial application to join the Eurozone was rejected by the European Commission in May 1998 due to its high debt-to-GDP ratio, but this decision was reversed just 18 months later. The debt criteria was changed to “approach the reference value of 60% at a satisfactory pace.”3 Rumors abound that Greece had cooked its books to show improvement in this regard, but similar statistical irregularities had been apparent since the beginning of its relationship with the European Union. Before the introduction of the euro, one European official complained, “We did send a mission to Greece, but they had a lot of problems getting their numbers right. We had to establish a small [working] group, which reviewed all of their statistics. All the figures contradicted.”4
Greece was nevertheless let in, because, according to John Palmer of the Centre for European Studies, “The Greek economy appeared to be doing well, and there was a strong desire to reward countries that had faithfully committed to the integration process. There was a political wish to be helpful.”5 The political idealism of European policymakers and their desire to see a united Europe overrode their intuition on the questionable nature of Greece’s statistics. And so, Greece entered the Eurozone in 2002 with a debt-to-GDP ratio of 101%.6
Credit Boom
European leaders believed that once Greece and other peripheral countries joined the euro, their economies would converge with those of the richer northern European states. On the surface, their hopes were rewarded. Between 2000 and 2008, Greece’s GDP grew at an average rate of 3.8%. However, this masked underlying problems. Like many other peripheral countries, Greece’s interest rates for borrowing dropped and consumers went on a spending spree. In the same time period, the country’s public debt-to-GDP ratio rose from 103.4% to 110.7%, and its current account deficit almost doubled, from 7.7% to 14.7%. In fact, 97% of GDP growth in that time period can be attributed to public and private consumption, a full 15 percentage points higher than its peripheral Eurozone colleagues and 26 percentage points higher than the Eurozone’s core countries.7 Similarly, corruption indicators in Greece began to worsen as well (see graphs in later section). When the financial crisis struck in 2008, Greek banks looked like they might go bankrupt. But with so much public debt, markets wondered whether Greece could bail out its banking system, and Greek bond yields began to rise. By 2010, Greece was in dire straits. Germany wavered as to whether it would bail out Greece. Borrowing rates exploded and the Greek government was forced to turn to the international community for help.
The European Commission, the European Central Bank, and the International Monetary Fund eventually formed a working group known as the troika to administer a bailout of Greece’s financial system, conditional on Greece slashing budgets and implementing labor market reforms. The troika has demanded massive cuts in government spending, equivalent to 9.1-9.4% of GDP in three years, as well as the elimination of 150,000 workers from the public sector by 2015, a cut of nearly 20% from July 2010 levels.8 The troika is also demanding a 22% cut to the minimum wage for workers over 25, a 32% cut for workers under 25, and the deregulation of many protected labor industries.9
The German Prescription
Germany is the largest economy in Europe and has contributed €211 billion, or nearly one third, of the bailout funds.10 Accordingly, they have an outsized influence on the policies demanded by the troika. Germany views the crisis as Greece’s fault. Angela Merkel has said that the periphery must “do their homework” and “atone for their past sins.”11 However, Germany’s understanding of the crisis and its remedies are informed by the German economic experience of the past 50 years. Germany has certainly been through its share of traumatic events, many of which have shaped the country’s economic and political culture. While most current literature points to the experience of hyperinflation during the 1920s under the Weimar Republic, or problems of reunification following the fall of the Berlin Wall, recent events have made a more enduring contribution to the German economic perspective.
In the early 2000s, Germany was widely considered to be ‘the sick man of Europe.’ The country was experiencing stagnant growth and stubborn unemployment hovering around 10%. However, in 2003, the German chancellor, Social Democrat Gerhard Schröeder, implemented the Agenda 2010 plan, which focused on structural reforms to make labor and product markets more flexible.12 The government reduced employers’ contributions to the personal healthcare system, made it easier for companies to hire and fire workers, reduced unemployment benefits, slashed subsidies, privatized publicly held properties, and cut taxes.13
Although these reforms cost Schröeder the support of his center-left Social Democrat party and his position as chancellor, they were maintained in the subsequent Merkel government. In her first address as chancellor, Merkel said, “I would like to thank Chancellor Schröder personally for bravely and resolutely opening a door with Agenda 2010, so that our social systems could be adapted to a new era.”14 Since 2005, German unemployment has dropped from 11.7% to 5.4%; the youth unemployment rate is 8.1%, the lowest in the EU.15 Germany is now the economic motor of Europe and third largest exporter in the world. The country’s resilience was on display during the financial crisis, as its economy grew by 4.2% in 2010 and 3% in 2011.16
Square Peg, Round Hole
The reforms being pushed by Germany are shaped by its own unique conditions and experience, and are not suited for the Greek economy. Under similar reform packages, it will take significantly longer for Greece to rebound, if it can implement such a package to begin with. Germany is a very open, export-driven economy. In 2003, when Germany began to implement the Agenda 2010 reforms, the country’s private consumption, exports, and current account surplus accounted for 59%, 36.1%, and 4.3%, respectively, of GDP. By 2006, private consumption stayed level at 58.5%, but exports and current account surplus as a percentage of GDP both rose to 45.1% and 5.5%, respectively.17 By comparison, in 2011, private consumption in Greece represented 74.6% of the country’s GDP, and exports only 25.1% of GDP, the lowest level of exports in the Eurozone. Greece was running a current account deficit of 8%.18 German consumption was never as high as in Greece, nor did it fall significantly with a rise in exports. Germany actually had a current account surplus at the time it began to implement the Agenda 2010 package. Reforms in Germany were simply meant to leverage a competitive advantage the country already had, not create a new one.
In contrast, the depression of wages and consumer demand has had significant repercussions for the Greek economy.
Since Greek businesses are structured for serving their domestic markets, it comes as no surprise that a drop in wages has damaged the Greek private sector. The troika believed that by implementing its reforms, the Greek economy could regain its competitiveness by reducing labor costs, increasing exports, and returning to growth. Unit labor costs have declined, but exports have not increased enough to sufficiently compensate for the precipitous drop in domestic demand. In 2011 and 2012, Greek exports increased by 2.4% and 2.9%, respectively, yet domestic demand fell by 10.1% and 9%.19 Projections show that only under the rosiest scenarios does Greece achieve a current account surplus by 2016. In fact, the average projection shows that Greece will continue to run a current account deficit between 4% and 6.6% of GDP by 2016.20
Greece’s international creditors are forcing the country to transform into something entirely new—an export- driven economy. However, the Greek economy is facing extreme readjustment costs including a massive displacement of its workforce. This makes reforms less politically sustainable in the short term, and Greece’s membership in the Eurozone questionable in the long term. Even if Greece’s leaders can survive this political challenge, readjustment costs will scar the Greek economy, hurting its ability to pay down its debt, and possibly negating any gains the troika’s reforms might make.
Short-term Consequences of Austerity
2013 will be the sixth consecutive year of depression in Greece. The country’s GDP has contracted by nearly 25% from its 2007 high. Unemployment has risen from 9.5% in 2009 to 26% in 2012 while youth unemployment has risen from 25.7% to 57% during the same period.21 Wages have been falling as inflation has been rising. Despite the fact that Greece’s large debt-to-GDP ratio was the determining factor behind the country’s first bailout in 2010, the ratio is predicted to rise from 126.8% in 2010 to 188.4% in 2013, as Greece’s GDP has fallen even faster than its government spending. Greek voters are beginning to take notice. Polls show that 78% of the population believes that the worst of the economic crisis is still to come, and 99% of the population believes their economy is in a bad state.22 This is certainly a difficult position for any incumbent government. While the European Commission forecasts that Greece will return to growth in 2014, at a paltry rate of 0.6%, the more immediate concern is whether Greek politics will sustain the troika’s austerity package.
Despite European pleas for unity, Greeks are moving towards the extreme ends of the political spectrum. Over the last few years, the traditional center-left and center-right Greek parties, PASOK and New Democracy (ND), have lost support to parties on both ends of the political spectrum. In the most recent election, these parties received their lowest share of the vote total in history, receiving the support of just over 40% of the electorate. Syriza, a leftist anti-austerity party, became the second largest party, earning 26.9% of the vote and 71 of the 300 seats in Parliament. Polls have shown Syriza virtually tied with ND at 28%.
The potential election of a Syriza-led coalition therefore presents the biggest short-term threat to the euro. Syriza leader Alexis Tsipras has threatened that “The first act of the new Left government, immediately after parliament is formed, will be to cancel the bailout terms and the laws passed to implement (austerity).”23 Even if Syriza does not win an outright majority in future elections, the Greek constitution awards the party finishing first an extra 50 seats in Parliament, giving it a strong hand in forming any government. Syriza is betting that the troika would not dare let Greece leave the euro, because this would create chaos in financial markets, threatening German banks as well as Spanish and Italian government borrowing rates. The question of whether Syriza actually intends to drop the common currency is debatable, but the party’s electoral success alone might reveal their threats as a self-fulfilling prophecy. Because Syriza’s rhetoric has challenged the terms of the bailout, which is the only thing keeping Greece in the Eurozone at the moment, their election would likely spook markets, causing an increase in bond yields, capital flight, and a further deterioration of the economic prospects for Greece and the Eurozone as a whole.
Long-term Consequences of Austerity
Even if Greek politicians can maintain their country’s membership in the Eurozone, Greece will pay the long-term costs of the readjustment period. If these costs are great enough, they could potentially outweigh any gains made by following the troika’s reform agenda, making the whole process self-defeating. Recent research documents the negative effects of youth unemployment and large government indebtedness on personal income and economic growth.24,25 Young people in the US and the UK who experience unemployment face earning losses that are significant and persistent, with measurable effects 20 years later. Currently unemployed youth are also at a higher risk for future unemployment. Work skills atrophy in times of unemployment, and employers generally have negative perceptions of youth who have been out of work for long periods of time.26 With a youth unemployment rate of 57% in Greece, there will likely be a large aggregate loss of income in the medium to long term, retarding Greece’s economic growth and ability to pay down its debt.27
Although Greece’s large debt-to GDP ratio was a precipitous cause of the crisis, the same ratio has risen under the auspices of the austerity package from 126.8% in 2010, to a projected 188.4% for 2013. Recent empirical research has found that, historically, debt-to-GDP ratios above 90% cause a one percent drop in GDP growth. Emerging markets face even lower thresholds for external debt (public and private), which is usually denominated in a foreign currency. When external debt reaches 60% of GDP, annual growth declines by about 2%, and, for higher levels of debt, growth rates are roughly cut in half.28 The IMF predicts that debt will fall to a “sustainable level” of 124% by 2020 if Greece sustains the troika’s policies.29 If it continues to cut debt at the same percentage rate, it would still take until 2024 to drop below a 90% threshold, and until 2028 to fall below a 60% threshold. Greece’s debt problem has ironically been exacerbated by austerity, and will have a lasting negative effect on the country’s prospects for economic growth.
Unfounded Optimism
The endemic corruption that has worsened over the last decade will only make reforms more difficult to implement. When Germany introduced its reform agenda in 2003, it was ranked 16th in the world in Transparency International’s Corruption Perceptions Index. It is ranked 13th today. Over that same time frame Greece has fallen from 50th to 94th, and is currently tied with countries such as Colombia, India, Benin, Djibouti, Mongolia, and Moldova.30
Source: Original Graph from Transparency International figures
The issue of tax collection reform clearly illustrates the difficulties of reforming the Greek public sector. Studies estimate that tax evasion costs the government between 5-15% of GDP each year. In 2012, the government only collected half of the $2.6 billion it was hoping to collect and conducted only a third of the audits of wealthy individuals and corporations that it had planned to do.31
The European Commission forecasts of a return to economic growth in 2014 and beyond, depend on “the crucial assumption of timely and rigorous implementation of the adjustment program.”32 This may be a crucial assumption, but it is not one based in reality. Since Greece’s accession to the euro in 2002, it has seen a steady increase in corruption perceptions and a decline in various indicators of governance. Given these trends, it is unlikely that Greece’s implementation of the adjustment program will be either timely or rigorous.
A New Hope
The forces of integration have been pushing European countries closer together for over 60 years. Together, they have managed to weather many other crises, so why should they turn back now? Oddly enough, public support for the euro remains higher in Greece (67%) than it does in Germany (54%).34 As repugnant as bailouts are to the German and northern European public, Greece is paying the brunt of the cost of readjustment. Greece’s exit would impose these costs on the rest of Europe. The ECB has €177 billion worth of exposure to Greek government debt, which represents more than 200% of its own capital base. A currency switch could also put Greek private debt owed to banks and corporations outside its borders in jeopardy. Eurozone banks are owed €28 billion by Greek banks and €21 billion by Greek non-financial corporations. Given the risk of contagion to other distressed economies, Portuguese and Irish debt would become considerably more risky. External obligations among these three countries alone totals €1.4 trillion, The German Finance Minister has reluctantly recognized these risks, stating, “A Greek bankruptcy could lead to the break-up of the Eurozone.”35
In the long term, the reforms necessary to make Greece competitive again will take a substantial amount of time. According to Mujtaba Rahman, a European analyst at the Eurasia Group risk consultancy, “The program is much, much more ambitious than economic reform. This is state building, as typically understood in traditional low-income contexts.”36 However, reforms would be much easier in the context of an improving economic situation, not a worsening one. In the short term, the consequences of a sudden Greek exit are too much to bear. Though Germany does not want to commit to permanent fiscal transfers, it has come to the conclusion that a Greek exit in the short term will be much more costly than a bailout. Right now, PASOK and ND are the euro’s best friends in Greece, as a Syriza victory in the 2014 Greek elections would only create more political and economic chaos in Europe. Excoriating Greece by saying they need to “do their homework” and “atone for their sins” and referring to them as a “bottomless pit” is counterproductive. The troika needs to ease the conditions on loans in order to bolster the pro-austerity coalition in Greece and buy time for Spain, Italy, other peripheral countries, and European banks to get their houses in order. If other European institutions were standing on more solid ground, it would give European policymakers more breathing space to deal with problems in Greece, removing the systemic threat to the euro.
The euro has always been about political and economic integration. Yet, after six years of austerity with few tangible benefits, the political terrain in Greece is like dry tinder in a forest; it only requires a bolt of lightning to set the whole thing on fire. It may never happen, but the continued depression is only providing opportunities to polarizing extremist political groups. A far greater danger to the European project is not the economic consequences of a Greek exit, but the rise of radical parties to positions of power that would challenge the status quo in the European Union and sow discord between member states. The political, social, and economic system cannot continue to bear the extreme costs of readjustment within the euro under the current austerity program. The next generation will already be scarred by high unemployment and huge debt. If Germany and the troika do not address the fundamental economic necessities of ordinary Greek citizens soon, the ability of Greece to grow its way out of debt will be severely damaged. Support for the euro remains high, but the ability of Greeks to persevere is being tested. If things do not change soon, Germany and the troika may be creating the very conditions for a Greek exit that they have been trying to avoid.
Benjamin Locks is a first year Master’s Degree student at SAIS, concentrating in Strategic Studies. He is originally from Chicago, Illinois. Prior to SAIS, he was a Peace Corps Volunteer in El Salvador for two and a half years.
Notes
1. Schumann Declaration. May 9, 1950.
2. Manolopoulos, Jason. Greece’s Odious Debt. 2011
3. Ibid.
4. Jones, Erik. “Getting to Greece: Uncertainty, Misfortune, and the Origins of Political Disorder.” European Consortium for Political Research. 2012
5. Manolopoulos, Jason. Greece’s Odious Debt. 2011
6. IMF, World Economic Outlook 2002
7. McKinsey and Company, “Greece 10 Years Ahead”, March 2012
8. Manolopoulos, Jason. Greece’s Odious Debt. 2011
9. “Euro Zone, IMF Secure Deal on Cutting Greek Debt,” Reuters, accessed 1/5/2013 http://www.reuters.com/ article/2012/11/27/us-eurogroup- greece-idUSBRE8AP05820121127
10. European Financial Stability Facility. “Frequently Asked Questions.”
11. “Schaeuble warns Greek promises no longer suffice,” Reuters, accessed 1/5/2013, http://www.reuters.com/ article/2012/02/12/us-germany-greece- idUSTRE81B05N20120212
12. Dullien, Sebastian and Guerot, Ulrike. “The Long Shadow of Ordoliberalism: Germany’s Approach to the Euro Crisis.” European Council on Foreign Relations. 2012.
13. “A Quick Guide to ‘Agenda 2010,” DW, accessed 1/5/2013 http://www.dw.de/a- quick-guide-to-agenda-2010/a-988374
14. “The Man Who Rescued the German Economy,” Wall Street Journal, accessed 1/5/2013 http://online.wsj.com/article/ SB100014240527023041412045775085 30981893226.html
15. Eurostat. “Euro area unemployment rate at 11.4%,” August 2012
16. Eurostat. “Real GDP Growth Rate”
17. European Commission, “The European Economy,” Spring 2005 and Spring 2008.
18. European Commission, “The European Economy,” Autumn 2012.
19. Ibid.
20. Eurobank Research. “A technical study on the determinants of Greece’s current account position,” April 2012.
21. “Euro area unemployment rate at 11.4%,” Eurostat: August 2012.
22. European Commission. “Public Opinion in the European Union,” Autumn 2012.
23. “Meet Alexis Tsipras, the Youthful Greek Leader Who Terrifies the European Financial Elite”, Business Insider, accessed 1/6/2013, http:// www.businessinsider.com/meet-alexis- tsipras-the-youthful-greek-leader-who- terrifies-the-european-financial-elite- 2012-6#ixzz2H8e7BXwN.
24. Mroz, Thomas A. (Yale, 2006)
25. Farlie and Kletzer (1999)
26. International Labour Office. “Global Employment Trends for Youth 2012”. May 2012.
27. Eurostat Unemployment Statistics October 2012
28. Reinhart, Carmen M., Vincent R. Reinhart, and Kenneth S. Rogoff. “Public Debt Overhangs: Advanced- Economy Episodes since 1800.” The Journal of Economic Perspectives 26 (3): 2012. 69-86.
29. “Euro Zone, IMF Secure Deal on Cutting Greek Debt,” Reuters, accessed 1/5/2013 http://www.reuters.com/ article/2012/11/27/us-eurogroup- greece-idUSBRE8AP05820121127
30. Transparency International. “Corruption Perceptions Index,” 2012.
31. “Greece Tax Scandal Shifts Focus From Collection Problem,” New York Times. Accessed 1/5/2013. http://bcjournal. org/volume-15/power-cycle-theory-the-
32. European Commission, “The European Economy,” Autumn 2012.
33. European Commission. “The Euro Area,” December 2012.
34. International Institute for Finance. “Implications of a Disorderly Greek Default and Euro Exit,” 2/18/2012.
35. “German Lawmakers Approve Greek Bailout,” CNBC. Accessed 1/5/2013. http://www.cnbc.com/id/50020394
36. “Athens told to change spending and taxes,” Financial Times. Accessed 1/5/2013 http://www.ft.com/intl/ cms/s/0/fde0e3d4-5e3b-11e1-85f6- 00144feabdc0.html#axzz2Nt9ceyk0
BCJIA Editors
Reader Comments (1)
Hi Bejamin. Just as an FYI, this sentence doesn't really hold up anymore: "Recent empirical research has found that, historically, debt-to-GDP ratios above 90% cause a one percent drop in GDP growth." I suggest you google Reinhart & Rogoff controversy. Otherwise, good article.