Politics and Economics

A Greek exit from the Euro is now the best possible outcome for Greece and the Eurozone.

The Eurozone nations would be foolish to bail out the Greek Economy without insisting on the structural reforms necessary to stop a repeat performance in a year or two.

And why should only Greece get special access to no-strings-attached free money?  Why should Germans be forced to retire at 67 so Greeks can retire at 55? A Greek bailout at Germany’s expense would cause a landslide of further left-wing governments in Portugal, Spain, Italy and elsewhere with hands outstretched and beaks wide open. The Greek debt is barely manageable by the Eurozone but an emergency bail out of any of the other larger economies would cause a pan-European economic catastrophe.

Greece’s existing deal with its creditors is very lenient.  Its private debts have already been largely forgiven and the remaining €243 billion of debt is to be repaid with outrageously low interest rates over a very long repayment period.  Its interest payments are currently less than 3% of GDP, which is manageable even for Greece.

The sad irony for the Greek people is that their economic fortunes had finally started to recover when Syriza came to power.  For the first time since the first Greek bail out five years ago the Greek Economy showed modest growth and a small budget surplus (excluding interest payment) in 2014.

Syriza should have used this firmer economic base to confront the pervasive tax evasion, abysmal public administration, inflexible markets and rampant corruption to drive further economic gains for the Greek people.  Instead it has embarked on a shambolic campaign to disprove the laws of arithmetic by insisting on implementing fantasy socialist economics without the cash to fund it.  This includes reversals to labour-market reforms and promises to raise the minimum wage to pre-crisis levels, both of which are madness in country with 50% youth unemployment.  They also plan the restoration of pension increases when they should slash early retirement rights to prevent more people switching from employment to dependency.  Their planned rehiring of thousands of public sector workers and the scrapping of privatisation projects is unaffordable and if they cannot collect income tax there is no choice but to raise more VAT, which they also oppose.   Their proposals would both breach Greece’s agreed bail-out terms and wreck the economy.  Since Syriza came to power the economy started shrinking sharply and the small budget surplus has once again descended to a massive shortfall.   This is despite increasingly desperate measures such as raiding the funds of municipalities and delaying payments to suppliers.

In 2001 Greece used some opaque and creative accounting to fool the EU’s auditors into believing it had a budget deficit of only 1.5% of GDP.  It subsequently emerged that the true deficit at the time was more than 8%, which is well above the 3% limit set out in the Maastricht treaty and would have prevented it joining the Euro.   If the Euro is to endure its rules must be enforceable. Mr. Tsipras is still ignoring those rules and he has torn up the legal agreement made by the previous Greek Government with its creditors .

So Syriza have done nothing to rebuild trust and economic credibility and many doubt that Greece would honour any future promises it makes.  Creditors are likely to demand more onerous terms than before and a rigorous inspection process to ensure the terms are honoured.  This is unlikely to be acceptable to the Greek people let alone Syriza.

Syriza’s adolescently amateurish diplomacy has alienated many of the Eurozone countries previously sympathetic to Greece’s plight. Mr. Tsipras’s courting of the sabre rattling Russian regime currently annexing parts of Ukraine, hysterical allegations of criminality against the IMF and revisiting claims of war crimes and demands of reparations from Germany are hardly going to win sympathy and influence with its allies.

Syriza’s conduct sets a poor precedent and if successful would open the door for other states to behave similarly in order to get access to free money from its partners.

Astoundingly these acrimonious economic and political disputes relate to the relatively trivial issue of how to conclude Greece’s second bail-out. Even if a deal is patched-up the funds will be immediately swallowed up.  Greece will still need to negotiate a third bail-out of about €50 billion. And unless Greece makes the much needed but much hated structural reforms this would still not be the end of it.

Compared to the last Greek economic crisis in 2012 the Eurozone is better prepared to manage a Greek exit. Its banks are well capitalised and have virtually no exposure to Greece; a large bail-out fund is established; quantitative easing is supporting bond and equity markets; and the weak euro is boosting exports.  A Greek exit would also dissuade other vulnerable Eurozone countries from dragging their feet on structural reforms and drain support from their extreme populist political parties.

So Syriza’s almost comical diplomatic and economic ineptitude has precipitated a situation where a Greek exit from the Euro and a re-launch of its own currency (the Drachma) is now the only realistic solution for any sort of independent long-term economic recovery.

By restoring the Drachma, Greece could have the flexibility to continually adjust its value on international currency markets to levels that cushion it from the shocks that are currently devastating its economy.

This is how it works:

Suppose on international money markets 100 Greek Drachmas is worth 1 Euro.  So a product that Greece was producing for 200 Drachmas costs 2 Euro in Germany. During a crisis the Drachma can be revalued to 200 Greek Drachmas to 1 Euro. Now when Greece exports its products to Germany its prices are much lower.  A product that costs 200 Drachmas to make is now selling for only 1 Euro, instead of 2 Euros.  This increases exports of Greek products to Germany, which supports Greek businesses and creates employment.  The Greek government gets more tax from successful domestic businesses and has lower costs because there is less unemployment and associated welfare costs.

Of course this also makes Greek imports more expensive.  Now if Greece wants to buy products and raw materials from Germany it has to pay twice as much.  To import a product from Germany which cost 1 Euro is now costing Greek businesses 200 Drachmas instead of 100 Drachmas.  This has the effect of causing Greek consumers and businesses to buy their products and raw materials from within Greece, which further boosts their economy.  It reduces imports and boosts domestic trade.

Furthermore Greek workers are still on the same salaries, which have the same buying power within Greece.  They will not notice a difference to their living standards unless they go on holiday in Germany where they will find prices very high.  This will encourage them to holiday at home further boosting the Greek Economy.  Also Germans will find being on holiday in Greece very cheap, so they will come in larger numbers, further boosting the Greek tourist trade.

So the ability to devalue a currency helps to smooth the problems of an economic crisis in poorly managed economies.

Now let’s consider the options for the Greeks if they share the same currency as Germany.

The Government cannot afford the interest payments on its loans and cannot borrow more so it must reduce Government spending and pay off some of the loans.  It must pay its public sector workers less salary and reduce government spending.  Greek industries are uncompetitive so they must reduce their costs too.  They must pay lower salaries and find further cost saving in its production.  This is not easy and lower salaries in Greece means lower spending by consumers causing the economy to slow further.  Germany has no incentive to buy Greek products or visit Greece on holiday, because it is just as expensive for them.  Unemployment stays high, which increases the costs to the Greek Government in unemployment benefit.  This means less money for investing in Greek infrastructure and industry that is essential to make them more competitive.

The situation is made worse for Greece if the German economy starts booming.  The value of the Euro will rise causing Greek exports to be even more expensive on international markets, which will cause their economy to slow even more.  This is because exchange rates are set at a level appropriate for the larger German Economy, not the smaller Greek economy.

To ensure that countries like Greece do not continue to mismanage their economies and cause future crisis within the single currency it is essential that their tax and spending policies are aligned with countries like Germany. Greece likes the economic security of the Eurozone and the financial protection it offers, but it seems they also do not want to to have their economic policies influenced by larger states.  They cannot have both.

This bailout is no longer working and a Greek exit from the Euro is now the best possible outcome for the Eurozone and Greece.   It will restore to Greece control of its economic destiny and restrict the consequences of its economic policies mainly to Greece.  It will also restrict an economic catastrophe to a mere disaster.

Politics and Economics

What is Quantitative Easing (QE) and why is Europe trying it now?

Europe’s QE (quantitative easing) initiative, planned for an initial 18 months, involves buying bonds to a value of as much as €1.1 trillion, or about 10% of Eurozone GDP. That is still well below the 25% of American GDP reached when the US Federal Reserve printed money to help revive the country’s economy after the 2007-9 financial crisis. The ECB is leaving the door open to expand its programme further.

What does Europe hope to gain from this initiative? And why are they doing it now?

Base rates are low (the rate the central bank lends to other banks) but the banks are not lending cash to its customers (businesses and individuals).  This may be because there is not enough “lendable” cash in the banking system because banks are trying to repair their balance sheets after the financial crash. They must also now comply with  the new international capital holding requirements to prevent another banking meltdown similar to the one we saw in 2008-9.  To a bank a “loan” is the same as an “asset” because they make their money by lending out money.   So the banks want to increase the proportion of low risk assets that they own. Government bonds (loans to governments) are seen as low risk because the chance of default (not paying back the loan) is low compared to say a loan to a business or an individual. When they do lend to businesses and individuals the banks are reserving their loans for ultra-safe investments and charging higher interest rates.

This lack of credit causes an economic slowdown as businesses cannot borrow money to fuel their investment for future growth.

Quantitative easing (QE) is a mechanism where the central bank “prints” new money and uses this to buy the Government Bonds (Government debt) held by the banks.  The idea is that banks take the new money and buy other assets to replace the ones they have sold to the central bank. These assets could be new loans or company shares. This raises stock prices and lowers interest rates, which in turn boosts investment. Interest rates initially may come down because QE injects new money into the banking system, which will encourage banks to lend more.  As other banks also have more cash through selling Government Bonds to the central bank the extra competition should ensure that their interest rates fall.  After all, banks make money by lending money rather than paying interest to depositors.

Some of this extra money will find its way to businesses and households because banks are more likely to lend due to the extra cash they have.  This extra credit is expected to stimulate economic growth in Europe.

What other benefits to economists believe Europe will get from QE?

Economists like inflation to be around 2% – the “goldilocks” theory. This ensures economic growth is sustainable i.e. not too hot and not too cold.   Economists use changes in interest rates to deliver this 2% inflation target. If the economy overheats, causing high inflation, they increase interest rates, which reduces the amount of money in the economy to slow it down and reduce inflation.  If the economy slows down they can boost it by lowering interest rates, which injects more cash into the system, which increases growth and inflation.

Economists are terrified of deflation (negative inflation) because there is a limit to how far they can reduce interest rates to boost the economy.  That limit is obviously zero.  Deflation causes a spiral of economic malaise because consumers will delay buying goods and services if they think they will be cheaper at a later date because they anticipate further price decreases.  This causes a further economic slowdown, which further depresses prices, which causes consumers to further delay purchases…….. Economists hate this because if there is low growth and zero interest rates they cannot use their main tool (interest rates) to further stimulate the economy because they cannot reduce interest rates below zero.

Japan had a decade of lost growth due to deflation.

QE is seen as the answer to deflation because the extra money in the system causes inflation irrespective of interest rates.

Whilst the initial effect of QE may be to reduce interest rates eventually all this new money in the economy will drive consumption and increase prices, ultimately increasing inflation and therefore requiring an upward adjustment of interest rates.  This will then signal the need to end QE, which was implemented to head off deflation.

So QE is seen as the solution for Europe because it has no growth and low or negative inflation.  As QE causes inflation it can only be safely used when deflation is a serious risk.

There are further perceived benefits for QE. The extra “printed” Euros in the system will reduce their value on currency markets, which makes European products cheaper for the rest of the world to buy (driving exports) and imports become more expensive (causing European consumers to buy home grown products).  Both of these further help to boost the economy of Europe.

Finally, the eurozone’s national central banks will be buying their own government bonds from pension funds, banks and other financial institutions.  As central banks are part of government machinery this effectively reduces government debt by using printed money to buy it back.  This should reduce these Governments’ future interest payments to the financial markets.

This is the theory of QE anyway.  But economists have been wrong before……

This type of monetary easing has already been tried in Japan, America and Britain, with mixed results.

Japan first began printing cash in 2001 after interest rate cuts failed to create growth.   Arguably despite QE they have still not recovered.

America followed, creating $4.5 trillion of new money, while Britain issued £375bn.

There are questions over how and if QE works, although in America and Britain growth has returned and unemployment is continuing to fall.   Inflation unexpectedly fell in the UK despite QE but the theory is it would have fallen even more without QE.

Germany has resisted QE until now because the Euro is already relatively cheap for their economy (although perhaps still too expensive for Greece, Italy and Spain) and they historically worry about inflation after they experienced catastrophic inflation after the world wars.

As QE prints “new money” many worry that some of this “cheaper” money will be borrowed at a low rate and used to buy other assets such as property and shares – pushing those prices even higher. This could create another asset price bubble with shares and property becoming overvalued and causing another future economic crash.

Many also worry that QE will stop the other Governments in the Eurozone making the structural changes they need to implement to be more competitive.  QE could cause the weaker economies in the Eurozone to become complacent in reducing their spending, reducing their deficits and loosening up their restrictive labour markets.

Germany has reluctantly agreed to QE because the serious threat of deflation is now a real risk.

So QE is a desperate measure to breath some life back into the Eurozone economies as they cannot reduce base rates further.  It is a last resort.