Sunday, January 6, 2013

Internal deflation versus external devaluation

Mark Weisbrot/Rebecca Ray have published a most interesting analysis of the Latvian experience with austerity. Even a non-economist can easily understand their conclusion, which is: given the chance, internal deflation is a much more costly strategy than external devaluation when it comes to turning an economy around. In the case of Latvia, the loss of GDP and the length of the adjustment period were greater than in all other compared countries which applied external devaluation (n. b.: Economists have a way of presenting their cases in such a way that a non-economist finds them totally convincing. However, there is always an 'on-the-other-hand', also in the case of Latvia, and that other hand of Latvia is presented here).

Does all this have a bearing on Greece? No, it doesn't if one follows the premise of given the chance. De jure, Greece did not have the chance of an external devaluation, something which is not provided for under the Lisbon Treaty (obviously, in practice no one could have prevented Greece from exiting at its own will).

The interesting thing is that Weisbrot/Ray's argument is more or less the same as that which Prof. Hans-Werner Sinn has made very forcefully from the very beginning of the crisis. According to Sinn, the length, social cost and unfairness of internal deflation would become socially unbearable, thus Greece should exit the Euro, make its adjustment within a Drachma-environment (because that is easier) and then rejoin the Eurozone. Sinn has been crucified for that view; Weisbrot/Ray are being applauded for it.

Personally, I have always been and still am against the alternative of a Grexit. A Drachma would return the Greek economy to a standard which may very well have been totally acceptable to Greeks 30 years ago (high inflation, continued devaluations, expensive imports, cheap tourism, etc.). However, I simply can't believe that the Greeks of today, particularly the younger generation, could be kept satisfied with 'such a Greece'. If they couldn't get in Greece the kind of modern life and living standards which they desire, they would simply leave the country, making Greece even poorer. Thus, the extreme adjustment pains of today are to me, theoretically speaking, nothing other than the price which one generation pays so that the next generation has a fairer chance in life.

Which brings me to those 'adjustment pains' (aka 'austerity'). Papers have recently been full with articles about the 'amazing mea-culpa from the IMF'. Had the IMF not made such blunders, austerity measures would have been much less front-loaded and the adjustment pains would have been a lot less severe.

That, of course, is assuming that it was the IMF's program which determined the Fresh Money needs of Greece and not the other way around. For 2009, Greece had a primary deficit of 25 BEUR and by now that seems to have been brought to break-even. In between, roughly 45 BEUR had to be lent to finance the primary deficit. Had the austerity been less front-loaded, Greece might have required 65 BEUR (or more) to finance the primary deficit.

The resulting program was probably a compromise between what the IMF would have considered as 'workable' and the financing constraints imposed by the lending countries. And there is no question that the results of the program are terrible. Unemployment of 25%+ simply cannot be considered as the 'normal price' which one has to pay during an adjustment process. On the contrary, it is a threat to social peace.

Paul Krugman argues that it will take Greece many, many years (far too many years!) to again reach the GDP-level of before the crisis. Once again, the Nobel Prize Winner sounds absolutely convincing. But does he make sense?

Greece's GDP was roughly 232 BEUR in 2008. Was that Greece's 'real GDP' or was it a balloon blown up beyond tolerance and seconds before explosion? Is that really the right base for comparisons? Shortly after the crisis erupted in late 2009, pundits calculated that if Greece returned to the Drachma, at least 40% of GDP expressed in Euros would be wiped out. From that standpoint, Greece's 'real GDP' of 2008 would have been closer to 150 BEUR than to 232 BEUR.

One must bear in mind the depth of the macro-economic mess which Greece was in by 2008. Here are a few facts:

* Exports were only 9% of GDP
* Imports were 27% of GDP
* For every 1.000 Euro of exports, 3.200 Euro were imported
* For every 1.000 Euro earned abroad, 2.900 Euro were spent abroad
* Current account deficit was 35 BEUR, or 15% of GDP
* Budget deficit was 15%

Yes, an IMF-expert analyzing from an office in Washington, DC, under no pressure to produce any 'desirable results', might have suggested that such a mess requires at least 10 years of reasonable adjustment to make the social cost bearable. At the same time, when looking at such a mess, lending countries probably felt that such a situation required a sledgehammer in order to justify the new lending to their electorates.

That brings me back to the million-Euro-question: What alternatives would Greece have had? What could Greece have done differently? What could Greece still do differently?

There is at least one thing which could have been done to reduce the social cost of the adjustment; in fact, to accelerate the adjustment in a positive way. Even a non-capitalist country like Cuba opted for that 'one thing' after they lost Soviet funding. One can only wonder why Greece as a country or the EU as a union have not been able to come up with the most obvious measure which becomes necessary when a country which needs foreign funding loses access to foreign credit.

That solution is foreign investment. Bear in mind that even Cuba, possibly the last communist stronghold in the word, realized that without foreign investment they would collapse. And Cuba attracted quite a bit of foreign investment, particularly Canadian investment in tourism.

It may well be that, beginning in 2013, Greece will transform into a success story for technocrats. For all we know, the primary balance of the budget might show ever-growing surpluses and so may the current account balance.

Yes, it could transform into a success story from that point of view but all of that could become totally immaterial if unemployment stayed around 25%, or even increased towards 30%. Such levels of unemployment totally thin out the social fabric. It may never come to an explosion or it may. If it does, it happens quickly and irreversibly.

The formula is quite simple: no new employment without new investment and no new investment (particularly foreign investment) unless specific measures of promotion are taken. Foreign investment is not only important in terms of the funding it brings but also, if not even more important, in the context of know-how transfer from abroad which comes along with it.

The more I read about the Cosco-experience in Piraeus, the more excited I get about it as a prototype for successful foreign investments. Cosco is a large foreign investment. There may not be too many in that category. Greece has to go for an industrial 'Mittelstand', i. e. many new investments, albeit smaller ones, all over the country.

"One little Cosco a day (or a week...) would keep many problems away!"


  1. I see government owned Container Terminal #1 handles 625,914 boxes in 2012 - an increase of 27.5%!

    Surely that's the effect of competition at its best - success breeding success.

    I think the internal traffic goes through #1


    1. I guess great minds meet... I had actually thought exactly the very same thing when I first read that article about #1.

  2. One can only wonder why Greece as a country or the EU as a union have not been able to come up with the most obvious measure which becomes necessary when a country which needs foreign funding loses access to foreign credit.

    I have some ideas on this which I need to ponder before committing pen to paper - the term 'single market' is one of the strands in my thoughts.

    In six hours we'll know if your friends prediction for a Grexit this weekend will come to pass. I tried to find a bookmaker to give me some odds. None were interested, I guess they couldn't find anyone to hedge with.


    1. I am afraid an old boy of the British Empire, my friend, will meet his personal Waterloo tonight, after all...

    2. I hope he didn't bet the bank on it

      I would have invested $20 if I could have found a willing risk taker - I should have asked Jamie Dimon :lol: