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The Greek economy three years into the crisis:

The Greek economy three years into the crisis: Structural weaknesses, adjustment policies and the way forward. Dimitris Malliaropulos * Institute of International and European Affairs ( IIEA ) Dublin, November 16, 2012.

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The Greek economy three years into the crisis:

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  1. The Greek economy three years into the crisis: Structural weaknesses, adjustment policies and the way forward Dimitris Malliaropulos* Institute of International and European Affairs (IIEA) Dublin, November 16, 2012 • Professor, Department of Banking and Financial Management, University of Piraeus • Economic Research Advisor, Eurobank Group

  2. Outline: • Structural weaknesses 2009 • Economic adjustment policies 2010-2012 • Rationale of 1st and 2nd MoU • What went wrong? • A graphical history of Troika’s policy (AD-AS) • Current state of Greek economy • Short and long term growth outlook • Conclusions

  3. Structural weaknesses 2009: • Overconsumption: Private consumption peaked at 75% of GDP (EA=57%) Graph • Weak external sector, loss in competitiveness: • Exports of goods (& services) 2009: 9% (19%) of GDP • Imports of goods 2009: 27% of GDPGraph • Size of underground economy ~30% of GDP • Fiscal profligacy GraphSlide 28 • Political clientele system / political business cycle: use of public spending to “buy” votes • Weak pension and healthcare system (weak population growth, one employee per pensioner) • Weak tax administration & collection system (36% of labor force self-employed, tax evasion >8% of GDP) • Ease to do business (Ranks 78 out of 185 globally)

  4. Economic adjustment policies 2010-2012 POLICIES SUCCESS • Fiscal consolidation + • Internal devaluation + • Structural reforms = • Privatizations - • Debt restructuring +

  5. Drastic fiscal consolidation 2010-2012 • Fiscal effort 2010-2012 = 23% of GDP • Planned fiscal effort 2013-2016 = 10% of GDP • Effective decline in budget deficit 2010-2012 = 9% of GDP Graph • But: decline in “structural” budget deficit 2010-2012 = 14% of GDP Slide 29 • The difference between “fiscal effort” and “fiscal outcome” (14% of GDP!) is due to deepening recession Graph • Gap between “effort” and “outcome” raises two questions: • 1. Issue of distribution of fiscal measures between expenditure cuts and tax hikes • 2. Did Troika underestimate the effect of austerity on the real economy? Size of fiscal multiplier in a recession

  6. Fiscal consolidation (continued) The breakdown of fiscal measures between expenditures and revenues • Fiscal effort was nearly evenly distributed between cuts in expenditure and increases in revenues. • Effectively, most of the deficit reduction was due to cuts in expenditures as deepening recession reduced tax base and increased tax evasion. • 2013 budget focuses mainly on expenditure cuts. • More even distribution in 2014.

  7. Fiscal consolidation (continued) Did Troika underestimate the size of the fiscal multiplier? • 1st and 2nd MoU was based on the assumption of an average fiscal multiplier of ~0.5 • A multiplier of 0.5 implies that for every 1% cut of primary budget deficit, GDP declines by 0.5%. • Recent IMF and Eurobank studies show that fiscal multiplier is much higher in a recession, of the order of 1.3 to 2.3, depending on the type of public expenditures • Fiscal multiplier is high for public investment, wages and pensions • Low multiplier for taxes (likely due to negative effect on tax base - tax evasion) • Two implications: • Troika underestimated the recessionary effect of austerity. Fiscal drag: 9% x 2 = 18% of GDP. • Focus on wage and pension cuts in 2013 budget will deepen recession

  8. Internal devaluation Faster than expected • Relative ULC restored to 1995 level within three years Slide 30 • Current account deficit declined faster than expected Slide 34 • But, effect on CA deficit mainly through imports/recession, not through exports (although the later did relatively well) Slide 35 • Competitiveness gains will likely pay out in the long term Graph • Why did wage cuts not translate into absolute price declines-deflation? Graph Is deflation desirable? • But, the competitiveness gap is mainly due to increase in relative prices of nontradables Graph • Also, competitiveness is a sectoral issue Graph

  9. Structural Reforms Slow LABOR MARKET REFORMS • Adjustment / Reduction of wage floors: • 22% reduction in the minimum wage • 32% reduction in the minimum wage for employees under the age of 25 • Structural measures to level the playing field in collective bargaining • Shortening the length of collective contracts and reduction of their ‘after effects’ time. • Removal of ‘tenure’ (contracts with definite duration defined as expiring upon age limit or retirement) in all existing legacy contracts in all companies. • A freeze of ‘maturity’ (referring to all automatic increases in wages dependent on time) until unemployment falls below 10 percent. • Elimination of unilateral recourse to arbitration • Adjustment to non-wage labor costs: • Close earmarked funds engaged in social expenditures • PENSION & (initial) HEALTH CARE REFORMS • Future rise in public pension expenditure not to exceed 2.5 % of GDP or the EU-wide average of 14% - (5/2010) • Retirement age in line with life expectancy; benefits linked to lifetime contribution; disincentives for early retirement • Health expenditure not to exceed 6% of GDP (2nd MoU) • Social security funds merged into one (EOPYY), equalizing benefits and contributions • Overhaul of the list of difficult and hazardous occupations, Disability criteria and rules revised (since Sep. 2011) • Pharmaceutical expense reduction (2nd MoU)

  10. Privatizations Insignificant • Ambitious target: revenues from privatizations EUR 50 bn until 2020 • Outcome: EUR 1.8 bn until now • New target 2013-2016: EUR 9.6 bn • Total assets of Greek state estimated at EUR 45-50 bn • But: Valuation is hugely imprecise – depends on future market prices. Market prices will likely collapse when government starts to privatize 20-28 bn of real estate assets

  11. Debt restructuring: Benefits and costs PSI too late (March 2012) • Benefits: • EUR 105 bn haircut • Interest savings on official sector debt 150 bps p.a. • Maturity lengthening from 7 to 12 years • Costs (EUR 50 bn): • Bank recap due to haircut EUR 30 bn • Hit on pension funds EUR 16 bn + EUR 4.3 bn in new EFSF bonds for pension funds (new debt) • Debt sustainability analysis: the role of growth • Debt-to-GDP: b(t) = b(t-1)*(r-g) + pd(g) • pd(g): For every 1% increase in GDP, b declines by 2.2% • Do we need an OSI? • Interest rate reduction on bilateral loans (EFSF loans) • ECB-ESRB holdings • Debt forgiveness?

  12. Debt sustainability

  13. The outcome of the Troika policies was a vicious cycle – “death loop” for the Greek economy Austerity  recession  more austerity  more recession Bailout + austerity Sovereign problem Economy Hit on banks • Greek recession is so far one of the largest in world history since the Great Depression. Graph. Likely to become THE deepest recession. • Question1: How did we come to this vicious cycle? A diagrammatic history of the Troika policy since 2009. • Question 2: How to break this vicious cycle and turn it into a virtuous cycle?

  14. History of Greece’s economic adjustment program. Greece 2009 Inflation Long-run aggregate supply LAS π Aggregate supply AS B A 2009 C Aggregate demand AD GDP Y* Y In 2009, Greek economy was operating above capacity. Excess demand (point A). Two possible equilibria (B, C). But B unfeasible, as it implies higher inflation, hence further losses of competitiveness. Troika tried to move economy to point C.

  15. Troika’s original idea during 1st MoU • Fiscal consolidation: Negative effect on real economy – recession • Internal devaluation: Positive supply side effect – economic rebound (projected for 2012) Troika also counted on two secondary positive effects: • Crowding in (fatal mistake for an economy such as Greece as interest rate channel did not work) • Rebound in exports due to higher competitiveness

  16. Troika’s original idea during 1st MoU (continued) Inflation LAS π AS fiscal consolidation AS’ A 2009 B 2010 C 2012 AD Internal devaluation AD’ GDP Y* Y • Basic idea of 1st MoU: Fiscal consolidation will induce a recession (point B). Wage declines and labor market reforms will gradually generate a positive supply effect and move the economy towards potential output (point C) in 2012.

  17. 1st MoU failed to initiate an economic recovery Three flaws: • Fiscal multipliers proved to be much higher than thought. Economy moved into a deeper recession as domestic demand continued to decline • Competitiveness gains need time to translate into higher export shares. In addition, Troika did not have a clear view on the role of relative prices of tradables vs nontradables. Instead, push for generalized deflation • Structural reforms proved more difficult to initiate. Democratic societies cannot change completely overnight. In addition, supply side effects materialize only in the long run

  18. 2nd MoU: more of the same shock therapy 2nd MoU official in March 2012 Main idea: push for further wage cuts – liberalization of labor markets in order to generate a stronger supply side effect. In addition, debt restructuring would restore confidence Three flaws: • Wage cuts and further fiscal measures intensified recession due to negative multiplier effect • Confidence was not restored after PSI as European politicians opened the debate on GREXIT • Troika underestimated risk of depression as economy was in 5th year of recession

  19. 2nd MoU: Greece in depression Even this policy could have worked in the long term, provided that suggested policy mix would not affect potential output. But it did as it affected long-run supply of production factors Destruction of human capital through long term unemployment Destruction of productive capital through negative net investment Graph Negative TFP effect as both capital and labor declined. TFP counts for 1/3-1/2 of GDP growth Capital flight due to talk about GREXIT Graph Liquidity squeeze of companies as banks were hit by huge capital losses due to PSI and ECB closed liquidity taps Migration of most valuable human capital

  20. The 2nd MoU: The “real” downsizing of Greek economy due to destruction of productive resources Inflation LAS π AS fiscal consolidation Internal devaluation B 2010 AD GDP C 2012 Y* Y • Note: deflation process started (GDP deflator: -0.5% 2012, -1.2% 2013). Further wage cuts likely to intensify deflation. But with π<0, supply side effects reverse. The interaction of deflation and negative supply side effects is a DEATH-LOOP. Trust Ben Bernanke.

  21. What was the missing ingredient in applied policy mix? There are two ways to fight a sovereign debt crisis: • Growth • Inflation None of these was allowed to Greece Main flaw of overall policy mix: No growth enhancing policies • Public investment downsized (from 6% of GDP in 2008 to 2% of GDP in 2011) • Fiscal targets became moving targets

  22. Current state of Greek economy • Five years of recession = depression! • Unemployment at 25%. Youth unemployment at 57% Graph • A fragile political system • Polarization, rise of extremism But, also some achievements: • Fiscal consolidation • Rise in competitiveness • Pension system and labor market reforms

  23. Economic growth: short term outlook • Two more years of recession. • Deeper than projected recession in 2013 Delayed recovery. Three main causes: • Fiscal multipliers higher in recession ( deeper recession) • Labor market reform  wage cuts  weaker personal consumption • Delays in structural reforms • Privatizations • Liberalization of closed professions • Product market reform Positive growth rates likely after 2014.

  24. Long term outlook: Will Greece be able to grow out of its troubles? Likely. Why? What are the conditions for a recovery in 2014-2015? Fiscal consolidation / primary surplus. YES GRAPH Restoration of competitiveness. YES GRAPH Completion of structural reforms. MOST Recapitalization of banks. YES Restoration of confidence. ? Political stability ?

  25. If these conditions are met, then… Three new disequilibria: Negative output gap (>12% of GDP vs 0% historically) GRAPH Negative net investment of cumulatively > 9% of GDP by end 2012 And Gross operating surplus of companies as % of Gross Value Added of 60% vs 40% in EU-27. GRAPH Supply overhang, restored competitiveness, high profit spreads. Likely to trigger a rebound of fixed investment. Potential growth can be restored back to above 3% p.a. Is long-term growth of 3% feasible? GRAPH In the short term, (2015-16) growth can overshoot potential

  26. How likely is this scenario? Not unlikely, as Greece has • A healthy corporate sector (profitability still above EU average) • An educated labor force • Fundamentally healthy banks post recap • Past experience: • Strong productivity and TFP gains GRAPH • Strong investment dynamism GRAPH • But, risks exist. Bad outcomes are still likely, though with relatively low probability.

  27. Conclusions Deep imbalances of Greek economy prior to 2010 Greek crisis was an accident waiting to happen Drastic fiscal consolidation & internal devaluation But huge cost in terms of output losses and unemployment Troika underestimated cost of austerity Program must be rebalanced towards more growth-enhancing policies Extension of program by 2 years (done) and OSI necessary conditions for economic rebound and debt sustainability Risks are significant. Political fragility, social unrest.

  28. Graphs

  29. Overconsumption fueled by cheap credit and secular decline in savings rates Source: Eurostat, Ameco and Eurobank Research

  30. Widening of competitiveness gap is associated with loss of export shares Source: Eurostat, Ameco and Eurobank Research

  31. By end 2012, recession in Greece will be the 4th deepest in past 100 years. Longer than the Great Depression in the US. Source: IMF, Reinhart and Rogoff (2009) and Eurobank Research

  32. By 2014, Greece will likely run a primary surplus Source: Eurostat, Ameco

  33. Twin deficits: Since the start of EMU, Greece had worst rank within EZ Greece is the biggest outlier, needs to improve competitiveness and its fiscal balances Source: Eurostat, Ameco

  34. Budget deficit peaked in 2009 to 15.6% of GDP! Source: Greek MoF

  35. Cyclically adjusted primary deficit has declined by 14 ppts of GDP since 2009 Source: Eurostat, Ameco

  36. Greek recession in its fifth year Source: Eurostat, Ameco

  37. Post-EMU Competiveness gap nearly eliminated. Source: Eurostat, Ameco database.

  38. Current account deficit down by 70% of 2009 level Source: Eurostat, Ameco database. • Current account excluding net oil imports is in surplus • Downside rigidity of CA deficit as 4.5% of GDP is net oil imports

  39. Adjustment of CA deficit came mainly through imports EUR bn Source: BoG • Decline in imports 2008-2012 = 34% • Increase in exports 2008-2012 = 3%

  40. Over longer periods, change in ULCs is negatively correlated with export shares Source: BoG

  41. Prices did not fall despite significant wage reductions because wage costs count for less than 22% of prices Decomposition of Final Price Index (ex VAT) profits Intermediate goods Fixed capital Wages Source: ELSTAT.

  42. Prices of nontradables increased much faster than prices of tradables. By 2009, 70% of competitiveness gap was due “internal” exchange rate Gap is due to increase in relative prices between nontradables and tradables Source: Eurostat, Ameco database, Eurobank Research.

  43. Competitiveness losses mainly in Agriculture and Industry Source: Eurostat, Ameco database, Eurobank Research.

  44. Deposit flight intensified after PSI due to GREXIT talk. Source: BoG

  45. The cost of austerity: Unemployment. Source: ELSTAT

  46. Recession has led to a huge output gap and loss in potential output. Source: Eurostat, Ameco database. • Accounting (since start of recession): • Real GDP -20% • Potential GDP -6.0% • Capital stock -2.3%

  47. Negative Net Investment implies destruction of capital Gross Capital Formation declined sharply from 20% of GDP in 2003 to less than 11% of GDP in 2012 Source: Eurostat, Ameco database.

  48. Greece continues to be a profitable investment destination. Source: Eurostat, Ameco database. Gross Operating surplus = Gross Value Added – Employee Compensation - Taxes on Production and Imports

  49. Decomposition of economic growth into its supply-side determinants Average GDP growth 1990-2008: Real GDP and factors of production, Greece vs EA Supply Side Determinants Source: GGDC, AMECO, Eurobank Research • Higher GDP growth was supported by higher employment growth, higher capital stock growth and higher TFP growth. • Contribution to long-term GDP growth = = capital 1.10 pp, labor 0.9 pp, TFP 1.00 pp. Potential growth = 3% p.a.

  50. Greek economy has shown high growth rates of labor productivity in the past. Source: Eurostat, Ameco database.

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