Originally Posted by katwrimos
Greece’s — and for that matter any country’s — government debt is meaningless when viewed as a mere number. What matters is not the size of the debt by itself, but its size relative to the total output that the economy produces, i.e. its debt/GDP ratio.
It is in these terms that any fiscal planning should be evaluated; if measures to decrease a country’s debt bring as a by-product an even greater reduction to its output, these measures are no good.
The austerity measures imposed on Greece by the EU and passed into law last week, are flawed in this sense. In a nutshell, Greece will attempt to reduce its debt by increasing the tax burden of households. Even individuals earning less than €12,000/annum will be asked to pay a few hundred euros more.
At the same time, the Greek government will further cut spending on practically all fronts. But the question is not how many euros the government can save. What matters, and what the markets are interested in, is how the debt to GDP ratio will be affected.
Sure, the numerator will decrease, but standard economic theory tells us that the denominator will decrease as well, offsetting any gains. GDP is the sum of consumption of households (C), government expenditure (G), investment (I) and exports minus imports (NX).
When the government taxes an individual in order to pay back debt, that person has fewer euros in his wallet to spend on goods and services, and the GDP drops, unless that person has enough savings to offset the drop in his income.
This is why taxing low-income households is likely to be contractionary, as their savings are insignificant and usually illiquid (that is, assets that cannot easily be sold to finance consumption, such as pension funds and real estate).
At the same time, reducing government spending by, say, cancelling an infrastructure project, yields some savings but ends up hurting the GDP even more as the income of the engineers and labours working on it vanish.
Worse, this is a feeble and self-reinforcing process: decreasing the numerator (debt) by one euro tends to decrease the denominator (GDP) even more. Acconcia et al. did the math for the case of Italy and found fiscal spending multiplier effects ranging from 1.2 to 2. I would not like to get too much into technical details but there are strong reasons to believe that their results are quite indicative of what to expect in Greece as well.
I am thus very pessimistic and expect the Greek GDP to contract substantially more than the 4-5% figures forecast by the IMF and Eurostat. The latest austerity measures have made the Greek debt burden even more unsustainable; thousands of households will suffer in vain.
And the bad news does not end here. At the moment, for all the irresponsible past excesses of the Greek government, households hold relatively little debt, which normally implies that once the debt issue is resolved, the economy can be expected to resume rapid growth.
However, in the face of such harsh austerity, it is very likely that households will find themselves in increasingly deteriorating finances. Waves of private defaults on loans and mortgages cannot be ruled out. Additionally, pain and fear might lead people to keep their money in safe assets such as deposits in German and French banks, rather than investing them.
Greece does not have its own central bank to make sure that demand for investment is satisfied by lowering the interest rate. If Greeks are keeping all their income in deposits in Germany because they are too scared to spend and invest, there is no one left to intervene and make sure that Say’s law becomes true in practice, even though it is wrong in theory.
I am therefore of the opinion, that even though the first austerity package passed last year was necessary in order to tackle structural problems in the Greek economy, the new one is a recipe for disaster, as it hurts the economy’s output in virtually all fronts; C, G and possibly I are in for a nasty ride.
The risk of turning a problematic yet manageable fiscal situation into a full-fledged balance sheet recession that might last several years is now more significant than ever. In fact, unless other factors such as an increase on EU-financed infrastructure spending or a significant increase in world trade prevail, the future for the Greek economy looks pale.
These predictions are not based on some occult arcane economic model. This is the same standard and uncontroversial neo-Keynesian analytical framework that was employed by economists such as Paul Krugman and Nouriel Roubini to timely warn of the 2008 financial crisis; that is used by the Fed and ECB to fine-tune the economy; that is used by financiers such as yours truly to make money.
It looks like a no-brainer that in a reality-based Europe, the EU decision-makers would employ the same framework to make sure that the entire Eurozone takes losses as small as possible, rather than repeating austerity, austerity, austerity on each and every occasion.
Why they have chosen to disregard it, in favour of dubious models and theories which the majority of academic economists call “heterodox crap” in private discussions, I do not know.
I can only speculate that we are witnessing the European version of a phenomenon that Paul Krugman first traced in the US (in a somewhat different, yet relevant in many ways, matter): in the dark age of Macroeconomics that we live in, policy makers have chosen to ignore the hard-earned past knowledge, in favour of whatever they think their voters want to hear, defending debunked theories that have been shown to be wrong in the process.
Unfortunately, we do not — presently — live in a reality-based Europe.
