Research Affiliates: Greek crisis shows limits of debt-financed consumption

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Chris Brightman, head of the Research and Investment Management Team and Shane Sheperd, senior vice president and head of macro research at Research Affiliates argue that the Greek crisis illustrates the limits of debt-financed consumption. 

The old saying, “You can’t squeeze blood from a stone,” vividly describes the futility of trying to extract more resources from something than it has to give. The expectations the Greeks have for renegotiating their debts requires them to do exactly this, squeeze blood from a stone. Only by increasing tax collections can Greece reverse the painful reduction in government spending, services, and employment known as austerity.

Today’s Greek crisis is no longer about its involvement in the euro. Nor is it about the disconnect between unified monetary policy and disparate fiscal policies—as important as that inconsistency is. The present standoff is a powerful demonstration of the limit to debt-financed consumption.

The amount of debt that Greece has accumulated is staggering. Where will the money come from to repay the mountain of obligations as they come due? In principle, Greece can take one of three routes:

1. Create the necessary new wealth through economic growth,

2. Transfer resources from existing programs to debt service, or

3. Kick the can further down the road.

But, given its meager growth prospects, the Greek economy cannot hope to generate the new wealth necessary to repay its maturing debts. And with the recent election of the Syriza party, voters have effectively rejected the implausibly deep and sustained cuts in government spending and services necessary to meet principal and interest payments. Greece may be able to “extend and pretend”—stretch out its past debt and make believe it will be able to pay it off—but no new credit will be available. The now unavoidable and obvious result is that Greece has hit its limit for debt-financed consumption.

The troika of European lenders (the European Union, the International Monetary Fund, and the European Central Bank) who hold Greece’s fate in their hands is insisting that the Greeks cut government spending in order to “live within their means.” But the reforms demanded go far beyond shifting amounts between lines in the budget. Implementing the reforms stipulated by the troika requires a dramatic shift in the entire ethos that characterizes the country’s economic culture.

For Greek citizens, tax evasion rises to the level of a national sport. The Wall Street Journal recently estimated that at the end of 2014 the Greeks owed their government €76 billion ($86 billion) in unpaid back taxes, roughly 35% of GDP! The Syriza party ran not only on an anti-austerity platform, but also with strong anti-tax rhetoric. As the party’s election became more and more likely, many Greeks halted tax payments, resulting in January 2015 tax revenues that were 23% below expected levels (Karnitschnig and Stamouli, 2015). Needless to say, this does not herald fundamental change.

Spending norms also require radical adjustment. As Figure 1 shows, Greek government expenditures have consistently and dramatically outpaced revenues over the last 35 years!

Obviously, this phenomenon was not brought about by Greece’s entry into the eurozone in 2001, although the fiscal deficit did reach a peak gap in 2009, with general government expenditures climbing to 54% of GDP and government revenues to 38%.

Many decades of unchecked spending and lackluster tax collections, as shown in Figure 2, have resulted in government debt levels soaring to 175% of GDP, a ratio that has only risen more with the recent program of fiscal austerity.

True, spending restraints have helped push Greece into a primary budget surplusillustrated in Figure 3, for the first time since the dubious statistics of the mid-1990s and very early 2000s were published. (The data were probably manipulated as Greece pushed for admittance to the eurozone.) But even if debt levels have fallen, GDP has fallen faster—at an average rate of about 6% per year over the last five years. The prescribed cure has arguably made the patient sicker.

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