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VIDEOTo Greeks, Germans: Don't Repeat the Folly of "Shock Therapy"
By
James Kostohryz
Feb 03, 2010 8:30 am
Consider this alternative.
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Reading about this presumed deal is depressing because it shows the utter inability of world leaders to learn anything from history.
As a finance professional, I cut my teeth as an emerging markets analyst in the 1990s, a time when IMF-sponsored “austerity plans” and “shock therapy” were all the rave. And anybody that's vaguely familiar with the implementation of these plans in Latin America and South East Asia knows that they were a colossal failure virtually everywhere they were implemented.
Cutting government spending and/or raising taxes while an economy is contracting has proven itself many times over to be a recipe for turning a recession into a depression.
The allure of such plans is inexplicable from an empirical standpoint. It's absolutely clear that these plans don’t work.
Thus, the allure of these plans can only be explained in psychological terms. Austerity plans satisfy the need to “punish” fiscal deviants for their bad behavior. They satisfy the human desire to see “justice” done whereby bad actions have predictable bad consequences for the perpetrators.
As understandable as austerity plans may be psychologically, they're bad economics and even worse politics. Deficit cutting in the midst of recession predictably causes a contraction in economic activity, lowers tax revenues, makes deficits even worse, amplifies fears of default, and seizes up credit markets for the sovereign’s bonds and the private businesses of the nation. Furthermore, unemployment and overall hardship rises to a level that's politically unsustainable, which almost always leads to the collapse of the governments that entered into the agreements. A complete reneging of the agreements by a populist and nationalistic successor government usually follows.
According to one research organization called High Frequency Economics, the attempt to cut Greece’s public sector deficit in half would probably push the unemployment rate there from the current 9.3% to over 16%. What kind of sense does such a policy make? It's suicidal.
Neither Greek nor EU officials have requested my advice. But based on my experience in this field, I'd offer the following policy alternative:
1. For fiscal year 2010, Greece should agree to freeze government spending and tax rates at 2009 levels -- levels that should be highly stimulative to the economy. This can create some positive economic momentum.
2. The EU will agree to provide guarantees to finance any amount of government deficit that the Greeks are unable to raise in private markets at a rate 250 basis point above a basket of EU sovereign bonds. Such a provision would ensure financing, and by virtually eliminating the risk of default, it would almost certainly insure a contraction of credit spreads to well below the above mentioned 250 basis points.
3. Starting in 2011, Greece should be obliged by binding covenants to cut government spending by an amount that's equal to 50% of the previous year’s GDP growth. For example, if Greece were to register growth of 3.0% in 2010, 4.0% in 2011, and 4.0% in 2012, government spending would be cut by the equivalent 1.5% of GDP in 2011, 2.0% in 2012, and 2.0% in 2013. In the context of positive economic momentum, such cuts will be unlikely to derail growth. To the contrary, they're likely to build tremendous “confidence momentum” towards the nation, a fact which should greatly stimulate private sector investment and employment.
4. Greece would maintain the above commitment for whatever number of years necessary until a fiscal surplus were achieved. At that point, the nation would be relieved of its covenants. (In the event of an intervening recession, the Greeks would be allow to increase government expenditures during the recession by as much as 3% of GDP.)
5. According to my own simulations, under the proposed plan, five years of consecutive GDP growth would be sufficient to bring the Greece’s finances into a comfortable surplus.
The plan that's apparently being worked out between the Greeks and the EU is just plain dumb. I fear for the Greek people. Furthermore, I fear for the potential repercussions that a failure of the plan currently being negotiated could have for the European Union and the world as a whole.
I write this article with full knowledge that it's highly unlikely that anyone with decision-making power in Europe is going to listen to my alternative proposal. But I offer this basic plan to show readers that better alternatives are available.
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