Souvlaki – May 10, 2010

About twelve or thirteen years ago, as the great Euro project was coming together, I had occasion to speak with a prominent European businessman, the treasurer of a major Spanish company.  I told him I was skeptical about the whole idea, because I did not see how so many disparate economies could mold themselves to a single monetary policy.  His response was illuminating, and uncharacteristically frank: he said European business hoped that the Euro’s disciplines would force politicians to make reforms to their social and labor policies that they did not have the political will to achieve on their own.

So much for that.
The Euro was always as much a political exercise in inclusion as it was the formation of a serious monetary union.  Everybody knew at the time that all the Mediterranean countries were fudging their accounts so as to meet the requirements.  They were re-classifying different types of governmental expenditure, making under-the-table swap agreements with other countries, understating debt, everything they could think of to qualify.  I remember how shocked we were when Italy was deemed to pass the test, when only the year before their national accounts were an absolute mess.
These shenanigans were far more consequential than just a little finagling to join the club.  The rules were set in place because the very experiment of a single currency and the European Central Bank depended for its credibility on one core principle: that there would be no “free rider.”  If any country failed to adhere to the debt limits established in the Maastricht Treaty, the question would inevitably arise – would the rest of the participants allow that country to go bust?  And if not, then there is no Euro discipline, and the Germans, Dutch, and French, the more industrious countries of the North, would be cast in the role of wealthy uncle to whom the indolent nephew comes whenever he finds himself in troubled straits.
This spring, Greece cried “uncle!”
Ironically, the deficit limits were first stretched by the French and the Germans – in the mild recession that followed the dot-com bust, they both ran deficits that were greater than the 3% limit.  There were no sanctions – instead, the rules were changed to make it less onerous, with more time allowed to bring large deficits under control.  After all, everybody knew that France and Germany were true-blue participants in the European project.  But the trouble with relaxing discipline is that it never tightens back up until one’s back is truly against the wall.
Meanwhile, Greece and the rest of Club Med was enjoying a free lunch they never would have had otherwise and ultimately did not deserve.  Interest rates were low because the fear of drachma devaluation had been removed and bond investors were more comfortable lending.  And instead of taking advantage of that largesse to put its fiscal house in order, Greece continued to spend more than it took in.
Greece is a good example of the logical end of “social spending” policies, and that’s why it’s a cautionary tale for us.   In Greece today, the government’s expenditures are 50% or more of the economy.  If you think it through logically, it is clear as day that a government cannot fund itself from the part of the economy that it pays for: that would be like paying your own salary out of your paycheck.  So the other half is supposed to pay for itself and the government’s part as well.  Except that even the non-government part is not productive, in great part because of the government – regulations and taxes make the Greek economy one of the least productive in all the developed world.
The place is riddled with distortions and special treatments.  It is common for government workers to retire at 53.  The number of special exemptions to taxes are legion – if you work in a “dangerous” occupation you are forgiven some or all of your tax obligations.  This includes such life-threatening livelihoods as hairdresser (apparently those chemicals they use should not be sniffed).  Some twenty percent of the populace pay the vast majority of all taxes.  Greece is also ranked with the lowest among developed nations in its measures of economic freedom, because of its corruption, and because it is so hard to start a business, to hire and fire people, to pay its onerous taxes, and so forth.
All this regulation and special treatment ultimately came about because politicians could not resist the temptation to feed constituents from the public purse.  As I have said so often it makes me weak, the path of least resistance is for politicians to spend other taxpayers’ money on those who elect them, or to establish rules that favor them at somebody else’s expense.  When that giveaway party becomes a culture, pols enable each other in the debauching of the national purse.
And the giveaways are very, very hard to take back.  That’s the big problem.  It’s not like a corporation, which can lay off people by the thousands if the money isn’t there.  Government employees, almost always unionized, can bring the country to its knees with a general strike, and the government almost always capitulates.  When the government pays for European-level service (hospitals, transport workers, truck drivers, ticket-takers, police, firemen, and all the rest), a general strike means doors stay closed across the country.  It takes a Maggie Thatcher to stand up to that kind of pressure.  More likely, some enterprising populist will come along and get himself elected by promising to repeal the laws of economics, and the merry go round takes another turn.
And now, Greece’s back is well and truly against the wall, and they will perforce push through the Draconian reforms that have been needed all along.  And the millions that have been counting on a cushy early retirement will be outraged – and not without reason.  It is not their fault that their feckless government made solemn promises it had no capability of honoring.  It will be the true test of this trillion-dollar bailout fund, announced over the weekend, to see if the government can hold with Thatcher-like steel in the face of repeated angry, violent strikes, in the face of riots, deaths, and an economy that is closed for the duration.
The true irony of this whole thing is that, if the reforms do go ahead, it will not bring about a cheerful economy until after years of recession.  Because at this point, the government has only two options – cut spending, and raise taxes.  The bailout money it is getting is coming in the form of loans, so that will not help the national accounts – it will only make the debt situation worse.  If they were smart, they would cut some of the reams of red tape that shackle the entrepreneur.  But otherwise their actions will throw thousands out of work and slow the economy to a crawl.  They have no choice, except a national default.
And that is why this is a doomsday vision of America’s course.  If we do not get a handle on our Federal spending, we may find ourselves in the unpalatable position of having to emulate Greece’s desperate measures – throwing people off the government payroll while at the same time raising taxes on those who are not.  While I’m all for reducing government employment, having to do so in a Greek rush while at the same time raising taxes will bring some of the same social fury and economic calamity that Europe is destined to face.  We do not want to go there.
Think it can’t happen here?  Look to California, where even the hugely popular Governator couldn’t overcome Sacramento’s culture of spending OPM (other people’s money).
One last irony: one of the demands the IMF is making of Greece in exchange for its bailout dough – cut back on government health care.
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