Legends of the Greek Fall

Why has the world’s premiere deficit-reduction laboratory produced such a dismal failure? European leadership still expects the painful über austerity measures imposed on Greece to result in a dramatic improvement of its debt to GDP ratio. But the experiment in endurance is not succeeding for an important reason: Austerity programs have been rooted in myths about what caused the crisis in the first place.

The popular notion that government overspending is the basis of Greece’s deficit woes is simply wrong. Evidence doesn’t support what seems to be a never-ending scolding about profligate spending.

Greek national expenditures were at about 45 percent of GDP in 1990, long before the crisis. That share remained stable through 2006. Proportionally, its size was well below that of France, Italy, or even Germany. While Greece has a reputation for a nasty, historically oversized public sector, in the lead up to the crisis it behaved no differently than its neighbors, and its rate of spending didn’t prevent it from catching and surpassing affluent eurozone nations in growth. Rapid spending increases weren’t notable until the 2008 recession. The timeline reinforces the conviction that long-term government extravagance hasn’t been key to the Greek meltdown.

Its debt picture was also steady. For years, Greece ran a deficit of 3 to 5 percent of GDP, and roughly a 120 percent debt to GDP ratio without any market upheaval. In 2000, just before it joined the euro, its deficit was 3.8 percent, where it more or less remained through the early euro years. Government borrowing didn’t explode until the sovereign debt crisis surfaced in 2009, which indicates that its record of national debt wasn’t the primary cause of Greece’s deficit crunch, either.

Other trends were more worrisome than government spending and borrowing. Revenues, for one, had been a creeping problem. Even before Greece joined the euro, it lagged considerably behind other European economies in tax collection. A Levy Institute analysis shows that by 2005, revenues from income and wealth taxes in particular, were still well below other European countries. The notable increase in government revenue, from 9.8 percent of GDP in 1988 to 2005’s high of 13.5 percent (before stabilizing at a slightly lower level), was mainly from an increase in social contributions. Tax evasion was rampant in the robust shadow economy.

In the late 1990s another danger emerged. Investment was concentrated in construction, while machinery and transportation equipment, more important for creating productive capacity, played a smaller part. Greece’s increase in investment relative to savings and its strong growth in real GDP became dependent on private sector demand that was driven by debt. Household consumption, meanwhile, was being financed by running down family financial assets, as well as by borrowing. The private sector became a net borrower against the rest of the world.

Sound familiar?

These weren’t the only issues underlying the Greek crisis, of course. To tick a few more linked fundamentals off the list: A problematic effective exchange rate was propelling a deterioration in the trade balance. Export prices had risen much faster in Greece than in the rest of the eurozone, with Greek companies unable or unwilling to absorb euro appreciation by lowering their margins. At the same time, the transfer balance—mostly remittances from abroad—declined. Then property income fell.

Most importantly for the future, in contrast to some other troubled countries, Greece’s private sector, as well as its government, has a net debt against foreigners. This combination means that Greece must transfer real assets, rather than just financial ones, if it is going to reduce total debt.

Not one of these problems is likely to improve under a continued austerity regime. And while the probability of reaching European Commission targets is a fantasy, the fallout from making deficit reduction the foremost priority has been radioactive. Poverty and unemployment have increased disastrously. The threat of even more worker lay-offs, with a resulting national collapse, remains. Per capita GDP has declined by at least 5 percent in each of the last four years. By these and numerous other measures, cost-cutting has fueled a deep recession and devastating economic and social corrosion.

Before Greece’s debt and deficit troubles can be resolved, GDP growth needs to be restored, not the other way around. This in no way minimizes the debt’s alarming potential, and the need to roll it over at low or even zero rates. Even at the current lower interest level, payments could quickly become astronomical. Despite this, a focus on growth must be central.

Last year we finally saw small, scattered walk-backs from support for austerity policies. Let’s hope that this year will bring a giant step away from cherished—but nonetheless imaginary—legends of Greece’s fall.