Percy Mistry

When pigs stop partying

— Percy Mistry

Extraordinary events have unfolded over the last six months. The apparently ‘sudden and shocking’ discovery of sustained Greek over-spending — resulting in an unsustainable debt burden — has destabilised the Eurozone. Belatedly, the Greek government has been found to be fiscally irresponsible and criminally negligent; cooking the books to obscure reality over a prolonged period. Whether that is also true of Portugal, Spain, Ireland and Italy (collectively referred to with Greece as PIIGS) is not yet known.

The most recent numbers (if they are to be believed, because the books are not yet properly reconstructed) indicate that Greece’s debt situation is, arguably, worse than that of Argentina, Brazil and Mexico (ABM) in 1982. If the numbers available for the other four PIIGS countries are to be believed (according to the IMF, they are of better quality and more reliable than those of Greece) their situation is not as bad; although the contagion effects of market reaction could make their situations much worse than they need to be. Of these four, only Ireland seems inclined to bite the bullet. The total debt of all five PIIGS is now nearly 4 trillion euro. That is 120% of the collective size of their economies, and about 30% of the entire EU economy. Their debt service requirements now amount to between 5% and 10% of their GDPs at a time when they are growing at about 0.5% on average and their debt is growing at an annual average of 15%.

It took a decade for ABM to emerge from over-indebtedness after a decade-long monetary and fiscal squeeze accompanied by dramatic serial devaluations. They saw their GDP decline by an aggregate of 35% from 1982 to 1992 with an average real per capita income decline of 40% over that decade. It was not until 2003 that Brazil saw real capita income climb back to where it was in 1981. The ABM countries effectively lost two decades of growth and development as a consequence of their over-indebtedness. Will the PIIGS suffer the same fate? That is the 4 trillion euro question.

In the ABM countries, in the 1980s eventual ‘recovery’ occurred only because creditors (after refusing to acknowledge reality for five years) were finally obliged under the Brady Plan (a variant of the Mistry Plan published in The Banker magazine in September 1987) to: (a) take a haircut of 40% on face value of the deep discounted bonds which were exchanged for syndicated commercial bank loans or, alternatively, (b) stretch out the terms of the residual debt held for 25 years at a substantially reduced interest rate — which resulted in discounted NPV of roughly the same amount as a 40% face-value reduction up-front. That background is sobering to remember for what lies ahead for Greece and other Southern European countries (the PIGS).

Only fiscal policy

With the demise of the drachma and adoption of the euro, the Greek tragedy has resulted inevitably in intense trauma for Europe. This was not unanticipated. It was an accident waiting to happen. Knowledgeable pragmatists were concerned about an artificial, synthetic currency with no ‘natural’ constituency, being adopted across a monetary union of 16 disparate economies (i.e. in terms of their structural characteristics, varying levels of development, and different political/public sector cultures governing fiscal responsibility). Though the European Central Bank (ECB) was created, there was no equivalent unitary fiscal authority to exercise fiscal discipline; in the same way that the ECB can exercise a limited degree of monetary discipline and provide a modicum of exchange rate stability. That accident has now triggered three different shocks:

1) A dramatic denouement accompanied by unwillingness on the part of the Greek (and other PIIGS) public sector and its civil servants in acknowledging culpability and facing up to a different future reality.

2) Reciprocal trauma on the part of Germany (the only large EU economy in fiscal balance and external surplus) which now has to pay for the profligacy of its Southern European neighbours (and possibly some newly acceding countries as well) with very little recourse to opt out; it is locked in to supporting the Euro.

3) Belated realisation on the part of the public sectors and the populations at large of the PIIGS that, being in the Eurozone, neither exchange rate flexibility nor monetary policy independence are available as tools for the structural adjustments they need to make. The burden of adjustment now falls entirely on fiscal policy.

That means a combination of tax rises (as well as a dramatic increase in tax collection which is lax in all PIIGS) and massive public expenditure cuts to bring fiscal deficits and budgets back into balance. That has to be done within a conscionable period (two years at most) before the patience of markets and creditors wears thin. The fiscal adjustment would not have had to be so extreme had the other two instruments been available (i.e. devaluation and independent national interest rate adjustments). In short, the PIIGS are trapped in a high-debt, high-tax, low or no growth, structural adjustment trap; with aggregate demand being sucked out of their economies as a result of public expenditure cuts and real falls in private sector incomes (of households and corporations) as well. Their exports cannot rise too dramatically because they cannot adjust internal exchange rates (only wage rates), nor capital costs. And since the bulk of their exports are to other EU countries a lack of growth across the EU constrains them as well. Thanks to the legacy left by the outgoing government, the UK is not far behind in that particular race to the bottom.

The 750 billion euro bailout for the PIIGS (and others) negotiated last week is not a panacea. It comprises 500 billion euro from the ECB via quantitative easing and a further 250 billion euro in standby facilities from the IMF. The ECB is now buyer of last resort of sovereign PIIGS obligations. The IMF will (at Germany’s insistence) ostensibly act as a politically acceptable fiscal disciplinarian in the absence of a European one. In any event, an EU institution aimed at enforcing cross-border fiscal responsibility would be seen as intrusive in sovereign affairs and therefore would become politically ineffectual, given the way Europe functions. The bailout package, hailed by markets as historic, will buy time (two years) for the restructuring of PIIGS’ debt to make it more affordable along with some netting out of intra-PIIGS debt obligations. But it will not achieve much else unless structural adjustment of PIIGS economies also occurs. Yet, it is not clear that such adjustment will take place in the way it should because of political, public and trade union resistance; with a powerful sense of entitlements and protection having become embedded in the European psyche.

What is required in Europe to maintain the integrity of the Euro and the credibility of the Eurozone as a monetary bloc, is: (a) movement toward a unitary supra-national fiscal authority to exercise surveillance and enforce budgetary discipline in a uniform manner across all EU members applying the same rules and conventions for public accounting and the auditing of public accounts; and (b) a drastic rethink of the social market economic model. Both will require revamping root and branch what EU governments attempt to do in the provision of public services and social protection, the enormous perverse incentives they create by doing so, the combined negative effect of their behaviour and profligacy on global competitiveness, and the assumption that deficits will be financed indefinitely by foreigners (mainly emerging markets and oil surplus countries) to fund an unaffordable standard of living in Europe because of ‘legacy rights’.


No more welfare states


The basic problems the PIIGS face now, actually confront all of Europe (including Northern EU countries) over the medium term. The European economic model is simply unsustainable (in a fiscal and financial sense) over the coming decades. What the PIIGS have proven in 2008-09 is that EU countries whose level of development and income generating capacity is lower than those of more developed Northern European countries cannot sustain universal welfare states with cradle-to-grave social protection, and large public sectors for the provision of public services that should be privately provided; even if publicly financed for the poorest and the most vulnerable. Universal provision at current levels in the EU simply cannot be sustained without a substantially larger voluntary (non-tax) contribution (especially for such services as healthcare, education, and pensions) from those being serviced and protected. The fiscal burden of running universal welfare states is now prohibitive, especially in the face of increasingly unfavourable demographics and the rapidly escalating costs of applying new technology, especially in healthcare provision. Worse still what public domination of services is resulting in is the suppression of competition and innovation in a constant quest for cost reduction and market advantage. Public sector provision is not driven by the same motives as private sector provision. And, public-private partnerships (such as the PFI) can result in the privatisation of profit and the socialisation of cost (and sometimes vice versa as will be the case when governments eventually sell their stakes in the banks they have saved).

Even for Northern Europe, where the unfavourable demographics of a rapidly aging population are being exacerbated by a visceral resistance to immigration to iron out the age-imbalance, such welfare states will require increases in marginal rates of direct taxation from around an effective 50% today, to over 60% by 2020 and nearer 75% by 2030. They will also require increases in regressive indirect taxation (e.g., VAT) of the order of another 20-30% above current levels. We have been through that before and seen the outcome in the UK and elsewhere. Oddly, Scandinavia has become accustomed to such levels of taxation to maintain social cohesion. But it is far-fetched to believe that the rest of Europe can become Scandinavian any time in the foreseeable future. The effect of such tax increases on European economies will be implosive.

European wealth creators will simply choose to avoid/evade taxes (as they do now) or relocate elsewhere. Thus wealth-creating activity will move even faster than might otherwise happen into emerging markets. The EU will be unable to compete on level terms with the US and will be overwhelmed by the emerging economies of Asia and Latin America.

* * *


What Greece points to, as far as the challenge of structural adjustment is concerned, is a fundamental problem that all of Europe must address soon. The trend that all centre-left or leftist inclined governments in the European Union (including the UK between 1997 and 2010) have entrenched since 1980 is to embed an inefficient and expensive bureaucratic monopoly for the intermediation of all services (making even services that can be provided privately, with greater efficiency, public instead) in the economy.

So-called ‘investment’ (actually grotesquely wasteful expenditure) in public service improvement has been extremely inefficient across Europe. Evidence in the UK over the last 13 years suggests that a 10% increase in such ‘investment’ yields barely a 1% increase in public service output, efficiency and productivity. That is creating a situation where public costs are escalating uncontrollably because of the bureaucracy and inherent conflicts-of-interests involved in the state providing and regulating such services.

Citizens (or subjects) across the EU are becoming clients of overweening sovereign states goaded by an effectively unaccountable supra-national mechanism. That is also leading to a degree of state intrusiveness into privacy and citizen-control that is becoming Orwellian in nature. Governments across the EU are now using the threat and spectre of endless and unstoppable terrorism to pass laws that threaten even further erosion of basic freedoms and vulnerability to bureaucratic risk. The state has attempted to make clients and customers out of all its citizens and make them totally dependent on the state for insuring them against virtually every sort of risk. The monopoly-monopsony situation that arises when the public sector reserves the exclusive right of direct provision has resulted in public costs spiralling completely out of control.

Across the EU, the pendulum has swung much too far in the direction of social provision and protection. Sadly, EU electorates have become hooked on it over the last two decades because such profligacy was financed almost entirely by external borrowing and not by internal taxation. That party has come to an end; and not just in Greece or the PIIGS (Portugal, Spain, Ireland, Italy and Greece). The rest of Europe needs to take heed of falling into the same trap — not least the UK. The legacy of the last 20 years needs to be unwound. The most profound element of structural adjustment that has to occur is a shift back to private provision and resumption of private responsibility for financing and insuring social protection and especially for funding pensions in the private and public sectors. That also means rebalancing European economies towards less consumption, more saving (on the part of households, corporates and, most importantly, governments) and more investment in capital formation to replace physical and social infrastructure that is deteriorating rapidly.

Growth in the EU over the next decade (which will be necessary to sustain a growing level of restructured debt service) will have to come from net exports and net domestic investment (i.e. gross capital formation) increasing by around 5-10% of GDP with consumption declining by the same amount. That will not be an easy adjustment — for an uncompetitive EU block (with the exception of Germany and one or two other efficient economies) — to make without substantial pain caused by a significant drop in real wages, inflation and effective trade-weighted devaluation of the euro versus other trade-partner currencies including in the US, Japan, China and the rest of East Asia (as well as countries like Brazil, Mexico and Chile).

But it is unlikely that the EU’s trading partners (especially the US and China) will permit such exchange rate adjustment to occur without resistance in the form of competitive devaluations that will impoverish all. The EU’s adjustment will be made even more difficult if the price of oil and gas rises dramatically, resulting in further implosive tendencies as far as growth is concerned.

Unfortunately, the electorate in almost all EU members is in no mood to adjust to such circumstances. The union dominated public sectors across the EU will pose the greatest threat and challenge. Across the EU, the size of the public sector needs to be reduced by between 15-30% across different countries. The EU needs to adopt a new golden rule that limits the size of the public sector (measured by its role in value addition) to only 40% of GDP (I would prefer 33%) without immediate equilibrating action being taken to contain it. When public sectors exceed 50% of GDP their economies run the risk of a parasitic function devouring the host that sustains it. Political leadership of extraordinary quality will be necessary to convince electorates of the situation they face. At present, such leadership is conspicuous by its absence; although the recent coalition formed in the UK has generated more hope than might have been thought possible a few days ago.

Greek tragedies have lessons for the rest of Europe that need to be learnt in time by all its members. The most important lesson of all is that the multiple adjustments that are needed in the five PIIGS — daunting though this is — need to be made NOW. These countries do not have the luxury of making haste slowly. Their efforts would be aided if the rest of the EU, which is not yet in the same dire circumstances (but soon will be, without a timely change of trajectory) were to travel along the same path. That would reduce the cognitive dissonance likely to arise from some EU members having to make massive adjustments to protect a common currency zone while others continue to indulge in the luxury of what they cannot afford.

The author is an economics and corporate finance expert

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