THE GREAT RECESSION, THE EUROPEAN FISCAL CRISIS AND LESSONS FOR PAKISTAN. Part 3: The European Debt Crisis

The Exploding Debt in Europe

By Kashan Wali, exclusive to the PTH

 

Wealth cannot be artificially created

Finance in a real world relies on underlying wealth of a society. Governments cannot create wealth by printing money. Print too much money and it will lose its value. A fall in the value of money leads to inflation. Inflation viciously attacks the value of savings of the population. As population loses the stored wealth, the population becomes dependent on the state. State has to pay more now for healthcare, education and in extreme situation, food and shelter for population that is going poorer by the day. Either way, unless the underlying wealth (net output of goods and services produced) does not increase, a country cannot become wealthier.

Let’s say state tries to pull another trick here; it starts borrowing heavily from the investors to boost its cash reserves. A smart market will quickly catch on to the trick as it analyzes the conditions of the local economies to see if this state has good books and stable revenues. If investors decide that the state cannot pay off its liabilities in the future, it will charge a lot more in interest rate to justify taking that excessive risk. Investors may decide not to lend at all to a government running shady practices.

Even worse scenario lies for badly mismanagement economies. As state finds it harder to pays back its debt, it cut backs on the infrastructure and other projects required to keep the society goods and services flowing. The economies fall into recession, joblessness increases, wages fall and the economy falls into a vicious cycle of deflation where the prices of goods and services start falling quickly. People hoard cash and stop spending. The vicious circle feeds on itself and the national debt burden increases astronomically. National output falls dramatically and social unrest starts overwhelming the country.

 A state may seriously consider defaulting, an equivalent to a national bankruptcy to avoid the punishing cost of debt. If the investors were local population, they would instantaneously lose the assets they were holding in the shape of government bonds. If it was international investors, that’s too bad for them. The state now still has a problem that no one will trust them for a long time. Where would they borrow in the future to run the governments? Remember, taxes are paid mostly at the end of the year, while the government has to run all year round.

This entire preamble was written to drive home a simple axiom that can be called the universal law of finance: “There is no free lunch in this world”. Printing money or borrowing heavily is a liability that comes back to haunt imprudent governments, corporations and individuals. There is simply no way around it. Wealth has to be created by innovation and efficiency. It cannot be created otherwise.

 

The European Debt Crisis

This brings us to the European debt crisis that is in the making for the last 20 years. The crisis is commonly blamed on the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) inability to rein in their budget deficit (expenditures minus revenues). Some blame it on the great recession that was unleashed in the world in 2008. Governments spent heavily to become spenders and lenders when private economies were faltering. In the process they borrowed heavily, and now financial markets are nervous as Governments themselves are finding it difficult to cut their expenses and pay back their loans in the future.

Another reason given regarding the reason behind the crisis is that Greece routinely lied about its financial situation. It kept on underreporting its fiscal deficits and indulged in accounting gimmicks to misrepresent its liabilities. Greece has a culture of tax evasion, is a heavily socialist state with huge expenditures that it cannot cut even if it wants to.

Tax evasion is so rampant that Greeks call themselves a poor country with rich residents. In rich neighbourhoods where satellite photos spotted almost 17,000 swimming pools within each house, just 324 residents declared that they had swimming pools in their houses. There are market rates at which bribes are paid to the government officials to evade taxes. The term fakelaki (little envelope) is meant for paying doctors with cash, so that doctors do not have to report that income. In a trendy neighbourhood, many doctors reported their income less than what the rent for the places they live in would be. There is a culture of bribery and corruption that is eating the country`s finances from within. It is estimated that Greece loses more than $30 billion per year to tax evaders. Small businesses are the worst culprits; and all professions, whether they are doctors, engineers, taxi drivers, restaurant owners, regularly evade taxes.[i]

Sounds familiar? Almost all of the problems can be verbatim attributed to the Pakistani society, to an even higher degree. This is why Pakistan periodically has economic crisis to go along with its internal law and order breakdown. This is why the current European debt crisis is a warning to all countries that indulge in bad fiscal managements and then rue the heavy handed IMF that bails them out and imposes strict conditions to get those countries to senseless spending.

Back to Europe now; the current debt problems are rightly attributed to Greece, Spain and Portugal for not adhering to fiscal prudence. But these countries have had historically weaker economies with bad fiscal management records. Question is: why were they allowed in the EU in the first place?

The reason probably lies in the fact that the Euro Zone was constructed primarily as a political union. Scarred by two world wars as Europeans killed each other with vicious abandon, the ageing leaders in Germany and France decided to pull Europe together in one economic zone in early 1990s. They wanted to foster European cohesion, a stronger geographical entity with no trade barriers, running a common money (monetary policy) and growing together to pool the developed economies of Northern Europe with a young and upcoming Southern Europe.

EU in its original plan wanted to impose strict conditions that member countries cannot run big fiscal deficits or high debt levels. However, having an EU without Italy or Spain almost seemed unthinkable. The European leaders compromised, a crucial decision that is coming back to haunt Europe now. The PIIGS countries promised fiscal prudence. Rules were bent to accommodate the looser countries, and most of PIIGS joined the EU. Overnight, all the countries were running the same monetary policy. The short term interest rates in Germany were the same as they were in Greece. The counties were under a single central bank deciding on the single price of money/credit for all countries, irrespective of their individual economic situations. One prescription was prescribed to all different maladies in all countries.

Think of the problem in terms of economic union in Pakistan. When Peshawar and its surrounding areas suffer economic problems, labour moves to Karachi or Lahore to hunt for better opportunities. When former NWFP announced tax free zones, capital moved from Karachi to NWFP to set up industries. NWFP cannot default as Federal Government would help out the provincial treasurer to fill in the deficit. Pakistan is a monetary and an economically fiscal union, as much as it is a political union.

On the other hand, Europe was at best a monetary union only. Labour rarely moves freely between different countries depending on different economic conditions. EU countries were running their own budgets, their own budget deficits and borrowing for themselves, although in the combined currency, the Euros. Soon Southern Europe was back to its old ways. High budget deficits and debt levels became the norm. Grossly inefficient rules and regulations made sure that PIIGS economies would grow only at a below average rates. Greece continued to misrepresent its finances for almost the whole last decade.

While the world economy was passing through its better phases in the 1990s and 2000s, the debt situation was manageable. It grew out of control when the recession arrived in Europe in 2008. Every one in five people in Spain are jobless now. Greek debt level is almost 120% the size of its whole economy. Greece owes more than what its economic size is, in total. While the nations have run these debts before (US debt grew to almost 150% of its economic size during the Second World War), the debt cannot be paid unless economic growth rates are very high in coming decades. It took the United States almost three decades to fully pay back its World War II related debt.

The present crisis in Europe will likely decide how the concept of EU will play out. If Europe cannot unite fiscally (where countries have to abide by strict rules to contain their borrowings and deficits), EU will likely disintegrate. In the present setup, prosperous countries like Germany and France are footing the bill for impoverished and less fiscally conservative countries like Greece and Portugal. With the current 800 Billion Euros bailout package for Greece, Portugal and Spain, the whole Europe is collectively assuring the world that Europe will implicitly back PIIGS’ liabilities. German public is aghast at helping out countries that are not abiding by their economic responsibilities.

PIIGS still have to pay back the huge amounts in the future that they have borrowed in the past. The present setup merely ensures that their debt is acceptable to the financial markets that had begun distrusting the government promises to pay back their debts. Trapped in a single currency, these countries will likely face tough financial conditions. They could have used Euro Zone to improve their economic infrastructure as they gained unfettered access to the rich Northern European markets. They missed those opportunities and now face a grim future. Greek unemployment rate will likely rise towards 20% or more. Deflation will take hold as prices will fall and population will stop spending. Government will have no option but to cut social benefits, public wages and increase the tax rates.

In simple terms, the whole Greek population will pay for its past transgressions. But since Greece blew away the advantage that came up by aligning itself with Germany and France, its pain will be longer and of much more intensity as it is trapped in a single currency that is not tailor made just for Greece. It is very much possible that Greek government may find the pain unbearable and decide to default anyway sometime in the future. If Greece and its fellow PIIGS can use the crisis to get their fiscal house in order, Euro may survive as an economic zone. Otherwise Europe will revert back to the old ways of different countries, different economies, different policies, with trade barriers between the countries.

The lessons from the whole Greek situation are becoming clear; time to fix the third world economies like Pakistan is now, not when the crisis strikes in the future. Tax revenues cannot be increased by altruism; tax laws need to be clearly defined and enforced if Pakistan wishes to remain solvent in the coming years. Fiscal prudence requires that countries define their priorities clearly. The state is responsible for running the governments efficiently, spending on health, education, police, judiciary, infrastructure and defence. But state needs a robust private sector and strong economic conditions to fund these expenses. A robust economy depends on strong law and order. It is all an interconnected loop where good actions beget good reactions. Ad hoc policies run for a few years. But ad hoc policies require payback sometime down the road many times more. Fiscal and economic imprudence, for individuals as well as countries is a disaster waiting to happen in the future.

Next week: Lessons from the recent crises for Pakistan


[i] http://www.nytimes.com/2010/05/02/world/europe/02evasion.html

3 Comments

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3 responses to “THE GREAT RECESSION, THE EUROPEAN FISCAL CRISIS AND LESSONS FOR PAKISTAN. Part 3: The European Debt Crisis

  1. i was wondering if i can borrow some of your content for a live lecture, (unless you’d like to join the conversation at millenium place in whistler BC on June 5th at 2:30) Facinating article!

  2. Greece is a poor country with very rich residents.

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