Greece, Spain and Germany, and the World

This is the latests on Greek GDP:

ATHENS—The Greek economy shrank further at the beginning of the year, official data showed Tuesday, confirming that the country remains deeply mired in recession even before new austerity plans are due to be implemented in the months ahead.

Greece's gross domestic product contracted by an annual rate of 6.2% in the first quarter of 2012 compared with a year earlier, the country's statistics office said Tuesday. This follows a year-on-year decline in economic output of 7.5% in the previous quarter.
The relatively slower pace of decline reflected, in part, a boost to business and consumer confidence following Greece's recent debt restructuring and promises of new aid from its European partners and the International Monetary Fund.

Still, even if the figures do show some mild improvement and were better than economists' estimates for a first quarter contraction of between 6.7% to 7.9%, many forecasters say the economy shows no signs of recovery with some estimating a decline of 7% or more this year.

The equation was very simple. As long as growth in the rate of borrowing continued unabated, the Greek economy could appear to be in growth mode, activity in the economy continued to grow, and government had the revenue from taxing the growth in activity in the economy to pay for previous borrowing. The apparently virtuous cycle had to stop sometime, as there comes a point at which the debt mounts to such a degree that repayment starts to look increasingly impossible. Then comes the downward spiral as the borrowing slows and activity slows, and then reduces, with commensurate reductions in government revenue, and the inability to meet the terms of previous borrowing. It is not a lesson for Greece, but for all who think that borrow and spend is the way to economic prosperity. Apparently, the Greeks themselves know that the game has now come to an end. This is the news on the Greek banking system:

ATHENS—Greek depositors withdrew EUR700 million from local banks on Monday, the country's president said, and warned that the situation facing Greece's lenders was very difficult.

In a transcript of remarks by President Karolos Papoulias to Greek political leaders that was released Tuesday, Papoulias said that withdrawals plus buy orders received by Greek banks for German bunds totalled some EUR800 million.

Citing a conversation he had with Greek Central Bank Governor George Provopoulos earlier in the day, Papoulias said: "Withdrawals and outflows until 4:00 p.m., when I called him, exceeded EUR600 million, they reached EUR700 million. That doesn't include all those orders that the banks received to convert to German government bonds and other such things. Taking those into account it sums up to about EUR800 million."

Again citing Provopoulos, the president added: "that the strength of banks is very weak right now."

This is not new, but the scale may be. And who can blame those people running for the exit. They compound an already dire situation, but each individual who is looking for a safe haven has good reasons to do so. Of course, the 'safe havens' are actually not so safe, they are just less unsafe. It has not taken much imagination to see the roll-on consequences from the deteriorating situation in Greece, for countries like Spain and Portugal, and for all of the 'at-risk' countries. When (and it now looks like 'when', not if) the Greek economy finally collapses under its own mismanagement, the massive losses to the holders of anything attached to Greek debt will send shudders of fear around the world. The problem is that there are more 'at-risk' countries than currently acknowledged, and this means that the consequences will ripple out into the wider European economy. 

The problem is this; rather than accept that the economic crisis was about something truly fundamental, governments and policy were directed towards saving a system that was unsustainable. The European economy is a micro version of the macro of the world economy. You have the big export creditor countries lending to the import and borrowing countries. To be simplistic, think Germany to Greece, China to the U.S. There are, of course, major differences, with the EU tied together by a dysfunctional currency union. The real difference here is that the union makes the problem more apparent more quickly. The fates of the lender and borrower become tied together, as the failure of the borrower country directly impacts upon the lender. The more money that is lent to the borrower, the greater the potential damage to the lender.

The problem is this; someone, somewhere is providing their savings to lend to the borrowers. This is not the abstraction that is so often reported. Economies are abstractions rooted in the actions of individuals and companies. I will grossly simplify here. When a bank lends the savings of a German worker to a Greek worker, and the Greek worker loses his/her job, that means that the German worker has just lost some money. But its much worse than this. When the German bank lends the savings of a German worker to a Greek worker, some Greek workers then use the borrowed money to buy German goods. This sends a signal to the German company to invest more money in production to meet the demand from Greece, and to hire more workers. These very same newly hired German workers are the ones who then provide further savings that will then be lent to the Greek workers.

The problem is this; it all appears as a virtuous circle, right up to the point where it is not. To illustrate this, think of Greece and Germany not in terms of financial flows, but in terms of goods. To illustrate, think in terms of Germany as producing BMW's and Greece producing Ford Fiestas. The value of these two cars are different, but imagine that each is making the same number and exporting the same number cars to each other, on a one for one basis. The Germans do so on the basis that, in the future, their workers will be able to call on Greece to provide more Ford Fiestas than they provide BMWs. When German workers, for example retire, they have a call on a Ford Fiesta which Greece is obliged to produce, in return for a Greek worker being allowed to drive in a BMW now. As long as this situation is one where there is the belief that Greece will provide future Fords, the Germans continue to provide BMWs for now, even expanding their capacity to meet the new demand from Greece.

This is all very well, right up to the point at which the entire capacity of Greece's Ford Focus manufacturing capability is unable to produce enough Ford Focus cars to meet their growing obligations. The German worker is alarmed to hear that, when push comes to shove, Greece is not going to provide the Ford Focus that they promised him in retirement. Even worse, the problem is that, as it becomes apparent that Greece is not going to return the promised Ford cars, workers stop lending money to Greek workers to buy BMWs. The demand for BMWs drops, and some BMW workers start to lose their jobs.

This is a highly simplistic illustration. It omits the aggregated way in which this process has developed, with governments and banks and other countries/economies sitting in the middle of the process. However, it is an illustration of what sits beneath the abstractions we are continually reading about. When an economist suggests that the solution is to lend ever more money to Greece, they mean that they will take the savings of German workers, or income from taxation, and will forward it to Greece so they can continue to buy their BMWs, and this will continue to support German employment of BMW workers. This does not alter the fact that Greece is only returning a Ford Focus for every BMW, and Greece continues to grow its future obligation in provision of the Fords.

I read today about an estimated cost of a Greek Euro exit to Germany, which is around Euros 90 billion. This is a recognition of the imbalance (to continue the illustration) between the consumption of BMWs and Greece's Ford Focus production capacity. For years, Greece has been exchanging a Ford Focus for a BMW, and has promised to provide more Fords than it could ever produce. The capacity in Greece will never grow enough to provide the Fords that it owes. The loss is simple to see. When our German worker goes to the bank at some point in the future, and asks for his 'Ford Focus', he will be told that it does not exist or, if he is fortunate, that he must accept a Ford Fiesta. A German bank received a promise from a Greek bank that the Ford Focus would be there for our German worker, and in turn the German bank promised the German worker the Ford Focus. Along the way, a Greek worker enjoyed driving his BMW.

The loss to the German worker is real, and nothing is ever going to change this. It is the reality of the problem. The losses are real. They cannot be wished away. Extending further credit just extends the losses even further. Lending more of the German worker's savings can only put the problem into the future, and make the problem worse. As for imposition of austerity on Greece, this is an attempt to free more capacity in the Greek economy towards 'Ford Production' for export, and a reduction in the import of BMWs (sorry to stretch the illustration this far, but I hope you get the point). However, even with austerity, the backlog of owed Fords is now so high, that no realistic increase in capacity will ever be enough to clear the backlog.

Lending more money to countries to continue to import goods is just a problem extension, not a solution. It grows the problem. The real solution is to accept the real losses now. It is painful, but miracles do not happen. Greece, Spain, Portugal and all of the rest of the 'at risk' countries are not, as far as I can see, going to have a productivity/competitiveness miracle that will increase their capacity to allow debt repayment. The extend and pretend policies that have been the business of governments have just made the situation worse, and the costs to the creditors are still growing. Whilst my account given here is simplistic, it is exactly how a trade imbalance really works. It is not some magical entity, but rooted in the exchange of value of goods x for value of goods y, with a deficit in the exchange amounting to z. The z is then supported by lending. The lending is expected to be repaid. If the country taking the deficit cannot repay z, the loss must be realised by somebody.

How is this so difficult, and how do so many suggest that this can fixed by continuing to lend to those who cannot repay, and will never be able to repay? The only question is the size of the losses, when they will be realised, and by who? These are the questions that are being evaded. The evasion of these questions is why we keep growing the problem. It is not just a problem of Europe, but a wider problem in the world.