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Wednesday, July 1, 2015

Greek Spending Hits the Wall

All government spending is limited — but the pain of extraction isn't

Last week, Greek Prime Minister Alexis Tsipras announced that this Sunday Greeks will head to the polls to vote on whether or not to accept the terms of the latest bailout offer. Then, today, it emerged that Tsipras had already agreed to the bailout he was asking the Greeks to vote on.

Confused? You’re not alone. Puns on “Greek tragedy” have proliferated since 2009, but this is becoming a grim farce.

The Greek government faces the problem that its revenue is insufficient to cover its spending commitments. Governments have three ways of getting money:

  1. tax it,
  2. borrow it,
  3. print it.

(If you can think of any others, let Mr. Tsipras know.)

I wrote a little while ago about how the government of an independent Scotland would finance itself. I argued that if Scotland adopted a common currency with Britain, its government wouldn’t be able to pursue 3, and if their fiscal situation was poor, they’d struggle with 2 (at least at a rate they could afford). This would leave them entirely reliant on 1, and I doubted that that avenue would provide the revenue necessary to sustain Scotland’s present levels of government spending.

The case of Greece is interesting. In the euro, its government cannot pursue 3, its citizens have a famously low tolerance for 1, and it has just about exhausted its capacity for 2. That is the Greek crisis in a nutshell.

If Greece left the euro, I believe avenues 1 and 2 would still be closed to the Greek government. I don’t think Greeks are going to suddenly start paying lots more taxes, and I doubt lenders will reassess the country as a sound credit risk after its default. But the Athens government could reopen avenue 3 — it would have control of a new drachma and could print it to finance its spending.

The obvious drawback is that this would be inflationary. All those euros that Greeks are unable to shift out of Greece would be swapped at some rate for drachma and that rate would, almost certainly, fall and fall quite rapidly as the government printed more drachmas to continue funding pensions which currently amount to 16.2% of Greek GDP. The spending power of Greek citizens will fall just as surely as if their wage had fallen in nominal terms from €1,000 to €800 a month.

But even this has limits. If they could find a counter party (a big if), holders of drachma could switch their currencies, even at heavy discounts, for other currencies in an effort to preserve something of their purchasing power. This is capital flight.

Alternatively, they could swap money for goods and services in Greece while their money can still purchase them. The falling demand for money relative to the demand for goods and services would increase the money price of those goods and services, leading to price inflation. Less generally, it could also push up only a few prices and create asset bubbles. The point to make is that all money is convertible, even fiat paper money. That, after all, is the point.

Governments, always and everywhere, have to live within the three means listed at the top. 1 is limited by the public’s willingness to pay. 2 is limited by people’s willingness to lend. 3 is limited by people’s ability to swap their money for something else.

Hopefully whoever is in charge of Greek spending in a month or so will come to grips with this reality.

John Phelan blogs at Phelanomics.