Tuesday, 27 January 2015

More on Greece: Krugman’s utopia or folly?

Nobel Laureate Paul Krugman’s case for reducing Greece’s debt service so that she no longer needs to run a large budget surplus is the following: “Suppose that the multiplier is 1.3 — which is what IMF estimates seem to suggest — and that Greece can collect 40 percent of a rise in GDP in revenue (roughly matching its average revenue/GDP). Then an additional billion euros in spending should generate around 0.5 billion euros in revenue, reducing the primary surplus by only 0.5 billion euros”.

However, his back-of-the-envelope calculation is based on an unfounded optimism about the public spending multiplier. I know that he knows that the multiplier effects of spending (public or private) are reduced through import and saving leakages. But, what he (and other optimists) usually miss is that such leakages are extremely dependent on the confidence about the spending policies being implemented.

For instance, if Greek politicians are not credible the multiplier could suddenly reduce to 0.5 and the primary surplus would be reduced by 0.8 billion euros. Or, even worse, if the ruling party is seen as revolutionary, as is the case with Syriza, the leakages may even turn the multiplier into negative values (e.g. -0.5), in which case the primary surplus reduction would be 1.2 billion euros and the current surplus would quickly vanish and destroy any lenders’ willingness to refinance the current debt level ad aeternum.

Indeed, without their own currency, capital controls and the possibility of imposing trade barriers, the leakage through imports is inevitable. Likewise the fear of the radical Syriza policies will accelerate capital flight which is a form of “hoarding”. Moreover, an unexperienced left wing political coalition is usually the most fertile ground for corruption and mismanagement which again act as a form of “hoarding”. In a country already plagued by a culture of corruption, a change towards a “loony left” will only exacerbate the problem.

In conclusion, Krugman’s call to give more importance to debt flows than debt stocks is not a folly, but in Greece’s circumstances it is certainly utopia. So the European countries should only agree to more public spending if Syriza passes a test of political responsibility and can be tied up to a properly designed adjustment program (not the ones implemented in the past by the Troika).

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