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I have now written several posts on the subject of the Greek crisis, but I thought it might be an appropriate moment to explain why we should all be alarmed at the implications of the Greek crisis. It is not a post about contagion, but about the fundamental problems for all of the countries that are financing huge and growing debts through overseas borrowing.

For regular readers, they will be familiar with the discussion that follows, but I hope they will forgive the repetition for any new readers. The problem that I would like to outline is the problem with the measure so dear to economists, analysts and policymakers; the measure of GDP. The fundamental problem of GDP is that it measures activity within an economy, rather than the underlying size of an economy.

As one extreme example of how flawed this measure actually is, if we imagine that a country has an earthquake that destroys a city, the activity that is generated from the rebuilding will possibly see a rise in GDP as the city infrastructure is rebuilt (assuming the loss of productive capacity from the city does not offset the increased activity from the rebuilding).

In other words, destruction of assets might give the impression that an economy is growing.

In addition to this problem, there is a more fundamental problem in this rather dangerous measure. This is the inclusion of activity financed through overseas borrowing in the GDP figures. The way this works is simple, and I will give an example to illustrate how it works.

Imagine that I go to a restaurant and purchase a meal with a credit card, and the origin of the finance for the card comes from Japan. When I purchase the meal, the activity will be recorded as activity within the economy, and will be reflected in GDP. However, it does not end there. The restaurant will then use that money to pay for a range of expenses, and each payment will also constitute activity in the economy. For example, the restaurant staff will be paid from my borrowed money, and might spend that money in a shop, again creating more activity, then the shop will use that restaurant worker's money and so forth.

What we have is a situation where my borrowed money will not just register as activity in the restaurant, but will also finance considerable subsequent activity. The problem is that this activity is really the result of the output of Japan, as it is Japanese lending that is paying for all of the activity. It is the equivalent of an individual earning £100,000 and borrowing £10,000 and imagining that he actually earns £110,000 per year. Yes, our individual can have a £110,000 lifestyle, but only at a future cost to his diposable income, and only for so long.

In an earlier post, I made a rough and ready calculation of US GDP if overseas funded activity was stripped out of the figures, and came to the following conclusion:

In other words, something like 17% of the US economy is funded by overseas borrowing. You may note that there is a large amount of 'fudge factor' in all of this, and comments and critiques are therefore welcomed (especially from those who are more numerate than myself - which is most people).

There were no critiques, and I would encourage readers to look at the original article, and again encourage critiques. The reason for bring this up in relation to the Greek crisis, and the concern that it should raise for the world economy is relatively simple. If we imagine that Greece does not receive the bailout from the EU/IMF we can see what will happen (I am assuming that there will be no further finance from the markets).

The Greek government will be in a position where it can no longer use the borrowed money to finance activity within the economy, and will have no choice but to enforce extreme austerity measures. As the flow of overseas borrowed money disappears from the economy, the level of activity within the economy will start to fall in an alarming and dramatic way.

What will then rapidly follow is that many businesses will find no customers for their goods and services, or a significant reduction, and they will find that they are no longer solvent. Furthermore, many direct employees of the government will be made redundant or have pay-cuts. All of this will lead to less activity within the Greek economy.

The next step will be that a large number of businesses will go bust or start laying off workers, and unemployment will start to rise rapidly. All the while this happening, GDP will be falling off a cliff, and with that falling off, the debt to GDP ratio will be rapidly moving in the wrong direction. Even more worrying is that, as the activity in the economy is falling, the size of the tax base supporting government activity will also be shrinking, causing yet more damage to the fiscal position of the government, which is already in a very poor state. The government will be forced into a further round of cuts.

What we will really see is the actual real output of the Greek economy being laid bare before us. If the ongoing injection of borrowed money is taken out of the economy, many of the jobs accross the economy will simply disappear. In a crude illustration, we might just focus on the amount of activity that is generated by a single civil servant going about their daily life, with their shopping, payment of bills, visits to restaurants and so forth.

If the civil servant is made redundant, we can see how the effects of that redundancy will ripple through the economy. Our civil servant will stop their trips to the restaurant, may not be able to pay for their mortgage and put their house on the market, the local shops will lose a customer and so forth. Each of these direct losses of income to businesses will see further downstream losses of income, multiplying the effect of the losses.

It is notable that, within our one rather crude illustration, it is evident that our civil servant will no longer be able to support their mortgage payments. Bearing in mind that unemployment will be rapidly rising over the whole economy, this problem will be replicated over the whole economy. The price of housing will sink, and with it the collateral the banks used for their previous lending. The same will be happening to commercial real estate, as the many businesses that will find that they are in trouble, or going bust, will see a growing flood of commercial properties onto to the market, either for rental or sale. Prices of real estate assets in the country will start to collapse.

That collapse of real estate assets will take away the foundations for bank lending. As businesses go bust, and individuals become unemployed in greater numbers, large numbers of what appeared to be sound loans will become delinquent. The banks will start to make large losses on what had appeared to be prime lending. With the values of property falling rapidly, they will not be able to recover their full losses, and they will be on a fast track to insolvency.

As they attempt to protect themselves against their losses, they will hold on to cash. They will not only hold on to cash to protect against insolvency, but also out of the fear that they simply do not know where future losses might originate; after all, prime lending is going sour before their eyes.

What we are seeing is that the assets in Greece have been valued not upon the basis of the underlying output of the Greek economy but upon the foundations of unsustainable overseas borrowing.

With bank lending in decline, sources of potential growth in the economy will be closed off. Furthermore, in the case of Greece, capital flight has already been taking place, but it will accelerate rapidly as the crisis progresses from bad to worse. The discovery of the mispricing of assets will create panic. Access to capital will diminish.

What we are seeing is a downward spiral that is resultant of Greece being forced to live within its actual means. To return to the GDP example, it is like the person who has been living on £110,000 having to move to living on £100,000. They find that they can no longer afford their mortgage payments, the trip to the expensive restaurants, and so forth. Moreover, they are now having to pay back their previous borrowing, and they find their disposable income is collapsing. They have no choice but to live a far, far more austere lifestyle.

The essential problem is this. The more a country borrows from overseas, the more it supports GDP growth (or forestalls GDP decline). As time goes on, the more businesses rely on the overseas borrowing in order for their businesses to be solvent, and the more employment is founded in borrowing from overseas. The more businesses and individuals that are reliant on the income from overseas borrowing, the greater the extent of assets being priced on the overseas borrowing. The greater the extent that assets that are priced on the basis of overseas borrowing, the more the banks solvency is reliant on overseas borrowing. In order for an economy to be kept from collapse, it is necessary to keep borrowing, and the more it borrows, the more the economy is adapted to survival on borrowed money.

The only solution is to break the borrowing spiral as soon as possible.

A long, long time ago I proposed reforms for the UK economy. At the time of writing I argued that the UK needed reform now. The reason for the urgency was the absolute necessity to keep creditors on board whilst the reform took place. My argument was that it was necessary to keep them onboard such that the transition to a more sustainable fiscal foundation could be undertaken with the minimum of hardship. I never pretended that it would be easy or painless, but I always had in mind the scenario I have just painted for Greece. Better to reform with the benefit of credit to ease the transition, than face the imposition of reform and change in a state of shock. I think I made the analogy of falling down a hole, or using a ladder to climb down. You arrive at the same place, but in the latter case without broken bones.

So here we are, about two years after I suggested reform, and no reform has been enacted. This applies to the UK, the US, and a host of other 'rich world' countries. Instead of using the access to credit to allow a transition to a sustainable and realistic economic structure, governments have chosen to use massive borrowing to support their faux economies, and frittered away the chances to make the transition to their real size as painless as possible. We have seen the situation get worse, not better. Rich world economies are now increasingly reliant on overseas borrowing, not less so. In doing so, governments have taken a severe crisis, and turned it into a potential catastrophe.

This is the lesson that Greece teaches us.

Source: Lessons From Greece: Why We Should Be Alarmed