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Two Competing Solutions to the Crisis

More government versus less government...

THE SAGA of the Greek bailout continues to resemble a broken record this week (and a horrible, broken tune at that), writes Nick Hubble at Dan Denning's Daily Reckoning Australia.

On Tuesday, China pledged to assist Europe's efforts to prop up Greece. Yesterday, EU finance ministers delayed the release of their bailout funds to force further austerity measures from the Greeks. And on Monday, Australians awoke to news of Athens burning. In fact, the violence has now spread as far as Crete.

Just another week in Greece then. But don't let the repetition fool you – this will have to come to a head eventually. The question is how.

We've given up on the question of when. There are plenty more can-kicking policies available. And it's in the interest of each stakeholder to buy as much time as possible. The bankers want their bonuses, the bondholders want their money, the politicians want their time in the sun and the pensioners want impossible promises kept for as long as possible.

The so-called Nash Equilibrium is for everyone to buy time. (A Nash Equilibrium is the logical outcome of a situation with several actors, where none has an incentive to change their behavior in light of what the rest are doing)

That's why every solution so far has been about delaying the inevitable. Even Chinese support will hardly solve Greece's problem. Still, it's on its way, according to the People's Bank of China Governor Zhou Xiaochuan. He said that 'the nation will invest in Europe's bailout funds and keep holdings of Euro-denominated assets, bolstering the debt-stricken region that is China's biggest trading partner.'

That policy has worked so well with America, we shouldn't be surprised the Chinese are willing to try it with Europe.

But it's not like Greece is running at a budget surplus. Nor is it growing. So how on earth can people believe this will end well?

Back to the question of how Greece's conundrum will end.

Consider this headline in The Age: 'Greece's economy shrank almost 7% in 2011'. Reading the articles about Greece's surprisingly bad GDP release makes you think this is unexpectedly bad news. But is it really?

The CIA World Factbook tells us that 'Greece has a capitalist economy with a public sector accounting for about 40% of GDP'. Never mind the contradiction in that sentence. Instead, focus on how critics often claim that austerity measures will deepen the recession. The idea is that austerity causes GDP to contract, which is a bad thing. And so austerity doesn't work.

Now in the world of information spin and ivory tower economics, this is a toughly debated point. But consider this. If government spending is included in GDP and you reduce government spending, it's painfully obvious that GDP will fall. For example, if 40% of GDP is the public sector – as the CIA reckons – and austerity measures reduce that public sector spending by say 17%, that leaves you with the 7% reduction in total GDP the world is fretting about. In other words, of course the austerity measures shrink GDP.

In the same way, increasing government spending obviously increases GDP, because government spending is counted in GDP.

The real question is whether such stimulus and austerity grows the private sector – the part of the economy that must bear the burden of government spending and debt by paying taxes. Is Greece's private sector growing? Good luck figuring that out. The public and private sector are simply too intertwined.

This is where 'crowding out' comes in. When government spends resources, it prevents the private sector from doing so. That's why so many economists oppose stimulus.

Anyway, if government imposed austerity isn't looking promising, don't lose faith. Market imposed austerity will definitely work. After a real financial crisis, that is. What's the difference between a real and a not-so real financial crisis? Real ones occur when governments can no longer prop up the financial system. Governments all around the world, not just in Greece, will be forced to return to a surplus or balanced budget. Otherwise bond markets will not fund them. And without funding there is no bailout.

(We'll leave the central bankers out of it for now. They can only buy time or cause inflation.)

How we get to the point where the financial system is built on more solid foundations than a sovereign debt market full of bankrupt governments remains open to question.

Option 1 – More Government

The Greeks can't afford their own government as it is, so they've asked the world to chip in with more government. The famed Troika (International Monetary Fund, European Central Bank and European Union) are now working hard on the Greek problem. Yes, the solution to too much government is more government, just on a different level.

But it's not just the cost of this new level of bureaucracy in Greece that has been added. No, members of the Troika (Australians too via the IMF) are now on the hook for Greek debts. But don't worry, adding another level of government and politics will solve things. You just have to look at the EU for inspiration. 

The new power bloc in the Greek political system didn't take long to exert its influence when it first arrived. We're not talking about the ballyhooed austerity measures. No, instead the foreigners at the Troika had the Greek's buy French warships and were pressing them to buy a German U-boat! (The previous U-boat deal was cancelled because the Greeks were 520-million Euros behind on their payments. And don't get the Germans started on the 'payment problems' regarding their Leopard II Tanks.)

This is called austerity.

Can foreigners really rule a nation against the will of the people who actually live there? We don't mean people as a group. There is no such thing. Each person acts and decides individually, unless they are coerced or forced to act in a certain way. Coercion creates groups. Government is the only entity with the power to use force and coercion in a free society. And it only has that power in order to prevent others from obtaining it. At least that was the theory.

But in practice, the power to create groups and treat them differently has been used by modern democracies to loot and subsidize; loot the productive, subsidize the unproductive. That's what is breaking down in Greece. It's a model that doesn't work for long.

That's what's so ironic about Greeks pointing out their proud history of founding democracy. According to Investopedia, the nation has been in default 'approximately 50% of the total period that the country has been independent'. The Greeks have demonstrated better than anyone how often democracy without restraints breaks down. Instead of letting this failed system in Greece crumble, the power to compel is now being abused across borders in economic warfare. The Troika is looting productive Europeans to subsidize unproductive Greeks. It's just a leech that's swapped hosts.

You'd think the Germans would know better than to attempt to control a nation suffering under crippling and irrational debts. It didn't end well for the Germans when they were in that condition after World War I.

Option 2 – Less Government

It's the recovery following World War II that the world should look to. In America, vast amounts of unemployed men returned home from overseas and government spending dropped drastically. The Keynesians cried catastrophe, but America boomed.

Over in Europe, West Germany pulled a fast one on its occupants. In much the same way that the Greeks should now, in our opinion. It's one of the most heart-warming stories free market enthusiasts like to recount.

Allied occupied and controlled West Germany wasn't a particularly pleasant place. GDP had halved from before the war and many working age men were dead. The Americans, British and French (the Troika of their day) controlled the German economy and had placed price controls on goods to try and stop hyperinflation. Ludwig Erhard, endearingly known as the Fatty because of his size, became the German economics minister. He was required to confirm all changes to economic policy with the American General in charge, Lucius Clay.

But Erhard wasn't a fan of centrally planned economies and their controls. So, one day, he decided to go on the radio and abolish them, having no authority to do so. Just like that. General Clay wasn't happy with the rogue economist:

Clay: "Herr Erhard, my advisers tell me what you have done is a terrible mistake. What do you say to that?"

Erhard: "Herr General, pay no attention to them! My advisers tell me the same thing."

Clay's Colonel: "How dare you relax our rationing system, when there is a widespread food shortage?"

Erhard: "But, Herr Oberst. I have not relaxed rationing; I have abolished it! Henceforth, the only rationing ticket the people will need will be the Deutschmark. And they will work hard to get these Deutschmarks, just wait and see."

Overnight, goods not seen for 10 years went on sale. A journalist wrote: 'The spirit of the country changed overnight. The gray, hungry, dead-looking figures wandering about the streets in their everlasting search for food came to life'

From then on, they dropped Erhard's nickname and replaced it with Mr Wirtschaftswunder – Mr Economic Miracle. Erhard didn't stop there. Economist David Henderson reckons Erhard's motto could have been: 'Don't just sit there; undo something.'

Will we ever see a Ludwig Erhard at the IMF, ECB or EU? Doubtful. 

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

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