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Greece? First Default, Then Recovery

Greece's fixing can't begin until the real problem is let loose...
THERE'S a certain order to things, writes Nathan Lewis at his New World Economics blog, in this story first published at Forbes.
First, the bondholders don't get paid – ie, a default. Then, and only after that, other contracts like pensions or employment agreements might be breached.
In the case of a corporate bankruptcy, pensions and employee agreements are generally senior to all bank loans and bonds. A corporation can't just raid the pension fund, or break employee wage agreements, to avoid defaulting on bondholders. That might happen after a default, but only after the bondholders take the first hit.
In the case of municipal government bankruptcies in the US, the bankruptcy can provide a framework for renegotiating pension or employment agreements. However, that is only after the process of bankruptcy has begun, by way of a default to bondholders.
In the case of Greece, everyone knows that there are going to have to be some changes. Excessive government headcount, wasteful programs and overly generous compensation packages are due for major reforms. But only after the IMF and other foreign creditors take the first hit. In other words – not until after the default.
Shouldn't the people of Greece – government employees, pensioners, and those who benefit from government services – come before some acronymic foreign debt tyrants? Of course. Thus, there will be resistance to change any of these things until after the debt is defaulted.
Greece is so far gone today (central government debt is now 192% of GDP) that avoiding default is not realistic. So, embrace it. Eventually, a debt restructuring should reduce this burden to something more manageable, perhaps in the range of 50% of GDP.
Once the default has begun, I think it will be much easier to restructure other expenditures. For one thing, the Greek government might not be able to borrow any more money. So, they will have to do with the revenue they have. A balanced budget! Let's call that a good thing.
However, now we have another issue. I often say: "You can't throw people out of the lifeboat until you reach dry land." People need a viable option besides some sort of government dependency and cronyism. In short: you need a healthy private economy, capable of expanding employment and rising prosperity.
When I say that "you can't throw people out...", I don't mean just in a moral sense, like you shouldn't do mean things to people. I mean in a practical sense. Just try to throw someone out of a lifeboat in the middle of the ocean. They will fight you with all their might. You simply won't be able to do it, even if you want to. But, after you reach dry land, all you have to do is ask politely.
Or, as it is sometimes said: "Good socialism is better than bad capitalism." You need good capitalism, healthy and prosperous, to provide a meaningful alternative.
Thus, before any big reductions in government spending, you should have a major tax reform to get the near-dead economy moving again. Steve Forbes has proposed a combination of a 10% flat income and corporate tax rate; a 10% payroll tax; and a 15% VAT. This is a fine strategy, and the result would be a gigantic expansion in economic activity. It is quite possible for Greece's nominal GDP, in Euros, to expand by as much as 300% in the decade following such a tax reform. Tax revenues, which have been falling since 2008, would expand by roughly the same amount.
It's amazing what a quadrupling of revenue can do for a government's finances.
At the very least, such a tax reform should be concurrent with government slimdown efforts. There has to be at least a hope of "dry land" in the near future, for all of those being kicked out of the government lifeboat.
The private economy would be where all the action is. Typically, after a crisis period, there are gigantic business opportunities everywhere, and many would get rich with stunning rapidity. Many others would attempt to replicate their success, in the process hiring thousands and thousands of workers. A middle-class life in the private sector becomes more appealing than life as a government parasite. The government's efforts to eliminate waste and cronyism (while maintaining valuable services) takes on a tone of moral imperative.
Britain's Margaret Thatcher led one of the greatest shrinkages of government ever seen in the developed world. From 1980 to 1987, the number of civil servants was reduced by 22.5%. Nationalized industries in coal, iron and steel, gas, electricity, water supply, railways, trucking, airlines and telecommunications were privatized. Public housing was privatized, sold to tenants at bargain prices. Union membership was made non-compulsory, and declined from 13 million in 1979 to 8 million in 1996. Many union members, and former union members, became Thatcher supporters.
She was able to do this, I argue, because of her tax reforms, and other business-friendly steps such as regulatory and monetary reform. This allowed the private economy to gain enough health to serve as a viable alternative to Britain's socialist policy of the 1970s.
Under Thatcher's leadership, Britain's top income tax rate fell from 83% to 40%. An investment income surcharge of 15% was abolished. The corporate tax rate fell from 53% to 35%. Capital gains taxes were simplified and indexed to inflation, and the top rate fell from 75% to 30%. These tax reforms were mostly enacted at the beginning of Thatcher's term, and the various privatizations followed later.
A fluke? In the last five years, Britain has reduced the number of government workers by 16%, falling from 6.3 million to 5.3 million. Another 650,000 reduction in government headcount is expected in the next five years.
This is a little amazing. We know how hard it is to cut the government at any level in the US How did they do it?
It is no surprise to me that Britain's Tory government has paired this slim-down with some meaningful tax reforms. The corporate rate fell to 20% from 28%; the top income tax rate fell to 45% from 50%. (The VAT has risen to 20% from 17.5%, however.) These are not big changes – nothing like a "10:10:15" reform in Greece – but at least they are in the right direction, away from Continental "austerity" including big tax rate increases.
We know that major tax reform is not going to be possible in Greece, for as long as it is begging week-to-week with foreign creditors for another "bailout" to allow the government to pay the interest on the last bailout. Hardly any of the money ever reaches the Greek people. These "bailouts" (as if putting Greece's government still further into debt is a "bailout") come with strings attached – horrible "austerity" programs including still more self-defeating tax increases.
Thus, the steps to take are now clear. First, the default. Second, tax reforms, and other regulatory reforms to make Greece a good – nay, a great – place for business. Third, eliminating all the corruption and rot inherent in the government's present spending patterns, while preserving important services and welfare programs.
Just follow the plan, and Greeks could be wealthier than Germans within twenty years. If they play their cards right, it might take less than ten.

Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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