(cross-posted from Troppo)

Public debts in Southern Europe only grew in 2011, and they were already unsustainable in 2010. Worse, the interest rates these countries have to pay on their debts has grown as all the long-term rolled-over debt held by these countries now carries a 7% upwards interest rate.

Greece is the worst affected, with a government debt to GDP ratio of about 160% and getting worse. It is clearly now on the other part of the Laffer curve and further tax increases will not lead to more tax revenue, but less tax revenue. Whilst for other countries, an ECB bailout is the most likely scenario, Greece is on a collision course with an official default that it can no longer turn away from. No one seriously believes the Greeks are going to pay their loans back. Greece is drifting irrevocably into the situation whereby it will officially default and simply not be able to pay the wages of its civil servants, the pensions of its elderly, and have Greek banks collapsing around them as well, unless the ECB bails them out completely, which now seems unlikely. Re-introducing a Greek currency would mainly add huge capital flight to the woes and solve nothing in the short run. It really is looking rather bleak for Greece at the moment, whether it manages to trick the rest of Europe into another stay of execution or not.

Here, I want to point to particularly interesting political processes that have locked Greece into a default death spiral: political paralysis, civil service paralysis, and population paralysis. And at the heart of them are the special interest groups that dominate Greece.

What do I mean by special interest groups and their hold on Greek society? Iannis Carras wrote a hilarious and informative piece on how it works in Greece. Iannis relates the story of how a particular set of rent-seekers conspired to divert water from Western Greece to Thessaly by means of large construction projects. Diverting this water via large dams and reservoirs was done against the wishes of local residents, against EU planning rules, and against the ruling of the Greek high court judging it to be illegal. How did the rent-seekers get round this? They nominally broke the project of water diversion from one region to another into several smaller ones and simply kept going. And what drove this project? European cotton subsidies! Cotton is very thirsty and so water was diverted to the area more suited for cotton. Who drove it? Construction companies, Thessaly major farmers, and Greek politicians, all happily flaunting Greek law. Worse, it turned many a Greek politician and former farmer into a pure rent-seeker. And once they got into that game, they kept going. A favourite means of extorting money out of their own government is now for Greek farmers to simply block the roads until someone gives them money!

Other examples abound. Greece is now full of museums, ports, and roads which no-one uses, paid by the European Union and spawning groups of entrepreneurs everywhere whose main income in life comes from lobbying either the EU or any other major institution. Indeed, in a quite cruel illustration of the increased power of vested interests in these times, Carras notes that the only real reforms being implemented in Greece are all in favour of the construction industry. The most recent such example is the removal of environmental obstacles to build houses, effectively allowing large-scale theft of government natural reserve land by private companies, which in turn makes a mockery of the intended sale of that same government land. A sale which was hoped to reduce the government deficit!

Iannis Carras’s sobering conclusion is that ‘EU aid has strengthened the position of intermediaries and rent-seeking elements in the Greek economy.’

Then the issue of paralysis, whereby the main thing to say at the outset is that paralysis mattered because it prevented structural reforms from happening.

Importantly, structural reforms could have tilted the balance of whether default was inevitable, but it has turned out to be impossible to legislate and enact structural reforms. By structural reforms, I mean tackling tax evasion, opening the economy up by means of labour market reform, and dismantling the legal apparatus supporting strong special interest groups that paralyse the professional service sectors and the civil service. Such structural reform was needed to get economic growth going, has been advocated by virtually all intelligent observers inside and outside of Greece, and initially would have involved pretty simple off-the-shelf legislation. Yet, it has not been done and it now clearly wont be done, even though the consequence is a disaster for the country.

The first and probably most important lock-in process is the civil service: the need for quick spending cuts meant that the public sector had to reduce in size and freeze wages. What do you think happens inside the ministries when this occurs? That the lesser-paid remaining employees are going to do their utmost for their country by devising and enacting radical reform legislation, or that those who remain will be the weaker ones who couldn’t get decent jobs elsewhere and whose principle worry is not to rock the boat and retain their job? The right answer is the latter.

As a result of this paralysis of the civil service, the sheer capacity for structural reform has been strongly eroded, as was nicely illustrated in this excellent piece on the impossibility of reforms. Greece, and to some extent also Spain and Italy, is now less able to legislate and support structural reform than 2 years ago. All that remains is austerity packages, which are technically easy: bit less money here, slight increase in tax rate there. Nothing new has to be set up or thought through.

 

The second lock-in effect is a gradual paralysis of the political system. At the start, when it became clear to the elites of Greece that they were looking at a major loss of status for their country if they kept going as before, the political elite had a kind of ‘we must stop this’ mentality. This moment came about 2 years ago for Greece.

Yet, just as more recently in Italy, Greek politicians forgot the crucial lesson of Machiavelli about reforms that go against vested interests: you need to implement them with lightning speed whilst the political will is there.

What Machiavelli warned his audience about happened in Greece: by being too slow, they alerted all those who would lose from reform, which cemented opposition to them. As a result, Greek politicians have basically done nothing in the last year and Greece is in complete political paralysis with no-one daring to offend the rent-seekers.

It is instructive to think a step deeper and ask why Greek politicians see it in their best interest to do nothing. The major political reality in Greece is the anger of voters who see their standard of living go down with plummeting housing prices, increased unemployment and decreased welfare, and who blame whomever is in charge, whatever they did or are trying to do about the problem. Such voters might want the country to avoid the shame of a default, but that sentiment is dwarfed by blind anger towards anything associated with the loss they are having to endure.

Interestingly, this public sentiment has only strengthened the hand of the special interest groups: when faced with high uncertainty, workers became more militant within their unions; major corporations increased their attention to political lobbying to make sure they wouldn’t lose out; the professions mobilised such that the legislation favouring them was safeguarded; etc. Since the early pain fell on the politically weakest, i.e. those not organised in special interest groups, the relative power of the problem groups has only increased within politics, the civil service, and the world of work. It is now only via the popular vote that there is potential mileage for a politician in advocating real change, but the popular vote is uncertain and easily swayed by the relentless media lobbying of the special interest groups. Hence, as a calculating Greek politician, not implementing any real reform and blaming the foreigners is an optimal strategy.

The Greek politicians were not alone in being too slow to reform: the Italians are making the same mistake. Italy just in the last 2 months shows how this goes: Mario Monti was explicitly appointed as a technocrat to do what needed to be done. To his lasting shame, he wasted his first salvo in December 2012 on a simple austerity package without any structural reform. By now, the major unions and interest groups have organised against him.

Monti’s latest round of reform is a good illustration of what he now does. In grandiose media style, he promised 5000 more pharmacies, 500 more notaries, and what looks like no more than a few hundred extra taxi licenses. This is really nothing more than symbolism: Italy needs millions of jobs, not a few thousands! Worse, Monti made a big point out of extending bakery opening hours to Sundays, which is peanuts in the scheme of things. Hence the story there so far is no real reform whilst minor reform is puffed up to be the real thing, and meanwhile it’s getting late and Monti’s political backing in parliament is slipping.

To be fair, other European politicians also were not quick enough in realizing long-run realities. Some 18 months ago, when informed observers already knew that Greece could never pay back its debt, what did the Northern European leaders do? They pretended vociferously that Greece would not default, that ‘Europe would stand behind Greece’, and they exposed their own banks and countries much more to a Greek default by direct loans to the Greek government and to support the buying up of Greek bonds by the ECB. This policy, which is the height of folly in hindsight, only made sense at the time within the logic of a political elite that had no idea what was going on and that bought into its own rhetoric of Greek competency. And the parliaments all approved this!

A final fascinating aspect of the Greek death spiral is the return to full posturing once it became clear to the senior politicians that a default was inevitable because the road to structural reforms was political suicide.

Greece, quite incredibly, in January 2012 had a PM who was openly threatening Eurozone leaders that Greece would pull out of the Euro if he didnt get more bailout funds. This is much like a thief threatening to no longer enter your house if you don’t send him more of your valuables! The cheek of the man has to be admired, but the cold political calculator should drily note that such posturing is entirely for domestic consumption and a clear indication that the PM is preparing his country for a ‘blame the foreigners’ story, even though in reality these foreigners have propped up the Greek government by well over 200 billion Euro in loans in recent years!

In Italy too, the PM is adopting posturing mode. The minister of finance and the PM both announced that they want the markets to ‘recognise’ Italian efforts. You might as well demand of the weather to recognise your need for summer! Merkel, astonishingly, echoed their voices.

Indeed, the Italian government now and then resembles pantomime-mode when it comes to reforms. The PM, Mario Monti, has announced ‘rolling reforms’, sector by sector, one sector per month. He is just these weeks going to ‘talk to the unions’ about labour market reforms. This is so counter to Machiavelli’s prescript of swift and unexpected reforms that it is almost laughable. It is like Jason in the Friday 13^th movies saying to all his intended victims ‘I am coming to get you….. in 6 months time!’. The act keeps the handouts coming from the ECB and the rest of Europe, but we will see how long it works without real reform. So far, Northern Europeans seem to be buying it, just as they did with Greece….