The 'right track' for Greece and the Troika's grave errors

This is the (updated) translation of an article that was issued February 26, 2015 on flassbeck-economics. We intend to publish one article in English every week to allow more readers to follow closely our analysis of global and European events.

Now that the Greek government announced its plans on how to proceed with the reform process, it is time to think through what exactly is happening within the euro zone and what needs to be done to make the European economy work. In reality, the New Greek government’s policies for the next four months, which have been approved by the Euro group, are not very important to the future of the euro zone. Greece did win a small victory, as it is not explicitly forced to continue with the extremely restrictive fiscal policies of previous years. I suspect that this is due to the mediation by the Commission, which, now that it is led by Jean-Claude Juncker, assumes a very different role than in the past. The real test for the Greek government is due in four months. By then, they need to prove that their new policies are working according to criteria that have been agreed by the Troika.

It is extremely unlikely that they will succeed. The eurozone is not going to change course in the meantime. As long as this course prevails, it is impossible to implement the necessary policies to turn any country and the European economy around. In particular, it is impossible for a small country such as Greece to create such a sea- change all by itself. The most important ingredient of mainstream policies is the widespread but mistaken belief within the EU that there is no alternative to austerity and “reforms”. Unfortunately, France and Italy, two highly influential countries, also share this view, and so the reforms, the budgetary cuts, the privatisations and the policies that are aimed at increasing labour market “flexibility“, continue unabated. One just has to look at the “reforms“ that President Hollande proposed with great aplomb past month (and which were in the meantime approved by a special decree circumventing parliament!) to realise how far the mind-set of normal policy-makers in Europe is away from approaching a solution.

It is true that the Troika is increasingly being discussed in public. Its functions, the results of its policies, its ideology and legitimacy are under the scrutiny of the wider public. This is certainly positive, but, for now, it seems to make no difference. Harald Schumann produced an important film about the Troika for ARTE. Schumann highlights many aspects of the inner workings of the institutions. He shows in great detail how fundamentally wrong the “recommendations“ of the Troika have worked out. He accuses the Troika for the human sufferings that its policies have caused (the film can be found here). The film’s basic shortcoming, however, is that it does not deal with the real underlying problem: the ways in which the Troika and the institutions behind it perceive and analyse economic, political and social reality, their theories on how a market economy is supposed to function and the role that governments have to play. However, if their theories, or, more precisely the basic premises of their theories, are wrong then none of their recommendations and reforms can be successful.

I will give two examples: The first deals with privatisations, the second with wage cuts and labour market flexibility. As is well known, the Troika aggressively stimulates privatisation. Its Memoranda (the agreements that outline the structural reforms) always demand privatisations of infrastructures and assets from any governments that fall under its spell. Privatisations are not always wrong but how – under the prevailing circumstances of recession and pressure on the government to act quickly – can privatisation help governments to improve economic performance in general and its own standing? In many cases, privatisations curtail the capacity of governments to act instead of increasing it. This is a simple but fundamental fact. Harsh as this may sound to the proponents of unfettered privatisation, no one has ever proved that privatisations improve efficiency within formerly public companies. This is all the more true for privatisations that are happening under great pressure and in dubious circumstances. For example, some parts of structural reform programs often leave the national government in question no choice but to adopt privatisation regimes and push the sale of assets through in a very short time. To insist that privatisations increase the performance of the economy of a country as a whole, is nothing but ideology.

Why was it that, during the last decade, the IMF almost completely lost its foothold in Latin America? Remarkably, this sea-change went unnoticed by many in Europe and especially by its policy-makers. Nonetheless, there are lessons to be learned. For many years, several countries in Latin America suffered economic crisis and financial disarray. The “structural reforms” of the IMF in general made the situation worse, not better. That is why many of them broke with the IMF. They let their currencies float, the privatisations were abandoned, and some utilities were even re-nationalised. Something very similar happened in Asia. The IMF tried to deal with the Asian currency crisis on the basis of a diagnosis, which was nothing short of irresponsible. It was devoid of all rationality and genuine insight. According to the IMF, the cause of the crisis was either crony capitalism (i.e. endemic nepotism) or, as they called it, “a rotten banking system“ that had to be “cleaned out“. The Asian countries cut themselves loose from the IMF as soon as possible and reversed the IMF policies. They have also been doing well ever since. However, none of this makes an impression to the IMF. It is true, when I tried to convince the G 7 as deputy German Federal Minister of Finance of a thoroughly different diagnosis of the Latin America crisis than the one of the IMF, I was stopped in my tracks by my American colleague Larry Summers (who, I am sure, until this very day does not understand what a currency crisis really is). But more important was that I did not get any support from my French colleague Jean Lemierre or my Italian colleague Mario Draghi. None of them was (as high ranking government official and supervisor to the IMF) either able or willing to accept anything from outside the mainstream economic paradigm, let alone that they should use it to change course.

The second example is even more serious than the first because its effects are much worse and it is clearly due to a fatal error in theory. Frankly speaking, to the Troika – and indeed to many of the policy-makers of the national governments in Europe – there is essentially no difference between the labour market and the potato market. Even if some civil servants and officials would doubt it, it is more or less impossible for them to raise objections because it would put a question mark on their suitability for the work that they are doing. Consequently, the Troika consists of people who share the same insights, who come from similar academic backgrounds and, due to their membership in the group, adhere to very similar world views even if they and have different political convictions and belong to different parties. There is no time for doubt and no room for dissidents. The blessings of the seemingly never-ending increase in “flexibility“ of labour markets are supposed to be beyond any doubt. The policies always amount to the same conclusion: the position of the trade unions has to be weakened and wages have to be cut. These are the vital elements of any “reform strategy.“ Perversely, this problem is exacerbated in Europe by the fact that almost everyone who is in power in Europe believes that it is precisely these factors that are responsible for Germany’s economic success. There can therefore be no doubt in the aforementioned course of action: the German example has to be followed. The great majority of German politicians preach the same gospel: every state member has to improve its competitiveness, which, within the EMU framework, cannot mean anything else other than wage cuts.

But if this is wrong – and it is, most emphatically, fundamentally wrong, as we have said and shown again and again – then nothing that the Troika is trying to achieve will be achieved. Figure 1 shows this very well. The Troika has been fundamentally wrong in its assessments of the economies that they have under their wings. Their theories do not explain what is going on. Instead, their assumptions make it impossible for them to properly interpret the world.


Figure 1: Projections of real GDP growth for Greece.

Figure 1 shows the forecasts or projections produced by the IMF regarding the evolution of the Greek gross domestic product (GDP) at different times. The horizontal axis is the time scale. The vertical axis indicates the IMF forecasts of annual GDP growth. The lines show the predictions of GDP growth rates at different times of the same year. Five different predictions are shown (from 2011 to 2015). The end of the curve gives the growth rate that was finally achieved. For the year 2011 (blue line), the series of forecasts begin in October 2010. This is the first square on the blue line. It is followed by the forecast in January 2011 (indicated by the second blue square), then comes April 2011, and so on. Every square indicates a forecast. For the year 2011, the IMF projected a decline of Greek GDP of 2.6 per cent. In reality, Greek GDP decreased by 7 per cent. The discrepancy between the forecasts and what happened in reality is even more outspoken in the second series of forecasts, the one starting in 2012 (orange line). The first forecast predicted a growth of the Greek economy of 1 per cent. This was subsequently revised to a decline of GDP of 5 per cent in April. In fact, real GDP declined by 7 per cent (in the year that had started with a prognosis of one per cent growth!) The forecasts of 2013 were also radically revised: from plus 2 per cent originally to minus 4 per cent.

It is under these circumstances that the Troika and the German Federal Finance Minister wonder how it is possible that the Greek population dares to question their expertise. The Troika fails to understand why the Greeks do not believe the promises of a recovery and an improvement of the situation as a whole. Is it really true that, after four years of massive misconceptions, false consolations and extreme hardships, the fruits of perseverance are around the corner? The Greeks obviously did not think so, which is why they voted the old government out. But this has no impact on the mind-set of the Troika; instead the contrary is true. Some of them openly admit to the failures of the reforms, not because they were bad policies, but because they did not go far enough. This ridiculous position seems to be the latest line of defence. According to the “institutions,“ as the Troika is called nowadays, even the most loyal citizens, such as the Greeks, lost confidence because the “reforms“ did not go far enough!

Let’s be serious. The massive failures that took place are not due to the inherent inability of a country to understand basic economics, as if, somehow, a whole nation is incapable of running its economy, its infrastructure and its businesses, in a fairly rational way. The problem lies somewhere else: in the inability – or the unwillingness – of mainstream economists to create the proper regulatory and political frameworks that market economies require in order to work adequately. The big errors that were made in the projections are not related to any methodological problem. Behind the faulty projections of the IMF lies a fundamental theoretical error, an error which is easy to identify but which is completely overlooked. It is an error that cannot be remedied within the confines of the prevailing doctrine (sadly enough, it is also overlooked by a significant part of more progressive economists).

For Greece and other southern European countries, the issue is not only or not even about the consequences of the fiscal restriction policies that the Troika consistently misunderstood and downplayed. It is, first and foremost, about the effects of wage cuts. I have pointed out in the past, during a debate on the so-called ‘multiplier effect’ of a fiscal stimulus, that neoclassical theory grossly underestimates the effect of wage cuts on domestic demand. The effect of wage cuts on domestic demand is greater than the effects of restrictive fiscal policies. In all southern European countries, unemployment rose while wages fell. Figure 2 shows the evolution of unemployment in Greece as an example. To the Troika, such results are highly paradoxical. It was something that they did not expect because it falsifies mainstream theory.


Figure 2: Unemployment and real wages in Greece.

The problem is that the self-reinforcing negative effect of wage cuts on the economy as a whole does not exist in the neoliberal world. Neoclassical economists are obsessed with the operational costs of firms, micro-economy and doctrines such as marginal productivity and the like. Characteristics of aggregate demand of an economy under conditions of uncertainty are neglected, if not downright ignored. The effect of wage cuts and austerity on aggregate demand and new investment, is a complete anathema to the mainstream. The labour market functioning like the potato market is utterly false. Unlike people, potatoes do not consume less when their price plummets. In the universe of the potato, lack of aggregate demand does not occur. In the real world, unemployed people and all of those who feel the pernicious effects of austerity consume less, making it less attractive for entrepreneurs to invest.

Without a complete turnaround in the theories that inform economic orthodoxy and the diagnosis of the crisis, the monetary union cannot be saved. We have been following the wrong direction for many years now. The situation cannot be remedied by making marginal corrections, even if they go somewhat in the right direction. The only solution is to change course completely. But how can such massive change materialise? Who is going to take the lead? Who is going to defend the new direction against the German superiority? Imagine that a coalition of Italy, France, Spain, Portugal and Greece would come to the fore. These countries could advocate for a complete change of policy in the right direction. They could confront Germany by formulating the realistic threat of breaking up the EMU if no changes are made. This is a possibility, but, all by all, it is extremely unlikely that it will ever come to that. Changes of such magnitude simply do not occur in political processes. It is much more likely that we will go on for another couple of years, taking no real decisions, tweaking some factors that are either basically irrelevant or only of marginal importance, until the electorate will become so tired of all of it and be so frustrated that they will elect radical governments into power – most probably right wing radical parties – and that, as a consequence, the monetary union will explode in one big bang. If this happens, the damage will be immense.

Transl. W. Denayer.