Friday, June 15, 2012

Inflation, Forever and Always?

Anyone who thinks that Greece et al. only need a one-off fix in the form of debt rescheduling or monetization from the European Central Bank is probably kidding themselves. The truth is that the European periphery needs inflation not only to stimulate growth and to pay down their debts in this instance, but also as a sustained, routine means of financing their government.

For decades before the Eurozone came into place, countries like Greece ran expansive government budget deficits through expansionary monetary policy and exchange rate devaluation. They elected to pay for the post-war European model of the welfare state not through concomitant direct taxation, but through inflation. For all intents and purposes, inflation represented perhaps the only effective, broad-based tax which existed in these countries.

No normative judgments here. Big government and high inflation present, certainly, their own inefficiencies and downsides -- but accepting them as the effective choice by democratic consensus in these countries, it should be strikingly obvious that this mode of governance is irreconcilable with what Germany wants.

To remain in the Eurozone, for Greece, is ultimately not a question of whether to accept austerity now in exchange for emergency debt relief. It is a question which asks Greeks to decide whether they are willing to forever pay more of their taxes and cut down the costs of their government, or whether they prefer the inflate-it-away method of financing government.

Let's look at the numbers. Since the 1970s, when Greece transitioned back to democracy, the average government budget deficit has been on the order of 8 percent of GDP, which is probably a good estimate of the Greek structural budget deficit. As of October 2011, it was 15.1 percent of GDP, and even in the best of times, the Greeks never got the budget deficit into the +/- 3 percent of GDP range which is required under the treaties governing Eurozone membership.

What this is about is a combination of high expenditure, even by European standards -- up to 52.9 percent of GDP before the cutbacks in 2010 -- and a consistent inability of the government to raise the appropriate revenue -- roughly 40 percent of GDP over the last decade, as compared to an EU average of 45 percent of GDP.

As a result, inflation was the de facto primary means of taxation. Between the time that Greece joined the European Union in 1981 and the Eurozone in 2001, the inflation rate varied between 25 percent and 10 percent annually. Only towards the end of the 1990s did it come under control, below 10 percent, and that does not appear to be related to any true improvements in Greece's structural budget deficit.Simultaneously, to maintain competitiveness, Greece devalued or depreciated the drachma extensively. A drachma in 1982 was worth five and a half times what a drachma was worth in 2000 in dollar terms.More disturbingly, Greece isn't the only periphery country which employed this strategy. Italy, Spain, and Portugal are also on the list.

This all leads me to a different, darker interpretation of what's happening in Europe, perhaps fittingly right before the Greek elections this weekend. I've already said in another post that I don't think it's primarily about debt, and that a massive derailment from these nations' growth paths of nominal GDP has a lot to do with it. That explains why we're having this crisis now, as opposed to five years earlier or five years later.

But ultimately what I am forced to conclude by virtue of the facts and the data is that the Greeks, and the rest of the EU periphery running such an "inflation tax" policy of financing government, were on a collision course with the more conservative predilections of the Germans running the European Central Bank. There is no way their government's fiscal-monetary policy strategies could ever be compatible in a currency union.

1 comment:

  1. If the base is about 5% of GDP, and inflation is 20%, you only get about 1% of GDP via the inflation tax. It's not a significant source of revenue in the steady state. The budget deficit numbers need to be viewed with caution for a high inflation country like Greece. The nominal deficit includes the nominal interest payments on the debt. But real interest payments were much lower, and hence the real budget deficits were much lower.

    ReplyDelete