Will the Greek crisis end in tragedy?

The glitterati of the economics profession have been out in full force to comment on the Greek crisis, what with Paul Krugman (http://www.nytimes.com/2010/05/07/opinion/07krugman.html?emc=eta1), Greg Mankiw (http://gregmankiw.blogspot.com/), and Nouriel Roubini (http://www.roubini.com/roubini-monitor) wading in to give their opinions.

OK, so things have erupted in Europe with the Greek debacle continuing to unfold - but the main question now revolves around 3 things: first, whether the EU bailout ( - I know Germany is contributing to this, but officially it is an EU initiative) is enough to "plug the dyke" in Greece's public finances; second, whether the EU measures will be enough to stop contagion taking place across Europe thereby threatening the euro area; and third whether Greece can remain in the euro area.

I pose these three questions separately on purpose, because as we all know, whether the actual bailout is big enough to stop financial panic is not how financial markets behave - they behave according to fear and irrationality as we saw in the Mexican peso crisis in the 1990s when panic swept across quite a few South American countries that were nowhere near to defaulting on their public debt obligations.  The last question is a matter of politics as well as economics, so I will also address that as it is now on the radar screens thanks to Paul Krugman.

But let's start at the beginning.  In the Maastricht Treaty, which was the original blueprint for the euro area, Article 104 specifies that "Overdraft facilities or any other type of credit facility with the ECB or with the
central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments."  This is known as the "no bailout" clause, and clearly states that the ECB cannot bailout Greece.  But in Article 103a it states that "Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by exceptional occurrences beyond its control, the Council may, acting unanimously on a proposal from the Commission, grant, under certain conditions, Community financial assistance to the Member State concerned." 

So that is what is happening this weekend - the euro area finance ministers are huddled together to hammer out an agreement to effectively lend Greece €110bn through "Community financial assistance" over what is rumoured to be a 3 year period.  At the same time the Greek government has put in place austerity measures to try to reduce it's budget deficit, hence the riots in Athens.  But today there are also signs that the Finance ministers want to "ring fence" the Greek problem by providing an enhanced (€110bn) fund to get Greece, Portugal and Spain through what was the €60bn emergency facility that allowed Latvia, Hungary and Romania to get through their balance of payments difficulties last year.

Let's now go back to the key questions we asked at the beginning.  Is this enough to "plug the dyke" that is the mess with the Greek finances.  The answer is an unequivocal "yes".  First, remember that the Greek economy represents only roughly 3% of the euro area economy.  If you look at the Greek Finance Ministry's last report on public debt (see http://www.mof-glk.gr/en/publications/debt/56.pdf which rather mysteriously ends at the end of last year, and hasn't been updated yet for Q1 2010) you'll see the following chart (click on it to bring up a bigger version), which shows the redemption schedule and term structure of the public debt in Greece. 

As you can see, total Greek public debt at the end of last year was reportedly just under €300bn with only 10% rollover due to take place in 2010, and 50% rollover required more than 5 years away.  So all this talk about debt restructuring, while it will make it easier for Greece in the short term, is nowhere near the order of magnitude that the media is hyping it up to be.  Now I'm not denying that debt in Greece is high, but at 120% of GDP this really is not wholly exceptional - take a look at Japan, which has debt levels approaching 200%.  But the main point to be made is that the €30bn plus to be either paid off or rolled over in 2010 can be funded through EU borrowings, so the amount provided through the EU is definitely sufficient to avoid a default. 

So to the second question - whether this is enough to stop contagion to the other euro area member states.  Of course what the financial markets don't like is surprises, and the public debt figures are higher for Greece than reported above (as some of the debt wasn't reported and was "hidden") so that the figure of €300bn is actually €356bn  - that, in my opinion, is the main reason for the panic - the financial markets cannot trust the Greek government to report the debt figure honestly or accurately.  Is there a similar situation in Portugal and Spain?  No, there isn't.  So although bond yields have spiked for Portuguese and Spanish public debt, the problem is not qualitatively similar to Greece's, so the concern about contagion is overdone in my opinion. 

As an aside, I'm not saying that there is a linear relationship between debt/GDP levels and financial crisis either, as Rogoff commented a few days ago in the FT (see http://www.ft.com/cms/s/0/ecea426c-5877-11df-9921-00144feab49a.html). What matters is that you have not offended the markets recently, and of course a country like Japan (with public debt levels approaching 200% of GDP), even with anemic growth, can still make it's bond payments because of low interest rates due to market confidence. Even a speculator extraordinaire like George Soros doesn't see Greece defaulting on it's sovereign debt. And there is little reason to think that either Portugal or Spain would follow suit even if Greece did.  Of course that doesn't stop speculators speculating on it, and that's exactly what happened at the end of last week (see http://www.ft.com/cms/s/0/c56eeec6-5b4d-11df-85a3-00144feab49a.html).  Incidentally, I think this is exactly the time to start buying EU stocks as clearly the euro will bounce back once this crisis is over - certainly if I had millions of dollars that's what I'd be doing right now!

So the next question, is whether Greece will  leave the euro area.  Krugman even goes as far as to state, after going through 3 options that Greece would have to consider to stay in the euro area, that "What remains seems unthinkable: Greece leaving the euro. But when you’ve ruled out everything else, that’s what’s left."  I think Krugman underestimates the political will of the larger members of the euro area to keep the show on the road.  The EU has always risen to the occasion when crisis hits, and this time will be no exception.  And let's face it, this is not a crisis of confidence in the euro itself, just a crisis of confidence in the economic policies of one of it's member states, Greece, and in the Stability and Growth pact and it's ability to control public debt issuance in profligate euro area member states. 

So Greece, in my opinion, will remain in the euro area but will face some really dark years ahead, particularly if EU growth does not pick up soon.  The main point I would make though is that the EU needs to start thinking a little more strategically about how the institutional structure of its design can weather different economic scenarios rather than what is the most feasible solution from a political standpoint.  The Stability and Growth pact (see my previous post on this blog) is a perfect case in point. 

There will definitely be a period of deep reflection in EU circles after this crisis is over, and hopefully it will lead to some decisive action, otherwise the EU is doomed to lurch from crisis to crisis, making rushed decisions in response to market forces rather than constructing an EU that is resilient in the face of economic shocks and downturns.

Economics as a Science

I want to start off by saying that I like Greg Mankiw’s intermediate economics textbook – that should be self-evident otherwise I wouldn’t have adopted it for the intermediate economics course I’m teaching this semester. But every time I start this course and look at the title of Chapter 1 (“The Science of Macroeconomics”) I feel immediately revulsion: I even went to the trouble of changing my powerpoint slides and calling the chapter “Introduction to Macroeconomics” as I couldn’t bear to look at that title!!  And Greg Mankiw's textbook isn't the only one that claims that economics is a science, it just happens to be the text I'm using this semeseter.

The Chambers English Dictionary defines science as “knowledge ascertained by observation and experiment, critically tested, systematized and brought under general principles, especially in relation to the physical world”. And yes, scientists use the scientific method, which comes from Karl Popper’s work. Karl Popper, the British/Austrian scientist came up with the framework for deciding what is, and what is not science – to quote from Wikipedia:

“Logically, no number of positive outcomes at the level of experimental testing can confirm a scientific theory, but a single counterexample is logically decisive: it shows the theory, from which the implication is derived, to be false. Popper's account of the logical asymmetry between verification and falsifiability lies at the heart of his philosophy of science. It also inspired him to take falsifiability as his criterion of demarcation between what is and is not genuinely scientific: a theory should be considered scientific if and only if it is falsifiable.”

So in other words, if you can show that something is false, then that something can be tested to see if it is false, and therefore you can use the scientific method. So this means that any economic theory that has data (or potentially has data) should be testable if economics were to be classified as a science. Now a lot of economics does have data that it is either already collected or could be collected in the future. But a lot of economics does not lend itself to the scientific method or falsifiability. Take the 2nd welfare theorem or the optimal currency area theory. These are not verifiable given that economics operates on the basis of human behaviour.  Even when things are verifiable, economists like to think that general rules are "laws".  Take the "law" of demand for example - it is clearly not a "law" in the physical science sense of the word, but economists abuse it by attaching it to human behaviour in the face of changing the price of a product, which depending on the type of product can actually lead to an increase in demand (Thorstein Veblen's "conspicuous consumption", for example).

And there lies the rub. I know this might sound semantic, but calling economics a science is to my way of thinking calling it a “physical science”, or at least something on a par with physical sciences. Economics deals with human behaviour, either individually or collectively, so in no way does it constitute being called a “physical science”; but rather fulfills the criteria for being a valued “social science”. Some economists would say that economics uses way more mathematics and statistics than other social sciences so that it is more like a “physical science”. Well sure, the methods we use can get quite technical at times, but that shouldn’t detract from the core issue of what we’re studying, not how we’re studying it.

Certainly in most Universities the Faculty of Science doesn’t contain the economics department ( - although Dalhousie University in Halifax, Nova Scotia is the exception to the rule here), and it is put in the Faculty of Arts and Humanities or the Faculty of Social Sciences or the Business School or Faculty. Why is this? Well one of the strengths of economics is that it is not easily categorized – it contains logic from philosophy, math from science, imaginative theories ( - which almost demand an artistic mind), and “touchy-feely” policymaking from public policy.

So, to sum up…is economics a science? Yes, it is in the sense of being a “social science”. Is it a science in the sense of being always falsifiable, which can be claimed for all physical sciences? The answer here is no.