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Greece

February 20, 2015 Leave a comment

Greece has a newly-elected government which campaigned on the promise that, if elected, it would renegotiate the bailout terms that previously were imposed upon the Greek economy by a previous government and its financial bailout partners. The reason for the desire to renegotiate terms is that Greece has been in recession with high unemployment and declining output for some time and the terms of the bailout require higher taxes and reduced spending, among other things, as a requirement for loans to keep the government from defaulting on its debt.  This drama seems to me to offer a number of lessons for the U.S. and other countries running persistent government deficits.

The Fallacy of Composition

Economists know that what is true for an individual in an economy is not necessarily true in the aggregate economy.  This fact is known as the Fallacy of Composition.  So if Greek politicians promise transfer payments to some Greek citizens, this does not imply that those politicians can promise such payments to all citizens.  Once you add up all the promises, one needs to ask how this will be financed and in many countries, such as the U.S., the answer is borrowing to keep these promises. Each individual wants what he or she has been promised but, if a government is unable to borrow, then what is true at the individual level cannot be true in the aggregate. Greece cannot keep all of the promises that it has made because it will not be able to continuously borrow to do so.

Greece and the EU

Greece is a member of the EU and so it cannot print money to cover its deficits if it is unable to borrow.  The reason is that Greece does not control the EU Central Bank.  If it did control its own money stock, it would undoubtedly be in the throes of a hyperinflation because it would be printing money to finance its deficits. Since it cannot print money, it sought loans to keep the party going but reduced spending and higher taxes were the price it paid for its bailout. The recession resulting from these terms are what has prompted the desire to renege on its previous agreement.

Ultimately, structural reforms are needed to promote economic growth, much like those discussed previously in this blog in connection with Italy which has problems similar to Greece (see Why Italy Declines). These reforms are so-called supply-side policies that remove regulatory and other impediments that reduce economic growth. These reforms appear not to be part of the bailout requirements but these reforms are the only way that the Greeks can achieve real economic progress.

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