Commentary

Taxes, Red Tape Leave Greek Economy in Ruins

Economic conditions in Greece are dire, with countless horror stories about families suffering economic deprivation. After years of supposed austerity and reform, the people have lost ground and the nation is deeper in debt. What went wrong?

Let’s look at some recent history.

When Greece gave up the drachma and joined the euro back in 2001, investors no longer needed a big “inflation premium” when buying bonds from the Greek government, so interest rates dropped substantially.

That access to cheap borrowing seemingly was good news, but Greek politicians acted like college students with their first credit cards and went on a spending spree.

This party was fun while it lasted, but when the economy tanked at the end of the decade, investors suddenly realized that they might not get repaid since tax revenues were falling and the burden of government spending had reached record levels.

After years of supposed austerity and reform, the people have lost ground and the nation is deeper in debt. What went wrong?

By the time most investors tried to sell their Greek government bonds, everyone else figured out Greece was in trouble. This meant people were only willing to buy Greek debt if they got very high interest rates to compensate for the risk of default.

This belated realization of Greece’s perilous fiscal status also meant that the government wasn’t in a position to sell new debt except at very high interest rates.

For all intents and purposes, Greek politicians had made all sorts of commitments to spend money, but suddenly they no longer had any ability to finance that spending with borrowing.

The government was faced with three unappealing options — cut spending, which politicians hate to do; raise taxes, which is always unpopular; and/or don’t pay back investors who bought bonds, otherwise known as a default.

This was Part A of the Greek fiscal crisis.

But there was also Part B. Big banks from nations such as France and Germany had purchased lots of Greek government debt in the years leading up to the crisis, especially since they were told by national and international regulators that government bonds were risk free for their balance sheets.

As rumors began to swirl that Greece might default on its debts, these banks faced the prospect of huge losses. Perhaps even insolvency.

This was why Angela Merkel and other major European leaders were so anxious to prevent a Greek default. If Greek bonds lost their value, their banks would suffer major losses and might even require bailouts.

To be sure, these politicians didn’t publicly admit that they were concerned about their domestic banks. Instead, they said they were trying to protect the euro, but this was window dressing.

A Greek default wouldn’t have threatened Europe’s currency any more than a default by Illinois would threaten the U.S. dollar. In effect, the pressure to give a bailout to Greece was really a back-door bailout for banks that mistakenly lent too much money to that nation’s fiscally incontinent government.

In fairness, the politicians from the rest of Europe had a semi-reasonable plan. The European Commission, the European Central Bank, and the International Monetary Fund formed a “troika” to oversee the bailout and insist on various fiscal and economic reforms to put the country on a sound footing.

It was similar to the Financial Control Board created by Congress in the 1990s to fix the mess caused by local politicians in Washington, D.C.

But while the Financial Control Board successfully guided D.C.’s local government out of a fiscal ditch, the same can’t be said about the troika. Greece’s economy today is in the toilet and debt has skyrocketed..

The only “success” is that banks managed to unload a lot of their dodgy Greek debt to the members of the troika.

So why did the troika fail? The simple answer is that it imposed the wrong kind of fiscal reforms. There were lots of promises of spending cuts and privatizations, but what mostly happened is that Greek politicians dramatically increased the nation’s already punitive tax burden.

The Organization for Economic Cooperation and Development’s fiscal database tells a very ugly story. In 2009, on the eve of the crisis, the tax burden in Greece totaled 38.9 percent of GDP.

This year, taxes are projected to reach 52.0 percent of economic output. Every major tax in Greece has been dramatically increased, including personal income taxes, corporate income taxes, value-added taxes, and property taxes. It’s been a taxpalooza that might even satiate Bernie Sanders.

What’s happened on the spending side of the fiscal ledger? Have there been “savage” and “draconian” budget cuts? Actually, there have been some cuts, but the burden of government spending is still a heavy weight on the Greek economy.

Outlays totaled 54.1 percent of GDP in 2009 and now government is consuming 52.2 percent of economic output.

Let’s close by reviewing Greece’s performance according to Economic Freedom of the World. The overall score for Greece has dropped slightly since 2009, but the real story is that the nation’s fiscal score has dramatically worsened, falling from 5.61 to 4.66 on a 0-10 scale.

In other words, during a period of time in which Greece was supposed to sober up and become more fiscally responsible, the politicians engaged in an orgy of tax hikes and Greece went from a failing grade for fiscal policy to a miserably failing grade.

The moral of the story is that higher taxes are a recipe for sinking further into fiscal quicksand. If Greece wants growth and sounder finances, the only successful recipe is spending restraint.

There’s a very impressive list of nations that have achieved great results by limiting budgets so that government spending grows slower than the private sector. Switzerland is a very good role model, assuming Greek politicians and the troika actually want to solve the problem.

Daniel J. Mitchell is a senior fellow at the Cato Institute who specializes in fiscal policy, particularly tax reform, international tax competition, and the economic burden of government spending.