Timely Greek lessons on the eurozone crisis

by George Provopoulos

Financial Times
January 23, 2012

Greece has undertaken painful adjustments and made progress in solving its problems, but the goals it is striving to achieve are taking longer than expected to be reached. The economy is in its fifth year of contraction, the unemployment rate is surging, fiscal and external deficits remain large and Greek borrowers remain shut out of the international financial markets. This is not what was envisaged under the May 2010 adjustment programme agreed with the International Monetary Fund, the European Commission and the European Central Bank, which anticipated a return to growth and access to financial markets in 2012.

As Greece negotiates a new programme, it is important to ask why the previous one went off track, and what are the lessons learnt. The first point concerns the implementation, which for many of the measures in our programme was slow and inefficient. Second, experience shows that programmes aiming for fiscal consolidation that are based on spending cuts lead to a smaller economic contraction than those based on tax increases. In Greece, last year’s adjustment measures were a mix of 60 per cent revenue (largely tax) increases and 40 per cent spending cuts. This mix has had several consequences.

It has reduced the incentive of companies to invest by reducing the after-tax return on investment. To the extent that some of the tax increases are meant to be temporary, they hold the economy back by creating policy unpredictability. The tax increases have also reduced after-tax income, restraining private consumption. Government spending has remained above 50 per cent of national output, reducing the scope for private-sector investment to boost the production of tradeable goods, something that would help the export sector expand and generate growth. Moreover, one of the areas in which government expenditure was most sharply scaled back is public-sector investment, a key contributor to the country’s future economic growth.

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