IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
WP 2018-11. Executive Summary.
The Greek Crisis is usually discussed in connection with three different deficits: the budget deficit (15.4% of GDP in 2009), the trade deficit (14% of GDP in early 2008) and the current account deficit (14.7% of GDP in 2008). The collapse of public finances in early 2010 and the ensuing damage to the Greek economy from the dismal expectations, the liquidity problems and the skyrocketing interest rates for sovereign bonds, led to the first bailout agreement in May 2010. However, Greece’s dismal indicators in 2010, but also in 2018, are not the end of the story. One should identify the root-causes of the poor performance of the Greek economy elsewhere. Because the three deficits and the gigantic public debt (142.8% in 2009) were only the symptoms.
We believe that the most important deficit in Greece in the late 2000s was the institutional deficit. By “institutional deficit” we mean the lack of an efficient institutional framework that is necessary for economic development. Greece lacked this institutional framework in 2009 and it still lacks it today.
After 8 years of very harsh austerity, consisting mostly of fiscal measures, esp. tax hikes, Greece managed not only to consolidate its public finances, achieving the largest primary surpluses in Europe but also to lower labor cost impressively. However, the achievement of major fiscal adjustments and the steep decline in labor cost was not enough to attract FDI, lead to a strong recovery, and help Greece exit recession. The reason for the stagnation is that the three bailout-adjustment programs, were mostly treatments of the symptoms and not of the root-causes of the crisis. Greece is still a closed economy with a serious institutional deficit: it lacked this institutional framework in 2010 and it still lacks it today. Institutional deficit in Greece has many different aspects: overregulation, low-quality regulation, selective enforcement, high transaction and administrative costs, delays and inefficiencies in processing judicial cases, over-development of inefficient social norms and underdevelopment of efficient social norms. Therefore, in “institutional deficit” we include seemingly contradicting phenomena like institutional atrophy and institutional rigidity but this makes sense in a legal system which is at the same time formalistic and inefficient.
Greece must replace its extractive institutions with inclusive institutions suitable for eco-nomic growth. It is very difficult for Greece to transition to more open institutions because of the phenomenon of “institutional trap”. Powerful groups are using their political power to preserve their rents and the Greek political system doesn’t seem resolute to cut this Gordian knot. The result is the perpetuation of the crisis which has been now very close to a decade, with an economy which still is the least free in the European Union, half-baked reforms and a reform-fatigue after 8 years of austerity, all of which made the situation even worse.
A country which falls into an institutional trap is a country who has managed to develop for many years, if not decades, with extractive institutions. Economic growth led this country, usually, to a middle-income status which was often the result of some partial liberalization of the economy and integration to the globalized economic system. Usually such a country has a corporatist model of development, with powerful government monopolies and government-protected cartels, a strong clientelist political system which is protective of strong pressure groups and anyone who works for the government. The quality of the rule of law is average or low, there is a suboptimal protection of property rights and contracts and the regulatory framework creates more administrative costs than it saves in transaction costs. The innovation is minimal, and the technology is imported. Businesses are dependent on the state for subsidies, they are targeted toward the internal market and exports are discouraged.
The level of inequality is high, and this creates a strong demand for redistribution which the government satisfies it in some degree, profiting politically, at the same time. Social benefits are presented as political favors which are given in exchange for votes. There is equilibrium in this system since economic growth and redistribution ensures that society is satisfied.
However, this system reaches its limits when further economic development cannot be based on extractive institutions. To return to growth the government should make bold reforms, introducing inclusive institutions and getting rid of the extractive institutions. The problem is that this course (upsetting the balance of power and introducing new rules for the game) is politically costly for any government. The reaction of the strong pressure groups is fierce since they realize that inclusive institutions will undermine their narrow interests. They create obstacles to the government from lobbying to street protests which lead, very often, to the government’s disorderly retreat. Under the fear of losing power, the government compromises by making concessions to powerful pressure groups trying at the same time to save face by introducing minimal, politically non-toxic, reforms. But this also means that extractive institutions stay in place and genuine inclusive institutions are not suitably introduced.
This deadlock is called institutional trap because the economy becomes stagnant or deteriorates since further growth is impossible without replacing extractive for inclusive institutions as needed. It’s a limbo state that is simultaneously precarious and non-sustainable, esp. since the undermining of reforms has repercussions such as underinvestment, disincentives for innovation and economic stagnation.
Greece is the textbook example of an institutional trap. One could argue that Greece is not a middle-income country since it reached high-income status and even today, after many years of a ferocious crisis and a loss of a third of the disposable income of its citizens, Greece is still considered upper-middle – it’s not the typical middle-income country. However, this was a borrowed prosperity. Greece, has many similarities with high-income countries, esp. in human capital and technological and managerial resources but also in living standards, a stable democratic political system for more than four decades and a solid liberal constitutional order. In addition, Greece is a member of every privileged club on the planet (from OECD to EU and the Eurozone). However, its high-income level and its economic convergence was not the result of high productivity, innovation, a generous investment in human capital, reforms and high-quality inclusive institutions. The Greek story is even more interesting if we consider the fact that, Greece was for several years a success story. It was one of the few countries which, according to the World Bank, managed to escape from the middle-income trap.
The reason for the current stagnation is that the three bailout-adjustment programs were mostly treatments of the symptoms and not of the root-causes of the crisis. Greece is still a closed economy with inefficient (extractive) institutions.
Modern Greece has a history of almost two centuries. During these centuries, the country managed to move from the backwaters of Europe to a prosperous liberal democracy. However, this development was based on extractive institutions and it was undermined by the twin phenomena of institutional rigidity and institutional deficit. The membership in the European Union and the Eurozone helped Greece put its extractive institutions under the rug of European Union convergence funds, cheap international borrowing and fudged statistics. The crisis of 2008 was the triggering effect of the perfect storm that hit Greece in early 2010.
Greece must replace its extractive institutions with inclusive institutions suitable for economic growth. I cannot see how this situation can be reversed without some very drastic and politically bold decisions by a Greek government which can understand the need for market liberalization and structural reforms. A government less myopic than the governments which ruled Greece for the last eight years.
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