Greece’s Excess Burden

By Paul Krugman. NYTimes.com

February 14, 2015  

Credit

What’s the state of the Greek crisis? I have no idea, or at any rate no idea beyond what any diligent reader of press reports might glean. I do, however, have a pretty good idea of what Greece is asking for on the fiscal side, and it might be useful to talk about the arithmetic behind that position.

Here’s the basic point: Greece has, through incredible sacrifice, managed to achieve a primary budget surplus — a surplus excluding interest payments — despite a depression-level slump. That surplus is believed to be currently running at about 1.5 percent of GDP. The Greek government is not calling for a return to primary deficits; as I understand it, it is merely proposing that it be allowed to stabilize the surplus at that level, as opposed to raising it to 4.5 percent of GDP, a number that has few precedents in history.

Now, you might think that 3 percent of GDP is not that big a deal (although try finding $500 billion a year of spending cuts in the United States!) Given the macroeconomics, however, it is much bigger than it looks. Much like the reparations the Allies tried to extract from Germany after World War I — although for somewhat different reasons — forcing Greece to run huge primary surpluses at this point would impose a very large “excess burden” over and above the direct cost of the surpluses themselves.

First, austerity has a very negative effect on output in a country that does not have its own currency, and therefore cannot offset the fall in demand with monetary policy. The attached figure shows what was supposed to happen to Greek GDP according to the original 2010request for a stand-by arrangement – that is, the original austerity-and-internal-devaluation plan — compared with what actually happened. There’s little question that the huge shortfall reflects the adverse effects of austerity, which the IMF admits it greatly understated. At this point a reasonable estimate for the Greek multiplier is on the order of 1.3.

This multiplier effect has immediate fiscal implications. Suppose that Greece were to spend somewhat more than contemplated under the current agreement; the primary surplus would surely be less than would otherwise be the case, but the effect would be much less than one-for-one. We can summarize the actual effect of higher government spending (ΔG) on the primary surplus (ΔPS) as follows:

ΔPS = -ΔG*(1-μτ)

where μ is the multiplier and τ is the marginal effect of a one-euro rise in GDP on revenues and/or cyclically linked spending like unemployment benefits. Say μ = 1.3 and τ=0.4, both more or less in the middle of the evidence; then higher spending would reduce the primary surplus by less than half the initial spending rise.

Or to turn this around, to achieve the extra three points of surplus the troika is demanding, Greece would actually have to find more than 6 points of GDP in spending cuts or tax hikes. And note that the multiplier is almost surely greater than one; this means that the fall in government spending would induce a fall in private spending too, which is an additional excess burden from the austerity.

The point, then, is that by demanding that Greece run even bigger primary surpluses, the troika is in effect demanding that Greece make sacrifices on the order of an additional 7.5 or 8 percent of GDP as compared with the standstill the Greek government proposes.

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