Terrible Calculations and Crisis History

In Thursday's article I gave some of the views Nobel laureate Joseph Stiglitz had on Europe. Notably, that austerity measures are causing the crisis and not the other way around. Who could disagree with that? A simple logical deduction will lead us to that. Let's see now the order things happened in the EU:

1. Sub-prime lending crisis in 2008, led by US banking and investment firms, and marked by the Lehman Brothers collapse in North America and the Northern Rock bankruptcy in the UK. (other financial institutions also failed in the EU, yet no-one was large in size). The sub-prime lending crisis had nothing to do with the now sovereign debt crisis. (it may have been the thing that pushed Greece over the cliff but this was not the cause that brought the Greeks at the brink of disaster. The Greek economy was unstable for years)

2. Greek scandal concerning the size of debt, deficit and GDP of the nation. (debt and deficit had been deflated while GDP inflated. Curiously, nobody was ever sentenced for this fraud) Greece opts for a bail-out from the EU and the IMF and the first austerity measures were put forward in the country.

3. Seeing that the debt-to-GDP ratio of Greece climbed even higher, regardless of the austerity measures (again, think about this: €100 debt with €100 GDP makes a 100% debt-to-GDP ratio. €100 debt with €80 GDP makes a 125% debt-to-GDP ratio. Unfortunately this was too much mathematics for the Troika and the expert economists to understand) the EU policymakers and Troika decided to give the Greek debt a haircut. The haircut consisted of 30% of the face value at first (i.e. for every euro the borrowers held they were going to get 70 cents) and then another 70% of the remaining later (i.e. instead of the 70 cents they were holding they were going to get just 21 cents).

4. This led to a significant shrinking of assets for the banks exposed to Greek debt (many of the Cypriot, Spanish and Italian banks as well as many German ones which curiously managed to sell most of their bonds), and with the new regulation raising capital reserves from 8% to 9%, banks were is serious need for money. 

5. Since many banks did not have sufficient capital reserves to allow them to function, they opted for a government bail-out. As banks are not really like any other firm (look here for more details) the nations had little option but to try and save them. However, the banks' needs being large, and the nations' debt being high made it more difficult for them to refinance. Thus, nations themselves needed to opt for a bail-out since their banks were dragging them along to the bottom.

Had the Greek haircut not occurred in such extremity (for an alternative read here), banking needs would have been lower and nations would not be in such a difficult state. Thus, the rough austerity measures could have been milder and with a longer time-span than now. This would have allowed nations to increase their GDP slowly, while simultaneously reducing their deficit and debt, which would mean that none of the current events would be happening. Although I am an advocate of the austerity measures in order to rationalize the budget, having too much too rapidly will only cause trouble in an already troubled economy.

P.S. The new idea now is that politicians and policymakers will offer more austerity with different measures than the ones the Troikans are proposing. Case study: Cyprus. The counter-measures proposed by the Cypriot government include a 9-11% cut in public servants wages (nothing of the kind was mentioned in Troika documents) in order for the Troikans to agree for the non-abolishment of the 13th salary (a bonus salary paid at the end of each year). Again simple maths: €1000 monthly salary is €12000 a year. A 9% cut would mean that €1080 euros are cut from the worker's salary each year. (provided that the 13th salary does not suffer the 9% cut as well). So in essence, the worker is giving up €1080 to receive €1000. (€1170 if the 13th salary suffers cuts as well). You may imagine what happens at the 11% level. 

Clear case of stupidity and obsession with an idea: the 13th salary should not be abolished, thus we are offering extra cuts, so that the 13th salary will remain but the overall hit would be larger than the one proposed by Troika. Hmm, one wonders who it is the officials work for. Troika would be much better in running Cyprus than its politicians.

Austerity Measures and Reforms in Cyprus

The first thing I read today were the austerity and reforms guideline plans prepared by Troika for the island of Cyprus, which has requested a bail-out in the summer. According to them, the country's fiscal deficit has to be reduced to about 4% of GDP in 2012, 2.5% in 2013 and in the realm of 1% in the next two years. 

Austerity measures for 2012 include:

1. Freezing of the Cost-of-living-adjustment (COLA), extension of the special contribution

2. Freezing of wages and filling of vacancies in the public sector for another 2 years (until 2015). Extend this regulation for all state officials and Members of the Parliament who will now see their allowances taxed (the law for the state officials has already been passed as I have seen)

3. Introduce an immediate early retirement penalty of 6% of the Government Employee Pension Scheme (GEPS)

4. Introduce a permanent contribution towards pension entitlements for all government employees

5. Abolish the 13th salary of the broader public sector employees and state officials, reduce 13th pension by 50% in the 1000-1500 bracket and 75% in the above 1500 bracket.

6. Increases in the excise duties for tobacco, alcoholic drinks, and motor fuel

7. Increase tax on dividends by 1% and to deposits by 0.015%

If one takes a good look in the above measures, the fact is that rough and rapid changes (like the ones in Greece) are proposed. The only measures which would be considered rough would be the abolishment of the 13th salary of all state officials and pensioners. However, we are talking about the 13th salary, an additional one which should not have been calculated in e.g. bank loan repayment installments. Granted, a 13th salary in Cyprus is part of the gross yearly salary and people are taxed on that, however, this is much better than actually reducing the rest 12 wages. As far as dividend tax is concerned, from what I understand, Cyprus has a fixed tax of 20% - which is rather odd since people who are earning 1 million euros a year and 50 euros a years end up paying the same rate. I would like to see the Troikans propose a new dividend tax scheme based on the tax bracket one belongs instead of a fixed rate (that is, for individual dividend-receivers). 

The 2013 cuts will include:

1. Abolishment of obsolete allowances as well as general government wages and salaries with a target reduction of 15% in the government bill (hopefully, they will be wise enough to focus on abolish allowances instead of reducing wages and salaries by 15%)

2. Reduction in social transfers by 10%

3. Reduction in the Easter, Christmas and Dietary allowance as well as abolishing heating allowance

4. Consolidate housing-related schemes

5. Reduce the number of government employees by 250 per year (1250 in total)

6. Reform shift-work system to reduce overtime remunerations by 20% in 2013, an additional 10% in 2014 and keeping the amount paid stable for 2015

Even in 2013, although Cyprus will still be in recession, austerity measures will not be so harsh as they have been anticipated. To compare in 2011 the Cypriot government had taken measures of 500 million euros compared to the 360 million of permanent measures the Troikans ask for 2012. Things will obviously get worse before they get better, however, the measures are much more conservative than those originally expected by the press and public. In addition, these measures were very much needed by the country, but just like any other nation in the world, politicians and policymakers did not want to make any reforms until the final hour. In any case, what I have been saying for over 2 months now, has finally been understood by the Troikans. Harsh and rapid changes are not a good solution for an economy. We have Greece to thank for that lesson (the country has paid a rough price for it though). Cyprus will have a much smoother bail-out period, provided of course that nothing extreme occurs!