What Does Regime Uncertainty Look Like?

To follow the development of the Euro crisis it sometimes feels like watching a slow motion movie where we know the final result, but we don’t know how is it going to be played out. News and uncertainty, again, about the future of the Euro and a potential default by Greece is like following the story of a character whose fate we know is sealed. That the Greek situation is delicate it is not new, but it illustrates that failure to deal with the underlying problem only delays the required solutions, and during the process things can get worst.

Greece needs to cut a deal by March 20, when a big bond payment is due. There are no expectations that Greece will be able to avoid default without an agreement with either bondholders or creditors (other countries or institutions like the IMF). The Euro crisis is a fiscal crisis: countries are unable to pay their debts. Some are in a more precarious situation, like Greece, but this is the underlying problem that all the countries of the region share.

Greece had received financial help and had committed to fix its budget, namely, to cut the deficit and improve its fiscal situation. But Greece failed on this regard and now it is replaying the same situation, but with less patient and open creditors willing to extend further financial help. The position of the national governments in situations like this is not easy. They face a conflict of interests when faced with the loss of rent seekers. If the government decides to improve its budget by cutting spending, then the particular beneficiaries of government expenditures and payments are affected. Not all, only some, are affected. Therefore social protests, union manifestation and strikes pressure the government against this approach. On the other hand, to raise taxes would impose a lower cost per capita, since an increase in taxes is paid by all citizens, but the overall cost in the economy increases if taxes go up. The rate of return of business decreases. And if the rate of return decreases, there is less incentive to invest and expand economic activity. This situation damages the economic performance in the medium and long term—to raise taxes is not a solution, but a strategy that politicians may use to pass the problem to the next government. A government, however, does not find itself in a situation like this due to bad luck, but only after a long period of unsound fiscal policy and failing for a long time to correct the course.

But this is not the only channel that affects the economy, and the situation in Greece illustrates this point as well. Since in the medium and long run there is no solution to the underlying problem, the uncertainty of what the next temporary measure will be affects the willingness to do business. In other words, a risk premium associated to the institutional framework in the country rises. This regime uncertainty may not only halt economic recovery, it may even expel activities out of the country. This is not a friendly situation for economic recovery.

Willingness to invest in Greece goes down, and businesses that are already working in Greece either postpone their plans for expansion or use those resources to avoid liquidity problems. The uncertainty of the future of the Euro in Greece has very expensive consequences for the Greek economy that worsen its situation even more. A note by The Economist, for instance, tells how some firms may see fit to move their business. Aquis, a firm that runs hotels and resorts in Greece, has moved its headquarters, and bank accounts, to London; or how foreigners are reluctant to extend credit to importers even if backed up by a Greek bank. Greek importers need to pay with cash-in-advance to import goods and factors of production. This imposes a higher liquidity constraint to the importer, which in turn implies that Greek banks dry up as Euros are transferred to foreign accounts as a payment for imports. In addition, the government is slow in paying back value-added tax (VAT) rebates, worsening the liquidity position of firms and banks.

Promises of reform are not enough if acts don’t point in the same direction. Greece failed to send a clear message that problems are going to be solved and its debt honored by failing to put forward the required reforms and adjustments. A government that is convinced of what the solution should be does not hesitate or cut short the required measures. It is this lack of commitment that increases the regime uncertainty in Greece, but also what prompted a call from Germany that Greece (and other countries going in the same direction) resign to their budget controls until their situation is improved. Namely, that any country in a position similar to Greece will have budget autonomy only on the resources available after debt payments. But if a government does not have control of its budget, what is left of that government as a government? This promises to be a very politically difficult solution.

The case of Greece illustrates a few important things. Economic problems do not respond to promises, but to expected acts and decision. Promises of cuts in spending that are not credible can have no effect; they only erode any goodwill the government has built when the problem knocks at its door again. It shows that the driver of the crisis is not so much financial regulation and bank solvency in itself, as much as debt pressure and fiscal deficits on part of the government. Debt can be high, but as long as a government runs a surplus that allows it to pay principal and reduce the debt pressure, then there is no stress on the financial markets. But if debt is high and there is also a fiscal deficit with governments uncommitted to tackling the underlying problem, then it does not matter what the monetary institutions are in place, the system does not hold and eventually breaks down.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

image: flickr.com/Sotiris Farmakidis

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