Greece: Is there a third way?

Steve Hanke has an interesting Cato piece defending Estonia’s currency board.  Although I recently criticized the tight money in the Baltic states; I should have also mentioned that due to their heavy euro debts, they don’t have any great alternatives at this point.   I also agree with Hanke that Estonia has pretty good economic fundamentals, and may well bounce back surprisingly well.  I know less about Latvia.  Of course not all of the problem was created in the Baltic states.  A part is due to the tight money policy in Europe and America that depressed nominal asset prices all over the world.  This Hanke comment was especially interesting:

Their rescue package fails to address the anti-market (antigrowth) structure of the Greek economy. For those who might question this statement, take a look at the accompanying table that compares the ease of doing business metrics for Greece and Estonia. Without growth, Greece is doomed.

This brings us to the euro. Many notable economists — from Harvard’s Prof. Martin Feldstein to Princeton’s Prof. Paul Krugman — have concluded that Greece is in a euro trap.

They assert that there is no way for Greece to become competitive and grow because it no longer has its own currency, the drachma, to devalue.

As Dr. Domingo Cavallo, Argentina’s former Minister of Economy, and Dr. Joaquín Cottani, former Undersecretary of Economic Policy in Argentina, have shown in a paper that will be presented at Palazzo Mundell in July, the devaluation trap is nonsense.

A Cavallo-Cottani supply-side reform would eliminate Greece’s huge employer contributions to payroll taxes. This would reduce wage costs and enhance competitiveness.

Their reform would also impose Greece’s VAT tax at a single, uniform rate — rather than at its current three rates. These two supply-side tax changes would be roughly fiscallyneutral, when based on conservative static calculations. But what about competitiveness? It would get a big boost, roughly equivalent to a 40%-45% currency devaluation.

This is one of those ideas that sounds good at first glance, but doesn’t sound so good if you know a bit more economics.  But if you know a lot more economics it starts sounding good again.  The proposal would cut Greek labor costs by eliminating the payroll tax, thus making Greek labor more internationally competitive.  Lost revenues would be made up with a VAT, which applies equally to domestic and imported goods, and hence doesn’t distort trade.  So far so good.

If you know a bit more economics you know that, in equilibrium, the effect of a 10% payroll tax cut combined with a 10% higher VAT should be neutral.  Both are consumption taxes.  Employers would pass on the employment cost savings from lower payroll taxes in the form of higher wages.  Indeed 10% higher, just enough to cover the higher VAT.  Nothing real should change.

If you know a lot more economics you know that, because of sticky wages, labor markets aren’t always in equilibrium.  Hanke’s idea is essentially aimed at nudging them back toward equilibrium.  Because of the crisis in Greece, the current Greek wage level is temporarily above the wage required to produce macroeconomic equilibrium.  Hanke’s proposal would cut total employment costs, even as the (sticky) nominal wage received by workers stayed the same.  The trick is that the government controls part of the total employment cost, and thus can adjust wage costs even if workers won’t accept explicit nominal wage cuts. 

This isn’t to say his idea would necessarily work; perhaps Greek workers and pensioners would riot over the VAT increase.  But it is a policy that can in principle work much faster than internal devaluation through long and painful nominal wage cuts.  It certainly deserves to be discussed.  Even if the full proposal cannot be implemented, a smaller payroll tax cut combined with a smaller VAT increase would help.  One thing I don’t know is whether the EU rules have a maximum VAT rate, and whether Greece is at the limit.  But rules can be changed in an emergency.  (There is also the problem of tax evasion, which rises as the VAT rate increases.)

Part 2:  Matt Yglesias in China

Here is Yglesias on China’s lack of mega-rich.

China’s growth has been accompanied by some stark increases in inequality, but it seems noteworthy to me that one area in which the People’s Republic is a real laggard is the development of mega-rich individuals. For example, according to Forbes’ authoritative list the world’s top 100 richest individuals includes zero citizens of mainland China.

.   .   .

As a bonus fun counterpoint fact, egalitarian Sweden has a wildly disproportionate number of mega-rich citizens. With only 9 million people and an overall GDP less than ten percent the size of China’s, Sweden boast two of the fifteen richest people on the planet—the heads of Ikea and H&M. That’s in part just a coincidence, but I also think it reflects the reality that high taxes and high public spending aside the modern-day Nordic countries actually have a very neoliberal underlying economic structure whereas China is very much the reverse.

Does that second paragraph sound slightly familiar?  I guess I have to exempt Yglesias from the group of those on the left who suffer from the following fallacy:

2.  Assuming that Dickensian conditions implies a country must be capitalist.  Many people on the left seem to create left/right mental boxes for countries based on their perception of working conditions.  Thus a country with poor working conditions and low wages (again China is a good example) is assumed to be “capitalist” and a country with good working conditions and a high level of equality (such as Denmark) is assumed to be “socialist.”  Actually it is much more complicated.  Economically speaking, China is a half-communist country with low levels of social insurance, whereas Denmark is an extremely free market economy with a large welfare state. 

Although I am much more free market-oriented than Yglesias on many domestic issues, we often see the big picture in surprisingly similar ways.  His blog posts on China tend to be very good, because he went to China already pretty well-informed on things, and thus was able to put what he saw into proper context.  

Here is Yglesias on the currency issue:

What I’d wished he’d [Yglesias' Chinese host] added is that there really ought to be a way out of this dilemma, namely for revaluation to occur in the context of the U.S., Europe, and Japan committing to more expansionary measures of a monetary or fiscal (or both) nature. For whatever reason, western political leaders seem to have determined that an extended period of badly elevated unemployment is a small price to pay to head off the possibility of hypothetical future inflation. China’s leaders, more sensibly in my view, have the priorities the other way around—trying to keep an eye on inflationary pressures, but predominantly focused on the actual and present danger of labor market collapse. But it’s just really hard for China to pull this off on its own and the Chinese economy simply isn’t big enough to serve as the engine of global demand. Making life easier for China’s economic managers isn’t the reason western leaders ought to do more, but it’s certainly true that better policy in the west would give them more wiggle room in a way that ultimately would make it much easier to resolve the contentious currency issue.

Here is Yglesias on the relative contribution of real and nominal factors in the worldwide recession:

To say that the world has solved its supply-side problems would be absurd. Greece really is overburdened with bureaucracy, Italian governance is a mess, we have too many useless homes in the Inland Empire and the suburbs of Las Vegas, and too much of Ireland’s GDP growth was based on a tax haven accounting gimmick. But Greece and Ireland are tiny, Italian governance has always been a mess, and the value of homes in the Inland Empire and the suburbs of Las Vegas has always been tiny relative to the vast productive capacity of the United States. To think that Greek overborrowing and over-bureaucratization could somehow maroon a global economy that’s featured the invention of the Internet and the liberalization of China and India is slightly insane. We right now have the capacity to produce more—much more—than has ever been produced before in the history of the planet. There are dozens of supply-side policies that could be improved in every country on earth, but that’s not a new fact about the world. What’s new is the lack of demand, the willingness of the key leaders in Tokyo, Frankfurt, Washington, Berlin, and now it seems London as well to tolerate stagnation and disinflation in the face of some of the most exciting fundamental new opportunities for human economic betterment ever.

Good stuff.

Part 3.  If I ran the Washington Post

The first paragraph of this WaPo story:

In a chest-thumping essay and book published 20 years ago, Francis Fukuyama asserted that the end of the Cold War ushered in the everlasting dominance of Western democracy. History, as Fukuyama famously declared, had ended — the evolutionary struggle between ideologies was over, and market democracy had emerged as “the final form of human government.”

Would be followed by:

And in the following 21 years Fukuyama’s predictions came true more than anyone could have imagined, as the world saw an unprecedented move toward democracy and market economies. 

Instead, for the 837th time that I have read something like the first paragraph of the WaPo article, in both newspaper stories and academic articles, it was followed by the following mindless cliche-ridden drivel:

Well, it turns out history lives on. Three convincing new books show that, far from ascending as predicted two decades ago, Western values are under threat in many corners of the world.

I don’t know why people write things like that.  Everyone knows what they will say, so why bother even wasting the ink?  Why not just write “insert cliche #837 here.”  Wouldn’t it be nice to have newspapers that didn’t just pander to our prejudices, that didn’t just tell us things we already know?  I am resolving to never again continue beyond that first paragraph.  After 837 attempts, there is no longer any reason to hold out hope that the rest of the article might contain an ounce of original thought.

Here is the article’s final paragraph:

The assumption among free-market proponents over the past 20 years has been that the globalization of wealth would inspire a growing middle class to lead a march toward ubiquitous democracy. Kampfner takes the reader around the world with him on an engaging first-person journey packed with interviews of locals and finds such optimism sorely misplaced. “It sounds good in theory,” he writes, “but it has not worked out that way.”

It didn’t?  You could’ve fooled me.  (The key phrase is “march toward.”)

PS.  I resolve to soon stop doing these ungainly conglomerate posts, and go shorter.



15 Responses to “Greece: Is there a third way?”

  1. Gravatar of Joe Joe
    31. May 2010 at 09:50

    Professor Sumner,

    Quick question. I’ve recently finished going through Mankiw’s Micro textbook, and making my way through his macro textbook. Afterwards, how should I go about learning to understand what you discuss in your blog? Often you guys speak about whether the problem is nominal, or real, or demand side, or a liquidity problem, etc. etc. I can’t follow anything. Can you recommend a good textbook of some sorts that would allow me to follow your “macro analysis.” Would Mishkin’s textbook allow me to understand all of this?



  2. Gravatar of ssumner ssumner
    31. May 2010 at 10:33

    Joe, You could try Mishkin, and I would also suggest reading some stuff by Irving Fisher and Milton Friedman. They are very good at distinguishing between nominal and real factors. A very different style from Mishkin.

    Money is tricky, so it takes a while to get the hang of it.

  3. Gravatar of Richard Richard
    31. May 2010 at 13:08

    There is no maximum VAT in the EU. Member states must apply a minimum of 15% on the standard rate and a minimum of 5% for the reduced rate. Some states apply up to 25% for the standard rate. Moreover, the UK standard rate is 17.5%, but they apply zero-rated to goods like children’s clothing and food, and a reduced rate of 5% for electricity and gas. Therefore, there is quite a bit of discretion for states to raise VAT but minimum floors to prevent beggar-thy-neighbour competition.

  4. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    31. May 2010 at 13:13

    Cavallo plan involves increasing Greek VAT right up to the maximum allowed by EU.

  5. Gravatar of sensei sensei
    31. May 2010 at 13:37

    The “mega-rich: in China are the Party Boss who control the State apparatus,the GSE’s and the PLA.

    This will not show up on the radar of Forbes, it is beyond their methodology. It is also rather specious logic to not account for relative wealth. I can assure you that in real terms the folks building the sky scrapers in shanghai are mega wealthy compared to the collies building them. The margin is much greater than in the USA.

    Beyond that, what hatred you have for the very notion of civilization–what naivete as well: A society that produces the “mega-rich” is not a source of evil–it is a source of good. To hold up a criminal, Communist regime such as the PRC as some sort of positive model goes to show just how far the left wing “elites” have gone from reason, decency and their own civilization.

    Collectivism, and with it its twin demons of envy and scapegoating, are a throwback to pre-history; IT IS ALSO RANK MARXISM. Equality of outcomes must be shunned and feared feared by any decent, civilized Westerner for it means the destruction of all fundamental freedoms and thus the destruction of our very civilization.

    You should be ashamed of yourself. If you do not like your lot in life then do something about it. If you cannot do something about it reflect on your own limitations and be thankful for what you have. Odds are that you have what you have because of those “evil rich people” and not because of your own merit.

    Matthew Yglesia, BTW, is a supercilious Marxist hack. He is not “well informed”, he has merely boned up on the latest left wing cant and agi-prop. That you could possibly hold him in esteem tells one all one need now about you.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    31. May 2010 at 13:38

    The Cavallo plan may be the only reasonable option for Greece if she wants to remain in the eurozone.

    Due to large euro denominated private debts Estonia probably had no other choice but to maintain the peg.

    However, Steve Hanke’s article seemingly ignored the huge depression that Estonia is digging itself out of. Hanke’s article uses IMF World Outlook data to argue that Estonia will have healthier growth than other countries from 2010-2015. He fails to mention that the same database also shows that Estonian real GDP declined by 16.5% between 2007 and 2010. For comparison’s sake Greece’s real GDP only declined by 2.0% over the same period. According to the IMF’s World Outlook Estonia’s real GDP in 2015 will still be 1.6% below where it was in 2007, eight years earlier. Greece’s real GDP will also be below its 2007 level by 0.1%.

    Latvia is in far worse shape. Its real GDP is forecast by the IMF to fall by 24.8% between 2007 and 2010. By 2015 its real GDP will still be 10.1% below its level in 2007.

    In short I found Hanke’s article to be anything but fair and balanced. I favor neoliberal reforms, as I think they have generally improved the Baltic states long run outlook, but they cannot comepletely insulate one’s economy from a severely deflationary monetary policy.

  7. Gravatar of happyjuggler0 happyjuggler0
    31. May 2010 at 15:10

    I could have sworn that the maximum allowable rate that an EU country was allowed to have was 25%; however wikipedia claims that they can set it higher if they want. Wikipedia has been know to be wrong before; so have I.

  8. Gravatar of scott sumner scott sumner
    1. June 2010 at 05:42

    Richard and 123, One of you is wrong.

    Sensei, I am not now, nor have I ever been, a member of the communist party. I am a libertarian. China is now more libertarian than under Mao. That is good. China is still not very libertarian. That is bad.

    Mark, All very good points. I didn’t mention the depressions there, because I had in my previous post. But you are right–they are quite severe. If they had never set up the currency board, and gone with inflation targeting, they would probably be better off today.

    happyjuggler0. So now we have three opinions—yes, no and maybe. That cleared things up!

  9. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    1. June 2010 at 06:15

    Looked up the latest VAT directive – 25% maximum is no longer there, so Richard was right.

  10. Gravatar of Richard Richard
    1. June 2010 at 06:48

    VAT coverage and VAT rates

    Given that EU law only requires that the standard VAT rate must be at least 15% and the reduced rate at least 5% (only for supplies of goods and services referred to in an exhaustive list), actual rates applied vary between Member States and between certain types of products. In addition, certain Member States have retained separate rules in specific areas.

  11. Gravatar of OneEyedMan OneEyedMan
    1. June 2010 at 07:33

    “If you know a bit more economics you know that, in equilibrium, the effect of a 10% payroll tax cut combined with a 10% higher VAT should be neutral. Both are consumption taxes. Employers would pass on the employment cost savings from lower payroll taxes in the form of higher wages. Indeed 10% higher, just enough to cover the higher VAT. Nothing real should change.”

    I believe this is only true if enforcement is equally easy for the VAT and Payroll tax. I suspect enforcement is much easier for the VAT and so lower rates would collect the same revenue.

  12. Gravatar of scott sumner scott sumner
    2. June 2010 at 04:50

    Thanks 123 and Richard.

    OneEyedMan, Good point, but I do know there are some enforcement problems for the VAT as well. But you are correct that in practice they would differ somewhat.

  13. Gravatar of Alex Alex
    2. June 2010 at 05:02


    If this plan is so good and politically possible I wonder why Cavallo didn’t put it in practice in Argentina in 2001 when he was “Ministro”. Now if someone else had come up with the idea then I would add: If I’m not mistaken exports in Argentina do not pay VAT while imports do (maybe in Greece it would be the same). I remember travelling to Argentina while I lived in the US and getting reimbursed at the airport (in part) for VAT I had payed on the goodies I was taking home. So a VAT is like a tariff on imports with or without all the other changes in the tax system. But if you want to make it revenue neutral then I agree that the labor taxes are a great way to start.


    PS: I don’t hate Cavallo, it’s just statistical discrimination.

  14. Gravatar of Doc Merlin Doc Merlin
    2. June 2010 at 14:24

    Re: Part 3.

    Just as a side note on the whole socialism vs capitalism story, people tend to forget that most of the Islamic countries are socialist (in the traditional meaning of the word, not the newfangled welfare democracy meaning). The US invasion of Iraq ended the Baathist socialism; the Iranian regime is having serious problems of its own now, and capitalism has made inroads into the arabian peninsula through some of the various city states.

  15. Gravatar of scott sumner scott sumner
    3. June 2010 at 10:32

    Alex, I don’t know enough about Argentina to know if it was politically and technically possible there.

    Many people wrongly think a VAT is like a tariff. It’s not, it applies equally to imports and domestically made goods. It applies to all goods consumed in the country, regardless of where they are made. Economists agree on this point.

    Doc Merlin, Those are good points.

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