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ZAPP: Knowing when to cut your losses

In “The Gambler,” Kenny Rogers sings about knowing when to hold and when to fold. This is a skill that seems in short supply and difficult to teach. Business leaders and elected officials alike seem unable to cut their losses when they face financial challenges.

We know intellectually that problems do not go away and, if not addressed, will only grow larger. Why then do we seem to believe that some heroic action can magically save the day, the company or the country?

The crisis in Greece is a perfect example of this human trait. In 2009, Greece’s conservative government informed the European Monetary Union that its budget deficit had reached 8 percent of gross domestic product, far above the Euro zone’s goal of 3 percent.

To cover the government’s shortfall, Europe supplied credit that Greece used to repay private bank loans.

Two years later, Greece’s newly elected left-of-center prime minister informed Europe that his predecessor had lied; Greece’s annual deficit was actually 12 percent of GDP. Additional European credit was extended along with requirements that Greece increase taxes and decrease public spending.

These terms were rational for lenders who wanted Greece to use a future budget surplus to repay these new loans. Unfortunately, anyone with knowledge of macro economics could predict that a surplus would force the economy to shrink and make loan repayments even less feasible.

With their economy shrunk by 25 percent, earlier this year Greek voters put a far left party in power after it promised to reject further austerity demands by European financial leaders. After negotiations failed to gain Greece a reprieve, Greeks voted 61 percent in a national referendum not to accept any new European austerity demands in exchange for new loans.

In the stalemate Greek banks lost access to new credit, and the resulting liquidity squeeze drastically limited the amount of cash citizens could take each day from their own accounts. The economy continued to contract.

To gain the credit Greek banks needed to operate, the far left government agreed to additional European demands in return for a temporary loan package. Details will be negotiated over five months in hope of a long-term credit agreement that would attempt to keep Greece in the Euro zone.

But why did Greece not return to their own currency (Drachma) six years ago when their economy was stronger and debt smaller? A flaw in the Euro concept is that individual countries cannot synchronize their fiscal and monetary policies.

A country with its own currency can devalue it when its economy needs stimulation as Mexico and Argentina did during the past two decades. Cheaper currencies make exports and local tourism more attractive to foreign buyers.

The current Greek debt cannot be paid, especially given the dramatic decline in its economic activity. Any attempt to force Greek repayment will only destabilize the country and possibly its democracy.

What else have we learned from this Greek tragedy?

The initial government deficit was not caused by overspending as often claimed. Instead, tax evasion produced the revenue shortfall. The budget would have balanced if tax compliance was stronger.

Recent research in Greece found that tax avoidance was closely correlated with the degree of a person’s independent employment. No surprise here. Hourly workers and pensioners have their taxes taken out automatically. But these are also the people who now suffer the most.

Finally, many of the original loans to the Greek government by private banks would not have been issued had the lenders not anticipated rescue actions by the European Union and European Bank. Economists call this problem moral hazard. If these loans had not been made, Greece may have had a better opportunity to fix their smaller problems.

 

Kenneth Zapp is a professor emeritus at Metropolitan State University and a Mentor with Savannah SCORE. Contact him at Kenneth.Zapp@metrostate.edu.

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