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I recently finished Thomas Piketty main book «Capital in the 21st Century» which contains a series of very interesting observations on the dynamics of wealth and (labor) income. The one that struck me the most is the fact that in cases where income and population growth is low (something that was basically true for the most part of human history until the Industrial Revolution), inherited wealth becomes very important for wealth holdings. Exactly the opposite happens when population growth is large (hence most children inherit almost nothing) and when income growth is significant and thus wealth accumulated through saved income becomes important in determining total wealth.

The above dynamic is quite evident in the case of Greece. First of all, population is actually falling with fertility rates at 1.3 children/woman. This means that most children grow up without any siblings and thus end up inheriting all of the family wealth (75% of all households have no more than 3 members):

ScreenHunter_1189 Nov. 17 11.08

Moreover, median income has fallen back to 2004 levels. The very large debt burden, high NPL ratios and the requirement for significant primary surpluses for decades to come indicates that Greece faces a significant risk of walking an Italian path in the following decades: Income growth will be stagnant while debt loads will stay high with a large part of income devoted to servicing old debts instead of financing investment and growth.

ScreenHunter_1190 Nov. 17 11.12

In such a setting, past wealth and assets become the determining factor for a person’s total wealth with current income not being able to create new saving and wealth flows. Actually, as I outlined in a previous post, Greek households are consuming past wealth on a grand scale in order to be able to finance current consumption, a reasonable outcome of the 26% fall in median income since 2010. According to recent figures, gross saving was a whooping -7% in 2017.

According to BoG Financial Accounts, more than 60% of household financial assets is in the form of currency and deposits and another 23% in unlisted shares. The rest of household wealth is probably in the form of housing. Listed shares (which typically are the assets that have the largest growth potential) are only 3% of total financial assets (they were 40% in the height of the 1999 stock bubble and close to 10% during the golden Euro years).

Roughly ¾ of Greek households own a primary residence with median total net wealth of 90,000€. The main residence has a median value of 70,000€ making it the most important asset while median financial assets of all households are only a couple of thousand €.

For a risk-averse person (such as the Depression hit Greek population) the main priority is wealth preservation instead of a growth potential (especially if the latter comes with a probability of a destructive tail event). Thus most people would probably prefer a low-yielding Euro asset instead of a re-denomination of wealth in drachmas. An early Grexit might have avoided the 25% drop in output and the current low-growth potential yet, as long as the Greek Depression is now considered a «sunk cost», wealth preservation takes priority and staying in the Euro becomes an attractive option, even if it coincides with low income levels and growth. The «attractiveness» of the Euro option most probably increases with wealth levels which means that it becomes a «hard-line choice» for the ruling class which has most wealth to lose/redistributed in a Grexit scenario.

The Grexit option might as well have come and gone.


I ‘ve been reading Robert Gordon’s interesting book concerning economic growth and its drivers during the last 150 years. Gordon’s main thesis is that not all inventions and technological advances are created equal or have the same impact. The major technological breakthroughs which had a significant effect on productivity (and thus on economic growth) took place mostly more than a century ago and involved creating the networks we still use. Networks of water, sewer, electricity, roads, telecommunication, transport. Networks which were introduced only once, had a strong effect on growth for decades and are now present without having any more major impact on productivity.

One can agree or disagree with his (pessimistic) view of the future, yet what I think everyone will agree on is his powerful and extensive description of how life was just 150 years and the way in which these inventions changed everyday life and how everyone used their time.

In my view, there is a clear and strong interaction between social norms, property/voting rights and technological advancement. As long as most peasants (who accounted for the bulk of the population) lived at the subsistence level on mostly self-grown food and self-made clothing, property rights were limited and even forms of slavery were present for centuries (mostly in the form of serfdom in Europe). Once technological advancement changed and enlarged the consumption basket as well as created a demand for factory workers (and an «exit» option for peasants in the country fields), labor services were remunerated in monetary terms and property started to become widespread. The introduction of large massive armies (as opposed to forms of professional army service) also accelerated the abolition of serfdom since nations needed free men to fight their battles.

As a result, while only a few centuries ago most people in the countryside had no property, faced serious restrictions in their movement (even in their most basic personal freedoms in the case of serfs), did not have voting rights and lived in the subsistence level, the 19th (and especially the 20th) century found them enjoying an ever expanding consumption basket, holding property and claiming an expanded array of rights. The Industrial Revolution and technological advancement was the main driving force for these changes.

In particular, not too long ago, even the simplest things that today we take for granted were extremely cumbersome tasks. Most families lived in rural farm houses, with no electricity, no central water and sewer systems meaning that all water (and waste) had to be carried by hand. Light was provided by candles, half the family budget was spent on food while most of the clothing (especially women’s clothing) was made at home by mothers and daughters.

In 1925, wives reported working an average of 6 hours per day for seven days on household tasks, which translates to more than a full-time 5 day/week modern job. Moreover, infant mortality was close to 20% while roughly one in four infants died before reaching the age of 5.

The high children mortality rate, coupled with the needs for household and manual farm work meant that the birth rate was exceptionally high. White women laid birth to an average of 4.6 children while black women to 7.7. Obviously that meant that the wife was usually busy raising a new born child, apart from taking care of the household on a full-time basis.

This all changed in a couple of decades. Clean running water and a sewer system led to a dramatic reduction of deaths caused by infectious diseases (37% of all deaths in 1900) and a drop of infant mortality rates from 20% to 5% in half a century:

ScreenHunter_1180 Oct. 23 23.16

By 1950, the introduction and diffusion of modern conveniences and appliances had reached a critical point. At the same time, clothing was readily available in stores and did not need to be home-made. All this, led to a significant drop of the amount of work required to maintain a household and a large fall in fertility rates. In 1940, while the US was entering WWII only 65% of consumer spending was on categories that existed in 1869, with the share of services in the consumption basket doubling from 24% to 43% (while food decreased by a comparable amount from 44% to 22%).

ScreenHunter_1182 Oct. 23 23.22ScreenHunter_1181 Oct. 23 23.22

WWII full employment along with the millions of men occupied on the front line fighting the enemy, led to the women massively entering into the labor force for the first time. During the following decades, changing social norms meant that women would pursue academic education and a career in all occupations, increasing their participation rate from 35% in 1950 to 50% by 1980 (and 60% in 2000).

Yet what is quite interesting is the fact that, until roughly the end of the 19th century, necessity was the main driving factor for women non-participation in the labor force. Keeping the household was literally a full-time job, while high fertility rates meant that there was almost always an infant present in the family requiring constant attention. One had to choose between working manually in the agricultural fields or taking care of the household. There was no central heating, no running water, no refrigerator, no sewer at the house and every duty had to be done manually, taking hours to complete tasks that take only minutes today.

Obviously this division of labor was also the result of long-standing social norms as well as a function of the hardship associated with manual agricultural work. No work by women with a monetary remuneration meant limited property rights and subordination with regard to men.

Yet necessity and (the absence of) technology played a decisive role in this division. Once advancements in technology dropped the amount of time required for household maintenance coupled with lower infant mortality and a lower requirement of a large number of working hands for agricultural manual work, women’s time was freed on a extraordinary scale. Women started entering the labor force, first as manual factory workers (in WWII) and afterwards in all sorts professions once college education was made available to them (a task that required extensive fighting from their part).

Technology did not only change the consumption basket, create new professions and free human time for more leisure but it also had profound implications on long-established social norms, the division of labor within households and personal property rights, things that had remained quite stable for centuries. Today’s equality between men and women not only rests on decades-long women’s struggles but also on inventions and advances that completely changed the landscape of modern households.

Since my last post was mainly focused on the issue of inequality I would like to continue on this road and introduce a concept which I will call «Economic Reproduction Frontier» (ERF).

The main idea is rather simple: Take the threshold of the major brackets of income distribution as a share of average per capita income and examine their course across time. I will be using data from the World Inequality Database on a per adult (equal split) unit for this exercise.

One can think of average per capita income as a crude pointer for both the consumption basket (or frontier) in a given country at a given time as well as the cost of human capital development for an individual. An income say 20% of average per capita income will correspond to a significantly different (and highly constrained) consumption basket and place large obstacles on the opportunities and capabilities of an individual increasing and expanding his human capital. Since most economic output is mass consumed and production is highly connected to human capital, the income available to a large proportion of the population will ultimately act as a constraint on economic growth. Especially if individual income as a percentage of average per capita income falls on a permanent basis.

To do this I calculate the share of threshold income for various income brackets in the US during the period 1966 – 2014 (due to data availability). Below are two graphs, one for P20/P30 percentiles and one for P40/P50. Linear trendlines along with the exact equation and R² for each percentile are also presented.

P20 P30 Percentile threshold % GDP 1966 - 2014P40 P50 Percentile threshold % GDP 1966 - 2014

It is striking how all threshold shares are on a permanent downward trajectory, as well as the very strong R² for all lines (over 0.93 in all cases with stronger results in the P40 and P50 cases). The relative stability of the threshold shares up until the turning point of 1980 is also evident. The regression coefficient points to a fall of roughly 50bp annually for the P40 and P50 brackets which means that each bracket losses almost 5% share of per capita GDP every decade.

P20 and P30 brackets start below 50% and fall to 20% and 30% by 2014. What is striking is that the P40 brackets falls to roughly 40% by 2014 starting from 63% (the P50 bracket falls to 56% of average income starting from 77%). This suggests that at least 40% of the population  cannot maintain a middle-class consumption basket and human capital without going into debt since it is severely income constrained. Even P60 and P70 brackets show a clear drop in the given period (from 90% to 73% for P60 and from 106% to 94% for P70) suggesting an extremely strong middle class hollowing out in recent decades, at least for the p30p70 bracket. Only the top-10% threshold share shows an increase in the given period from 170% to 184% while even the P80 threshold share lost 2.5%:

Change in threshold share of average income 1966 - 2014

Although I am sure this simple exercise will have methodological issues it still suggests a strong loss of income resources for a major part of the general population with serious consequences on long-term growth. If 40% of the population are not able to finance their human capital development through their income nor afford a basic middle-class consumption basket without going into debt, this suggests that long-term growth will be affected in one way or another.

Modern capitalist economies are based on large scale production of mass consumption goods and on using a highly educated workforce in a large part of the production process and sectors.  Linear extrapolation suggests that the P50 bracket will fall to 50% of per capita income by 2026 (while P40 will be 35% and P30 24%) making the above process highly constrained. We might be nearing an inflection point for economic growth due to growing inequality.

Recently, the IMF published its long-awaited Article IV consultation on Greece which includes an assessment of the latest developments of the Greek economy as well as its own DSA on Greek debt (which rests on significantly different assumptions than the ESM DSA).

The IMF starts with a stark chart showing how the Greek tragedy compares to the US Great Depression, the 1997 Asian crisis as well as the Eurozone crisis:

IMF Greece Crisis US Great Depression Asian Crisis

The depth of the Depression is quite similar to the US case while Greece has managed to «maintain» a 25% lower GDP for a period of 5 years.In contrast, even the US managed to return to its pre-crisis GDP level 7 years after the start of the Great Depression. This is a clear indication of the way the Greek case was tragically mismanaged by the European countries and the IMF whose priority was avoiding a principal haircut of official loans rather than a quick return of Greece to growth.

The IMF projects that Greece will grow moderately during the 2018-2022 5-year period which also coincides with the period during which the country will have to register primary surpluses of at least 3.5% GDP. Most of the growth is projected to come from fixed investment with private consumption contributing 0.5% annually and a neutral contribution from the foreign balance:

IMF - Greece 2018 - 2022 main macroeconomic projections

As I have outlined in the past, such a growth path rests on the assumption that Greek households will continue dis-saving at the order of €9bn annually even while they have already depleted their financial assets by €34bn in the 2011-2017 period. This is based on the fact that, given a neutral external balance and a 3.5% primary government surplus, sectoral balances indicate that the private sector will need to maintain a negative net asset position in order for the other sectors to achieve these balances.

Projecting nearly 1% annual increase in private consumption during the 2020 – 2023 period without any countervailing factor (such as a positive external balance or a significant relaxation in the fiscal stance) seems quite optimistic. An annual negative balance of just €8bn means that households will have to consume another €40bn of their financial assets in the 2018-2022 period. Only employment growth (which will increase disposable income of the household sector) will act as a countervailing force. It’s a pity that the IMF does not use sectoral balances to check whether assumptions for private consumption and government surpluses can be realistic in the long-run.

The other important part of the IMF document is obviously the Greek debt DSA as well as its assessment of the possibility of maintaining large primary surpluses for many decades.

In its baseline scenario the IMF staff agrees with the ESM that debt-to-GDP trends down and Gross Financing Needs (GFN) remain below 15% of GDP in the medium term.

Nevertheless, the IMF argues that Greece will be unable to maintain a primary surplus larger than 1.5% of GDP after 2022 while its long-run economic growth will hover around 1% in start difference with the ESM which is projecting a primary surplus of 2.2%. As a result, the IMF is much more pessimistic for the long-run, projecting that Greek debt will become unsustainable after 2040:

IMF - Article IV 2018 DSA

What is also quite interesting is how even medium-term sustainability rests on assumptions of large primary surpluses and growth during the 2018 – 2022. A small 2 year recession during 2019-22 (with a total of -3% GDP growth) coupled with a small primary deficit for just one year will immediately push debt-to-GDP close to 200% and GFN to 20%.

IMF - Adverse Scenario 2019 - 2022 Greek Debt

Lastly, the IMF staff try to justify analytically why Greece will be unable to maintain high primary surpluses and economic growth in the following years. While the specific arguments have been put forth many times in the past, it is interesting to repeat them here once more (in IMF exact wording):

  • Ceteris paribus, aging would imply an average yearly decline of 1.1 percentage points in Greece’s labor force during the next four decades.
  • Total factor productivity (TFP) growth over the last 47 years averaged just ¼ percent annually, by far the lowest in the Euro Area. Assuming this historical average TFP growth rate going forward, labor productivity (output per worker) would grow only at about 0.4 percent in the steady state (the rate of TFP growth adjusted for the labor share in output).
  • Combining the historical growth in output per worker of 0.4 percent with expected growth in the number of workers of -1.1 percent would imply long-term annual growth of -0.7 percent.
  • While studies have documented an impact on output levels of 3 to 13 percent over the initial decade, the impact of reforms on growth tends to fizzle out afterwards.
  • Lifting long-term growth from its baseline of –0.7 percent to 1 percent requires reforms to add 1.7 percentage points to growth per year for the next decades. The OECD (2016) estimates that full implementation of a broad menu of structural reforms could raise Greece’s output by about 7.8 percent over a 10-year horizon, which translates into an increase in annual growth of some 0.8 percentage points for about a decade. Bourles et al. (2013) estimate this gain to be slightly higher, at about 0.9 percentage points per year, while Daude (2016) finds that reforms focused on product markets and improving the business environment in Greece could boost growth by about 1.3 percentage points per year for a decade.
  • Implicitly, the 1 percent growth projection presumes that Greece would manage to increase labor force participation to levels that exceed the Euro Area average (to offset the significant projected decline in Greece’s working age population) and that would generate TFP growth rates permanently far above Greece’s historical average.
  • Historically, Greece has been unable to sustain primary surpluses for prolonged periods. During 1945–2015, the average primary balance in Greece is a deficit of about 3 percent of GDP, although a brief period of near-zero primary balance took place at the time of Greece’s EU accession. The high water-mark for Greece was a primary surplus exceeding 1 percent of GDP during eight consecutive years (1994–2001).
  • In a sample covering 90 countries during the period 1945–2015, there have been only 13 cases where a primary fiscal surplus above 1.5 percent of GDP could be reached and maintained for a period of ten or more consecutive years.
  • Economic conditions matter. Among EU countries, before entering a period of high average primary balances, countries tend to have strong real GDP growth (2.7 percent) and modestly high inflation (4 percent). They also have moderate unemployment (10 percent) and low net foreign debt (24 percent of GDP), conditions that do not conform to those now applying in Greece. Moreover, during the high primary balance periods, growth has been rapid (about 3.4 percent), inflation slightly elevated (3 percent), and unemployment contained (at about 7.2 percent). This suggests that sustained periods of high primary surpluses are driven by strong economic growth rather than by sizeable fiscal consolidation.
  • Unemployment weighs on the budget through higher social expenditures—such as for unemployment benefits and social safety nets—as well as lower income-related revenue. Greece’s unemployment rate is exceptionally high—only 10 countries have had unemployment higher than 20 percent in the postwar period.Within the above sample, the average primary balance corresponding to countries suffering double-digit unemployment rates is about zero percent of GDP (i.e. balance). For double digit unemployment lasting for 10 years or longer, the average primary balance is about -½ percent of GDP. With long-term unemployment likely to remain high for some time, pressures on social assistance spending in Greece—such as the guaranteed minimum income—are likely to mount.

Overall, the IMF tries its best to provide Europeans with political cover for the medium-term outlook on the Greek front while still presenting a scientific case for why the targets set in the Greek program are highly unrealistic and will not be achieved. In my view it should pay closer attention to sectoral balances which would make it even easier to argue why large primary surpluses cannot be maintained in a country with a structurally negative external balance.

Since a previous post tried to answer an Austrian argument regarding how large parts of the (Greek) population are dependent on government, I would like to use the opportunity to elaborate a bit on a number of political economy arguments in favor of big government (and taxation). These will mostly revolve around the issues of scale, insurance, sectoral balances and investment, although I am sure others can think of more.


What distinguishes the iPhone is basically exactly that. For most people the iPhone is a product which differs significantly from other cell phones, provides social status and higher utility than a much cheaper smartphone. In other words, the main achievement of Apple is that it can sell the iPhone with a large profit margin.

Yet Apple is not in the business of making Ferraris. Its aim is not to produce and sell several hundred iPhones. On the contrary, its business model is centred around manufacturing millions of iPhones which it will sell at a high enough price to achieve a large profit margin yet not so high that it will threaten its sales volume. Its profits depend on a scale effect meaning that it depends on earning a lot per product yet coupled with a large volume of production.

Although Apple can affect its profit margin (through marketing, brand name, product design and features), the scale effect is an externality from its own viewpoint. In order to achieve this effect it requires a large enough base of medium/high income customers and an infrastructure that can support its large distribution and retail network. Ideally Apple would like to not bear any cost for maintaining these networks yet reap all benefits from their existence.

The same goes for almost all companies in the world which base their business model on mass production instead of scarcity. Their P&L statements contain sales proceeds and direct costs entries yet no entry for the cost of the scale effect which they leverage in order to achieve their profits.

Although this scale effect is to a large extent an «emergent property», meaning that as all these companies pay for their costs and investments a large customer base emerges it also depends on a central government to provide for all the infrastructure and networks needed for «the market» to operate. This might be the rule of law, enforcement of contracts, transportation networks, payment systems, standardisation of equipment and networks and so on.

In this sense, taxes can be seen as payment for the provision and maintenance of all these networks that allow the scale effect to continue.


To a large extent, what distinguishes a wealthy from a poor person is the ability to self-insure through market mechanisms. A person with high enough income and wealth can cushion itself against bad luck, self-insure using a legally binding contract with a specialized firm against tail risks such as health issues and accidents, buy a high level of education and acquire a long-term contract to provide for his retirement along with his large stock of savings. A poor person will find it very difficult to self-insure against typical risks (such as health problems), have a very small stock of savings to use in a rainy day (ie unemployment) and will not be in a position to acquire high quality education unless it is provided at low/no cost. Such a person might not have access to housing at reasonable prices while his low income, frequent unemployment spells and inexistent wealth would make retirement very painful and entering (and staying) in a retirement plan quite unlikely.

Almost the only way to provide insurance for poor people (health, unemployment) and a level playing field in areas such as education against high income people is through centrally provisioned services by the government. The government will be the one to create an education system accessible to all people, institute unemployment benefits (paid by all employees),  provide housing to low-income communities and some form of universal health insurance scheme which will not allow people to suffer from illness only because of low income.

Sectoral Balances

I think that most people have understood by now that there is no way to avoid the sectoral balances of saving in any economy. By definition total saving must be zero which means that the private sector can net save only if the external of government sector is a net borrower. Unless a country can very quickly move its external balance (which is quite difficult to achieve, especially with regards to exports) this suggests that the government is the sector of choice to allow the private sector to net save in a downturn (especially through automatic stabilizers).

Actually, one of the major reasons why the Great Depression did not happen again is exactly the fact that governments are much larger today than they were during the 1930’s which maintains demand both through government purchases and large swings in the government deficit. Absent a large enough government sector, downturns would be «corrected» through very large changes in the unemployment level just as they did during the Great Depression.


Although I touched this subject in the scale effect section I think it is quite important to warrant a separate section. The main idea is that apart from their own capital stock, all households and firms in an economy require a large public capital stock consisting mainly of networks such as transportation, communication, electricity and others. Although these networks are extremely important and would make it mostly impossible to conduct market transactions in their absence, the fact is that their benefits are diffused among the general population.

As a result, they remain an externality from the point of view of each individual and firm which means that each of them would like to use them without paying for them. The main way to overcome this difficulty is for the government to construct and maintain these networks and pay for their construction through the general tax system.


I think that the main idea is clear. From the point of view of each individual scale effects, social capital (law, contracts) and infrastructure appear as externalities which are diffused among the general population. Unless a central player acts to introduce and maintain them it is almost impossible for the private sector to coordinate in providing for them while covering their costs. Moreover, insurance is a privilege for the rich (and healthy) and only pooling and central provisioning can allow for less fortunate individuals to enter the market without having the rules of the game rigged against them from the start.

In other words, a private economy by construction includes inequalities and market failures which require a central actor to overcome them. One of the most significant market failures is an economic downturn when the private sector in the aggregate wishes to increase its net saving yet only another sector can provide the necessary assets by increasing its liabilities. Unless the idea is to achieve the desired net saving through mass unemployment and hardship, the government sector is the next best thing.

As I ‘ve highlighted many times in the past, the level of future long-run primary surpluses for Greece plays a major role in the debt sustainability scenarios. The major difference between the IMF and Euro institutions projections is identified in the primary surplus assumptions. The IMF projection for a 1.5% surplus makes debt restructuring necessary while the European institutions assume much higher primary balances which make debt sustainability more favourable.

IMF vs Euro Institutions Greek DSA

A recent ESM paper on Greek debt reveals the importance of these projections. If Greece achieves 3.5% primary surplus until 2032 and 3% until 2038 no debt restructuring is required as long as economic growth is 1.3%. On the other hand, the IMF scenario of 1% economic growth and a primary surplus of 1.5% after 2022 makes Greek debt explosive.

European institutions try to make the case that episodes of large and sustained primary surpluses are not uncommon in European modern history. The ECB especially highlights the cases of Finland and Denmark as well as other countries:

The European Central Bank says such long periods of high surplus are not unprecedented: Finland, for example, had a primary surplus of 5.7 percent over 11 years in 1998-2008 and Denmark 5.3 percent over 26 years in 1983-2008.


ECB - Selected Episodes of large and sustained primary surpluses in Europe

My comments are twofold. First, the average primary surplus figure is not always equal to the year-by-year primary balance. Denmark achieved a primary surplus equal or higher than 5.3% in only 5 years during the 1983 – 2008 period. Actually, the primary surplus was at least 3.5% during 9 of the total of 26 years.

Yet the most important element that is not highlighted in the above cases is the fact that large primary surpluses were achieved in the context of equal or (mostly) higher current account surpluses. This is highly important since it allows the domestic private sector to achieve a positive net asset position even when the public sector is in surplus. As a result, economic growth is not threatened by the public sector and the private sector maintains a healthy balance sheet.

To illustrate the above I ‘ve «corrected» the primary surplus by subtracting the current account surplus. I ‘ve also deliberately set the vertical axis maximum to 3.5% which is the surplus requested from Greece to illustrate the fact that it is almost never achieved.

corrected primary balance for current account - selected high surplus episodes.jpg

On the contrary, of the total of 60 years in the above episodes, 26 had a negative corrected primary surplus while it was lower than 1.5% in 40 years illustrating the fact that the IMF assumption of a 1.5% surplus is not unreasonable.

Since the Greek cyclically adjusted current account is highly negative it is clear that the assumption of high primary surpluses which will be maintained for decades is almost without precedence in the context of the private sector balance. Assuming a 3% nominal growth rate (based on the IMF assumption of 1% growth), a 10 year 3.5% primary surplus is equal to a 30% GDP transfer from the domestic private sector while a 20 year 3.5% surplus is equal to 52% GDP transfer which will not be counterweighted by a current account surplus.

In my view, the European institutions continue to make assumptions consistent with avoiding explicit costs for Greece’s creditors but inconsistent with economic reality and sectoral balances.

A recent paper tried to perform a very important exercise of evaluating the balance sheet effects of a Euro exit for various Euro countries. Its results were that the relevant sectoral net positions will be the main drivers of balance sheet effects. Periphery risks are concentrated on the net positions of the government and the central bank while the financial and non-financial sectors mostly hold a positive net position.

net position by sector and country

More specific risks do arise from the fact that certain sectors (within countries) have significant levels of short-term debts, although this fact does not change the overall picture substantially.

Debt by sector and country

I would like to use this opportunity in order to take a detailed view at the sectoral balance sheet risks from a Grexit scenario relying on BoG Greek NIIP data (data are for 2016Q3). I am focusing on specific categories and not taking categories such as direct investment or derivatives into account.

Greek Sectoral NIIP 2016Q3

On the asset side:

  • BoG now holds a large stock of foreign bonds as a result of its participation in the ECB QE program.
  • MFIs have a total of €19bn in deposits and €59bn in bonds a loans. Nevertheless, a large part of the latter are EFSF notes offered as part of the various rounds of Greek banks recapitalization exercises.
  • NFC and households have substantial claims in the form of deposits and banknotes, more than €52bn in total.
  • The general government holds no assets while its foreign exchange reserves are very low and mostly in the form of monetary gold. Although Greece does have a claim on the ECB reserves this would not change the picture in a serious way.

On the liability side:

  • The general government is the largest debtor with €28bn in bonds and €236bn in loan liabilities. Yet most of the bonds and almost all of the loans are long-term in nature.
  • BoG is the second largest debtor with almost €93bn in liabilities which consist of Target2 and extra banknotes.
  • MFIs have a large stock of liabilities in the form of deposits (which are usually a proxy for repo trades).
  • NFC and households have a very small stock of liabilities in the form of bonds and loans (a bit over €10bn).

Overall one observes that:

  • The largest part of the Greek NIIP is attributed to the Greek government with over €260bn in debt.
  • Taking into account the bonds held as part of QE, BoG net foreign liabilities drop to €47bn.Using the most recent available data (January BoG monthly statement) this figure further decreases to a bit over €38bn or close to 20% of GDP.
  • NFC and households hold a strong positive net claim from the RoW equal to almost €44bn. This most certainly masks firm-specific risks and mismatches but overall, the Greek non-bank private sector will improve its net position in the case of a currency depreciation (following a Grexit).
  • Using only deposits figures, Greek MFIs have a net liability close to €28bn. Since a large part of their liabilities will be under foreign (instead of domestic) law this creates a serious risk of missing debt payments or being unable to roll-over short-term repos and other obligations. Given that the Greek banking system will be the one intermediating in all of the private sector’s foreign transactions this net liability position can create rather difficult scenarios.

I will also use BoG MFI balance sheet data to take a closer look at Greek bank foreign risks:

Greek banks foreign risk Jan-2017

It is clear that things are a bit complicated, especially since Greek banks have a large stock of intra-group transactions with group members in other (Balkan?) countries. Nevertheless, after correcting for such transactions one observes that they owe €13.6bn in net liabilities to other MFIs (€18.5bn gross) and another €8.6bn in foreign deposits. The main source of risk will mostly be the first item which is usually secured by a standard contract (master agreements) and is under foreign law.Missing a payment on these liabilities will create serious problems for the corresponding bank and its ability to continue transacting in international markets. Obviously a risk assessment would be made easier if the maturity profile of these liabilities (and assets) was known.

Regarding the BoG liability position I believe that in the event of a Grexit, securities held for monetary purposes will be used to settle the largest part of Eurosystem claims while the remaining net position will be settled with some form of Greek government long-term securities (probably floating rate notes paying Euribor).

In summary, I generally agree with Kostas Lapavitsas who believes that a Grexit scenario will necessitate increasing Greek government foreign reserves to at least €12-15bn. The main immediate sources of risks are the short-term debt of the Greek government and Greek banks. The first consist mainly of liabilities towards the IMF (since SMP Greek bonds are under Greek law and would be converted to the new currency) while the second require a thorough risk analysis. A Grexit would be extremely difficult if Greece only held €7bn in foreign exchange reserves (with 2/3 being monetary gold) since a bank debt payment failure would create serious disruptions in the country’s international transactions.

The recent narrative regarding Greek debt sustainability has moved from the debt-to-GDP ratio towards the annual debt financing costs (interest payments + maturing debt). According to this analysis, Greece already enjoys very generous terms until 2020 and beyond and will only require small debt reprofiling measures in terms of interest rate payments and debt maturities after 2022. What is needed according to its creditors is for Greece to continue on the reform path, achieve economic growth and commit to credible fiscal measures that will allow it to maintain high primary surpluses close to 3.5% of GDP. Unfortunately that can only be achieved through tough measures on the pension front. «As long as Greece continues on this path, creditors will do their part» as the story goes.

In my view the above story is problematic, mainly because it relies on Greece achieving and maintaining a 3.5% GDP surplus target, a target which I believe is not credible in the long-run. In order to examine the subject from a theoretical point of view, I will use some well known concepts in economics, debt overhang and dynamic inconsistency.

Debt overhang is a concept usually used in corporate finance. It is based on the idea that, as long as the corporate balance sheet carries too much debt (which always takes precedence in payment over stock), stockholders do not have an incentive to contribute new funds in order to fund new investment projects if the proceeds are mainly used to improve the recovery rate of creditors. Balance can only be achieved if creditors ‘share the costs’ through a restructuring of the liability structure of the company balance sheet.

The same applies in the case of Greece. Its own ‘stakeholders’ do not have an incentive to contribute funds (in the form of high taxes or lower pensions/wages) if the increased surpluses will mainly be used to improve and ‘guarantee’ the recovery rate of foreign creditors. Given that Greece has a negative external balance (especially the cyclically-adjusted figure) it is an accounting fact that a primary surplus will involve a deterioration of the Greek private sector net financial assets position. Maintaining a 3.5% surplus target in the indefinite future involves a very large transfer of financial wealth from the Greek private sector to foreign official creditors with only a small part of the (possible) growth dividend staying in Greece. Most corporations would not accept such a bargain unless under threat, something which is more than evident in the Greek case where the Grexit threat has been thrown around for more than 5 years now.

Dynamic inconsistency on the other hand involves the idea that sometimes the solution to a dynamic optimization problem depends on the specific time when the problem is evaluated, which has the effect that a specific action time path is not credible.

A classical example is capital taxes. A fiscal authority might want to commit to low capital taxes in order to achieve large investment and growth. Yet at time t=1 investment has already been made and the temptation is high to increase capital taxes in order to enlarge fiscal revenue.

In a way, the same applies in Greece. In order to achieve debt sustainability, the fiscal authority must commit to a path of large primary surpluses. Yet, given the fact that such surpluses deteriorate the private sector position and the possibility of a negative shock hitting the economy, it is highly likely that Greece will have to lower its surplus (or even run a deficit) at some point in time. When the time of a negative shock comes, the optimal solution for the sovereign is to try and smooth the effects of the shock on the economy, not maintain a target that will only make matters worse.

As a result, especially given the need to maintain the surpluses for a very long time (in order to achieve debt sustainability), such a path is not credible. The fiscal authority will deviate ‘at the first sign of trouble’.

Combining the debt overhang with the dynamic inconsistency argument leads to a clearly unstable equilibrium. Both the sovereign and the Greek private sector (Greek stakeholders) do not have the incentive to commit on a high surplus strategy. Under completely rational behavior they have every reason to not damage their financial position and maintain the best possible growth rate. Any commitment on the high surplus strategy will not be credible but only a ‘temporary deviation’ in order to avoid short-term negative outcomes since the Grexit threat is still considered credible.

In my view, only a path of low future surpluses (accompanied by a large upfront debt restructuring) is a long-term credible strategy. Otherwise, we ‘ll keep on observing the current ‘stop and go’ path, with the Greek government implementing the least possible measures and its creditors using Grexit as stick and the (insufficient) future debt reprofiling as carrot in a repeated game with a non-optimal outcome.



Recently we had to write a large essay on the bank loan pricing procedure of the banking system under imperfect competition (for the banking course we ‘re currently attending). The end result was quite interesting and we have posted it as a Working Paper on ssrn. The paper is heavily based on the relevant work of Ruthenberg and Landskroner (2008) which has been extended with more realistic assumptions such as a non-zero Recovery Rate on loans and a securities portfolio to match capital and reserves.

The paper first describes a few stylized facts of modern banking with sections on modern monetary policy implementation and the actual interbank market (where monetary policy acts as an interest rate cap on ‘competitive spreads’). This is followed by a general (stochastic) model for the term and credit risk premium added on loan rates.

The model assumes that a bank finances a new loan by borrowing in the interbank market under Cournot oligopoly and Basel capital requirements. We only examine the case of a properly functioning interbank market with very low excess reserves and liquidity hoarding. The end result is the following equation:

bank loan pricing under imperfect competition

where RL is the loan rate, Ps the borrower’s probability of survival, Rf the risk-free rate, θ the spread in the interbank market over the risk-free rate, k cost of equity (RoE), H the Herfindhal-Hirschman index of concentration in the loan market, ε the elasticity of demand in terms of RL for new loans by bank customers and φ is the risk premium per borrower which is equal to:

φ = PD x LGD

(PD: Probability of default or 1-Ps and LGD: Loss-Given-Default).

Based on the above equation, it is clear that the main drivers of the loan rate are the  Probability of Default and the risk-free rate (these two factors account for over 90% of the loan rate). PD enters the equation both as a ‘compounding factor’ and in the risk premium φ. The end result is that for PD higher than 5% the compounding factor increases substantially and a loan becomes very expensive. The obvious conclusion is that the PD is used as a ‘first line of defence’ by banks in order to determine if a loan will be offered in the first place and the amount made available (especially as a percentage of available collateral, proxied by the Loan-to-Value ratio).

This explains why credit crises and large recessions lead to a ‘credit crunch’ since a large enough PD will result in loan rejections and not in a (very large) increase of the offered loan rate. Updates to a borrower’s PD /LGD (after a loan has been extended) are usually large enough that a bank cannot include them in the loan rate risk premium (without pushing a borrower to an early default) and are incorporated in Loan-Loss provisions.

Under perfect competition (H close to zero) banks are not able to earn a premium over the risk-free rate (apart from the borrower risk premium) and only get their required RoE. If market power exists banks are capable of gaining an above normal profit which is rather marginal for H lower than 0.1 (usually lower than 10% of the risk-free rate). For large enough HHI the premium becomes quite significant.

Both the RoE and Basel capital requirements play a role in the loan rate offered although that depends mainly on the loan’s risk weight.

The model specification was followed by a simple application in the Greek banking system during the Euro era (and before the 2007-2008 credit crisis). Although we did not use any econometric techniques in this essay, the model performed quite well with an R² of 0.93. Given the current HHI of 0.214 it seems that banks have gained (through M & As) significant market power and are able to impose a premium of close to 30% over the risk-free rate in their quoted loan rates (based on the model’s projections).

Our next step is to use the model in order to look into the Greek banking system with more detail and estimate an econometric specification. Still, the basic stylized facts that can be drawn are quite significant and can explain why credit crises lead to a credit crunch and how higher probabilities of default eat into bank profits through loan-loss provisions. Obviously we would appreciate any comments on the paper and the outlined model.

I find studies of income inequality and economic growth especially interesting since, apart from anything else, they highlight the differences between the neo-classical consensus and the post-keynesian view of the world. In this context I found two papers by Simon Mohun published on the Cambridge Journal of Economics and focusing on income inequality due to supervisory wages growth and on capital productivity long-term movements very enlightening. The fact that the author uses simple accounting exercises instead of relying on heavy econometric work is also quite positive since it keeps the analysis simple and not easily questionable.

The author starts by looking at the evolution of the US profit share (defined as profits to the capital stock) since the early ’60s. The rate is decomposed in the profit share (profits to value added) and capital productivity (value added to the capital stock) using a simple chain rule:

pre-tax average rate of profit profit rate - profit share - capital productivity

What the author then does is to decompose the economy into ‘productive’ and un-productive sectors and the workers into supervisory and non-supervisory employees. It turns out that supervisory workers saw a large increase in their wage share especially after 1980 while non-supervisory workers experienced a large fall in their own share after a mild increase in the 1964-1979 period:

table 5 - growth in shares of MVA

If one expands the ‘capitalist class’ to also include supervisory workers which means that their wages should be included in the profit share, the actual path of the profit share turns out to be quite different than the original series:

profits and supervisory wagesAs a result, the ‘expanded’ profit rate actually shows a significant increase after 1980 with a large part attributed to the expansion of supervisory wages and not only to the increase of capital productivity:

expanded profit rate - profit share - capital productivityWhat should be stressed at this point though is that this expanded profit rate does not provide the financing means for an expansion in investment (which would be naively assumed to be the driver of the increase in capital productivity) but rather is appropriated by the supervisor ‘worker’ class.

In the second paper, Mohun takes a deeper look at capital productivity as well. Keeping with the productive/un-productive distinction, the capital productivity growth is decomposed into:

  • the expansion of the productive and un-productive fixed assets (which tend to explain a small part of the growth)
  • relative prices (between capital goods and general output) and
  • the ratio of labor productivity to capital deepening (the ratio of the capital stock to labor hours).

The findings on relative prices are in agreement with other studies on the subject which find that capital goods ‘got cheaper’ since 1980 and were a significant driver of the divergence between labor productivity and real wages. The author finds that during 1982-1998 relative prices contributed around 35% to the change in capital productivity:

price of net fixed assets and inventories relative to the price of output

The major driver though was the large change in capital intensity. While capital deepening (it is named technical composition of capital in the paper) grew close to 3% in the 1966-1982 period, it stagnated (-0.1%) in the 1982-99 period. Labor productivity growth remained roughly the same at 1.5% and 1.4% respectively.

table 5 - annual rates of growth - labor productivity - capital deepeningSo it seems that firms not only took advantage of lower capital goods inflation in order to increase their capital productivity but were actually able to maintain growth in labor productivity without investing into productive capacity (at least in relative terms). The paper speculates that this growth was achieved through the introduction of more efficient ‘management and organization techniques’.

In any case, the papers make it quite clear that the deepening income inequality since 1980 was driven primarily by the rise of the manager class whose renumeration grew at the expense of productive workers and normal profits. This growth was made possible by the lower relative fixed assets inflation and continued increases in labor productivity despite a complete reversal in capital intensity by corporations.

The above is also reflected in a more detailed study of income growth in the top income earners based on US tax return data:

Table 7 shows that the share of national income (excluding capital gains) received by the top 0.1 percent of income recipients increased from 2.8 percent in 1979 to 7.3 percent in 2005. Again, the shares received by executives, managers, supervisors, and financial professionals increased markedly, with the increase in the share of income among these occupations accounting for 70 percent of the increase in the share of national income going to the top 0.1 percent of the income distribution between 1979 and 2005. The pattern is similar in Table 7a when we include capital gains.

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Kostas Kalevras

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