Taxation without representation

Imagine that you are a country that has achieved a primary budget surplus, even though just a few years ago it run a double digit primary deficit (and that deficit was not due to bank support for the 2008 crisis). This surplus becomes even more impressive if one looks at the structural primary balance which runs close to 4% of GDP (and is not achieved because of an output gap close to 10%).

This country has also managed a substantial current account surplus which is positive even if EU transfers are taken into account. Nevertheless, the country still has a sizable negative NIIP, close to €218bn for 2014 (or 122% of GDP). But taking a closer look at external assets and liabilities the reality is that the country’s private sector has a strongly positive net position while it is the government and the central bank that accounts for most of the liabilities. In particular the government registers €36bn in government bonds held by the foreign sector, €3bn in money market instruments and €227bn in (official) loans, a total of €266bn (almost 150% of GDP and – excluding T-Bills – more than 85% of total government debt). Moreover, its central bank has foreign liabilities of almost €50bn.

This country has gone through immense austerity and internal devaluation in order to achieve the above surpluses with a loss of more than 25% of its GDP. Its output gap is still close to double digits and more than 26% of the work force is unemployed with GDP growth rates hovering around zero.

As you have probably imagined by now this country is Greece and most of the losses described so far can be directly accounted by austerity. What is being demanded from Greece right now is to ultimately continue the transfer of resources from Greek people (a budget surplus is always a net reduction of financial assets of the private sector) to official lenders under the threat of default and Grexit. Yet is such a transfer the rational thing to do?

It is obvious to most people by now (including the IMF) that the Greek bailout was mostly a bailout of private bondholders and the transformation of Greek government debt from Greek law bonds to English law billateral and EFSF official loans. This mistake was officially recognized in 2012 with the Greek PSI, the subsequent debt buyback and the November 2012 Eurogroup statement although the actual reduction was too little, too late. With official lenders insisting on their state of denial the Greek government is asked to achieve large primary surpluses in order to maintain the illusion that its debt will follow a downward path towards sustainability until 2020 and the official sector will not lose its assets. The above is achieved through a ‘stick but no carrot’ approach of dictating both the primary surpluses figures and most of the austerity measures details, always in conjunction with ‘growth enhancing structural reforms’ (which nevertheless don’t seem to be that growth enhancing according to IMF itself) under the threat of the ECB closing down Greek banks (through capital controls or restrictions on ELA) and withholding funds to pay.. the official creditors.

Corporate Finance 101 states that under debt overhang it is not rational for the equity holders of a company to finance new projects since any improvement on the recovery value will mostly accrue to debtholders (who are senior) and leave little free cash flows for other stakeholders. This is exactly the case of Greece where its main stakeholders (government and people) are asked to increase ‘equity’ by transferring resources that will be used mainly to pay official creditors (mainly the IMF at this point in time). Greece is mostly given promises of future reductions in debt service costs (which should have been implemented a year ago) and growth through the structural reforms impact.

Yet under a scenario of a (partial) default by Greece, the reduction would almost exclusively hit foreign creditors. and immediately improve the country’s NIIP and debt service costs. Given its twin surpluses and the reduction in the face value of its debt, Greece would almost immediately gain access to financing (defaults do not usually result in long-term market exclusion) and be in a position to dictate its fiscal policy and (slowly) return its economy on a growth path.

The real battle therefore is not one of what reforms are appropriate but ultimately a battle of resources. The actual stakeholders of Greece are asked (in a fairly undemocratic manner) to ‘lower their stakes on Greece’ (as Paul Mason put it) and transfer resources to official creditors that will improve their recovery rates on loans granted only to repay past debts. Creditors demand debt seniority with management rights available only to equity holders (who usually settle for being junior in the balance sheet structure and earn only a ‘call option’ on future free cash flows for the right to manage). At some point, ‘taxation will have to coincide with representation’.