Keep Your Eye on the Ball

I managed my son’s little league team years ago. Before one game the league President stopped by and warned me that my third baseman’s parents were in a nasty divorce fight. He noted if the father showed up to a game and caused trouble, I was to call the police. Sure enough the father showed up to the next game with a male relative that was three-sheets-to-the-wind. Now the father turned out to be a nice fellow, but in the fifth inning the police car showed up. It turned out that the relative had gone over to the adjacent softball field and started a ruckus.

The real crisis we should be paying attention to is China’s stock market, not the Greece’s monetary and economic woes. Let’s look at the basic economics of Europe in this memo and the Chinese market crisis in the part two of this memo.

The concept of Comparative and Absolute Advantage has forced the relatively small economies of Europe to band together. The concept proves that it is better to specialize making what you do best, or having the least disadvantage will lead to more and cheaper products for all.

The United States’ economy from the start combined all the states into one country which gave us a huge economic advantage. Each state or region specialized in what they did best, resulted in more product that was cheaper for all. When you go to Indiana from Chicago there is no tax, no passport required, and you do not have to exchange your money. All of these events add to the cost of making the product.

Europe finally figured out that their costs were higher (insurance to cover exchange rate variances, labor costs of dealing with export and import requirements, etc.) and decided to combine into one economic unit so they could effectively compete with us. That’s not going to change given the concept of Comparative Advantage.

Criteria was set up to become a member. The European Union (EU) established the common currency (Euro) so Greece and the others in 2002 could reap the rewards. One key requirement for the Euro adoption was that each member had to keep their debt at a certain percentage of their Gross Domestic Product (value of the goods and services they produced each year.)

Now here’s the problem, in 2001 a major U.S. investment bank created a financial product that was legal at the time, which effectively allowed the Greeks to double their debt without letting any other country know. So some contend that they lied to get into the EU to start.

Combine this fact with the Greek’s reputation as Robert Reich (Secretary of Labor under Clinton) recently stated that they have: “years of corruption and tax avoidance by its wealthy and socialist government spending patterns.” Many Greek civil servants, according to The Economist, could retire after 35 years with 80 percent of pay. Germans get 70 percent of pay after 40 years.

You have a recipe for disaster.

In 2008 the world financial crisis hit and the Greek hidden debt was now outed and everyone knew they were going to default on their loans. So in 2010 the EU bailed them out with a $145bn rescue plan. But the EU attached strings that limited the Greek government’s ability to stimulate the economy.

In the United States the American Reinvestment and Recovery Act, Cash for Clunkers (Car Allowance Rebate System), Troubled Asset Relief Program (TARP) and reductions in taxes were strong Keynesian economic responses to the Great Recession. Our Will County Board and the State added more stimulus. The EU debt constraints prevented the Greeks from doing this and their economy died. The European Union leaders’ response was to channel 109bn to Greece in loans with more cost cutting requirements.

So they temporarily stave off the default problem, so the EU countries could continue to reap the rewards of Comparative Advantage; but they piled more debt and shackles on the Greek economy. Unemployment rose to 25% and 40% for their youth. Germany took the lead in setting up the agreement.

It should be noted that in 1953 the allied countries under the London Debt Agreement forgave Germany many of its debts. They were simply wiped off the books. It allowed the Germans to become a world economic power.

So what is the bottom line here?

  1. With the help of bankers, the Greeks were able to mislead the EU and gain membership.
  2. It is in all the Europeans economic interests to have a common currency and economic structure.
  3. There will be reform of the EU to a more central government but that will take time. (Each country can’t be trusted to act independently on spending and taxes).
  4. With unemployment skyrocketing all the young talent will leave Greece, as it did in the early 1960’s).
  5. No matter what the current crisis agreement, the bottom line is that Greece without Keynesian stimulus will not be able to hold up its end of the bargain.
  6. Sooner or later the EU will have to forgive part of the debt.

How does that impact the average American?

  1. Don’t buy Greek bonds.
  2. Stocks that are sensitive to short run ups and downs of external crisis like this one can lose significant value quickly, but will recover if the fundamentals of companies are good (they make a profit, pharmaceuticals are a good example).

Don’t breathe easy yet. The Greek drama is only the side show. The real crisis that can impact us significantly comes from China. Their stock market has lost 40% of its value in three weeks. The causes are strikingly similar to those of the Great Depression. That is the subject of the part two of this memo.

Following that I will finally write the memo many of you have asked for on the Federal Reserve’s long drawn out promise to raise interest rates.

Of course, the fall and next spring memos on the Presidential candidates’ economic proposals and policies should be fun to write. I’m looking forward to writing about: Donald Trump’s, Rand Paul’s, and Ted Cruz’s economic plans.

The rules for buying houses and cars is also in the future.

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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