Christos A. Ioannou & Dimitrios A. Ioannou, Greece: Victim of Excessive Austerity or of Severe "Dutch Disease"? June 2013

Greece: victim of excessive austerity or of severe Dutch disease?
Christos A. Ioannou1 and Dimitrios A. Ioannou2
As the Greek economy contracted by 25% since 2008 and the unemployment soared at 27%, Greece appears as an outlier in the crisis that hit eurozone. The actual GDP performance that has been worse than projected, is critical for the debt sustainability, and leaves an open question to explain the nose diving GDP. In our view the key is the buildup of a large structural imbalance between the tradables and the non-tradables sectors of the Greek economy.
Economist (Ph.D) with research works on labour markets, human resources and employment relations. His latest publications include Recasting Hellenic Industrial Relations for Internal Devaluation in Light of the Economic Crisis and European Integration, IJCLLIR, Vol. 28/2, 2012 and Greek public service employment relations: A Gordian knot in the era of sovereign default, EJIR, forthcoming.
2
Economist with research works on macroeconomic and monetary policy and international trade. His latest publications include Stories about Defaults Analysis Bulletin of the Centre for Analysis and Planning (of the Greek Ministry of Foreign Affairs), no. 70,2011, and The 'structural collapse' of Greek economy, Foreign Affairs Hellenic Edition Vol.14, 2013 (in Greek). Page 1
Christos & Dimitris A. Ioannou - Greece: victim of excessive austerity or of severe Dutch disease?
The key factor of tradables- non-tradables. The distinction between internationally tradables-non-
tradables is used in the economic literature mainly for two purposes: either to assess the real exchange rate of an economy or to calculate the real consuming capacity of its population (purchasing parity power theory). Nevertheless, there is a lesser known and referred, third aspect, which is relevant to the influence that the two kinds of goods exercise upon the long term trend of growth of national economies. It is under this scope that their relation presents important interest as regards the current -structural- economic crisis of Greece. It has been firmly
substantiated by Kuznets (1966), Balassa (1964), Samuelson (1964) and Baumol (1967)3 that the lower the average productivity of a national
Of course only Samuelson and Balassa refer explicitly to tradables and non-tradables.
Nevertheless Kuznets suggestions about the way that the structural composition of national economies evolves through time as the bulk of manpower moves from agriculture to industry and then to services, following the average growth of productivity, belong to the same line of thinking. On the other hand the economic sectors described by Baumol, where productivity increases exponentially through time, are identical to the main core of tradables, as we suggest in this article.
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economy is, the bigger as a percentage of GDP the sector of internationally tradable goods and services should stand. The internationally tradable goods can be transported and consumed away from the point where they are produced. Therefore their price is determined on a global level (one price law). The local producer that cannot offer her product in an equal, or better, price that her foreign competitors, is inescapably excluded from the market, even of her own country. Internationally tradables therefore are produced for a global competitive market according to the real comparative advantage of each country. For this advantage there are two facets: it is based either on the natural endowment of the country (natural gas for Norway, sun and sea for Bahamas), or on its possibility to produce at the efficient frontier, that is along the supply curve of the global economy (which could be the cost-efficient frontier for Bangladesh clothing industry or the technological frontier for US internet companies).
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The sector of internationally non-tradable goods and services, instead, comprises a different kind of products. Haircut is the typical example. Although there is a strong possibility that barbers in Marrakech make a much better job that their colleagues in Manhattan, for the onethirtieth of the price, no New Yorker cares to grasp this opportunity. To travel to Marrakesh just for a grooming or to bring the barber to New York for the same reason is not an economically rational act due to the cost of transportation. In this respect barbers in Marrakech and New York are not competitors at all. Each side has its own market, totally segmented and isolated from the other. Internationally non-tradable goods and services can be consumed only in the vicinity of the point of their production and, therefore, their price is determined locally. Tradables in the first place are extremely important from the development point of view: it is this sector that generates and provides the investible capital that allows the economy to increase its per capita productive capacity. The endogenous growth potential of the economy is unavoidably closely related to a, more or less, vibrant sector of
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tradables. This of course does not imply that non-tradables are irrelevant to development, since they are used, as well, as productive inputs. But the fact is that even their quality depends on the level of quality of the tradables which by their nature incorporate the latest advances of scientific knowledge and technology and therefore predominate over, and exercises the decisive influence on, the whole economic process. Given that their supply is limited by the current productive capacity of the local economy, the special feature that characterizes nontradables is that in case of a sudden surge of their demand, their supply cannot increase in the short run because it is not possible to import more of them. Therefore, in the short run, the market has to clear through a price adjustment. As a matter of fact, for both Balassa-Samuelson theorem and Baumol effect hypothesis to hold, non-tradables can capture the gains of productivity that occur in the productive, that is tradable, sectors of the economy if -or when- their income elasticity is equal or greater to one or their price elasticity is less than one. In the medium to long term, though, productive resources of the economy can
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move from the tradables sector to the non-tradables in order to take advantage of the widening profit margins, generating thus a rise in their produced quantities. This phenomenon will be reinforced in case we have to deal with a small open economy which is a price taker (as is the case for Greece): the miniscule fluctuations of demand for tradables that the small economy represents cannot have an impact, whatsoever, on their globally formed one price. Thus, in the small open economy even an increase in total aggregate demand that is not particularly directed to the non-tradables, will have the same results: increase of their relative prices in the short term (which is equivalent to exchange-rate appreciation) and transformation of the structure of production, with a proportional overgrowth of non-tradables sector in the medium to long run, provided that excess demand persists. Indeed, in this particular case that aggregate demand remains permanently in excess of the productive potential, and the producers of tradables, facing continuously declining relative prices for their
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products, and therefore declining profitability, find more convenient to move their resources to the non-tradables sector where the increasing prices of the output allow for more profitability, the shape of demand remains very accommodating to the whole transformation as it seems irrelevant whether there is complementarity or substitution between tradables and non-tradables. If there is complementarity, consumers can remain at the same group of indifference curves while moving to a higher level of utility combining more tradables, that are imported, with more non-tradables that are produced locally: the lots more (importable) tradables that are demanded as they become relatively cheaper, can only be consumed through the intermediate of the wholesale and retail trade distribution networks, namely non-tradable activities that flourish under similar circumstances. Substitution, on the other hand, has similar effects because, with the decline of investments in capital productive goods, savings are siphoned to another non-tradables sector, such as the construction of new houses. Thus, thanks to constantly excessive
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demand and for as long as (foreign) borrowing remains available, the small open economy specializes itself in producing this particular sort of goods and services, that is non-tradables. Strangely enough, this process, at least as long as it lasts, is usually perceived by economists, statisticians and policy-makers as a course of growth or development. Which according to some economic theorists of the first decade of our century was a particular kind of development: it was sorted as Mediterranean because it was driven by consumption (!), which supposedly made it different from the other kind of development, the Asiatic which, on the contrary, was driven by production. Life finally revealed that there is only one type of development, with no need of geographical prefix, and this one is solely and closely related to the improving of the productive capacities of an economy. The currency-union membership factor. Of course, as regards the above explanation of non-tradables sector overgrowth, one could notice a logical inconsistency: the
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extensive recourse to imports, in order to satisfy the augmented demand for tradables, and the subsequent widening external deficit (along with the brushing inflationary pressures) would have forced a
depreciation/devaluation of the national currency which would have resulted in a reequilibration of the internal balance between tradables and non-tradables. Even in a Bretton-Woods type system of fixed exchange-rates this would have been the final outcome of the whole process: readjustment through a formal devaluation. The answer to this objection would be: yes, that is correct and valid, but, unfortunately, not exactly in all cases. There are two cases, at least, where reequilibration by the means of readjustment of the exchange rate would not be possible. The first such case of an excessive growth of non-tradables is observed when a country happens to be producer of proportionally large quantities of some commodity with a good penetration into the international market and an overtime positively evolving price which helps improve the overall terms of trade by which the country
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conducts its trade with the rest of the world. The appreciation of the relative price of non-tradables in this case is the parallel effect of the appreciation of the real exchange rate. This phenomenon known as the Dutch disease, according to the term that was firstly introduced by The Economist magazine, in the seventies, in order to describe the effects that natural gas exports had upon the economy of the Netherlands, in a way runs counter to the formulations of BalassaSamuelson theorem and, especially, to the Baumol effect hypothesis that, both, attribute the appreciation of the real exchange rate not to the abundance of an exportable commodity but to the continuous betterment of the productivity, evidently in the non-commodities manufacturing sectors of the economy. The second case is different. It refers to countries that do not deal in their own national currency because they are members of a monetary union and, therefore, they have no possibility to influence exchange rates. Unfortunately, if they are small economies, they have no possibility, either, to influence the monetary policy of the monetary
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union, since this is calibrated and implemented by the Central Bank according to averages in which the contribution of big economies which possibly go through a different juncture of business-cycle that the small economy- has much more weight. The Greek evidence for the period 2000-2009. When Greece was connected to the euro system, in the year 2000, its sector of internationally tradable goods and services, according to our calculations, corresponded to 25% of its GDP4. This was a very low ratio, -actually the lowest in the EU 15 at that moment. Nonetheless, instead of a high productivity that could explain the lowest tradables percentage, Greece had the lowest productivity of the industry sector in the EU15 as well (for instance see Manganelli, 2000). Moreover, Greeces weakness as regards tradables was evident in its inability to satisfy its consumption with a commensurate production of its own. The
4
NACE codes 1-33, 50, 55-56, 62-63, 72 in Gross Value Added by Industry (A64),
2000-2011. Source: Hellenic Statistical Authority (EL STAT).
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balance of trade and the current account, both, presented significant deficits (in 2000 at -9,5% and -11,2% of the GDP respectively). The weakness of the tradable sector of the Greek economy, therefore, was not the corollary of high productivity but of a structural deficiency, well known to all for a long time. In this respect the convergence process at the start of the eurozone, as regards Greece, was understood not as a course towards less tradables but, on the contrary, as a course towards a stronger sector of tradables and a more balanced overall structure of Greek national economy in general. What happened since then? In 2009, when it became evident that the Greek economy was collapsing, the tradable sector had shrunk to 20,5% of GDP. And the question then arises: was that shrinkage, in one way or another, connected to the failure of the Greek economy? Or was totally irrelevant, simply the natural result of the improvement of overall productivity as economic theory postulates, and had nothing to do with the nose-diving of income levels and the severe depression that today runs its sixth year?
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According to a certain narrative the correct answer is the second: the current crisis is unassociated with the structural transformations that took place the previous years; simply it is the offspring of bad handling on the part of the troika (IMF-ECB-EC) that implemented a wrongly conceived contractionary fiscal policy in recessionary circumstances. Although this narrative does not have time to waste with structures (because it believes that only flows matter in an economy and not stocks), we could hypothesize that the extension of its claim would be a Baumol effect explanation: as the economy of Greece was developing, with a productivity rate of growth that was measured to be higher than the eurozone average, it was perfectly natural that the tradables sector had shrunk and the non-tradables grown (which is the classic symptom of Baumol disease). But is this correct? In order to answer this question and for better understanding the movement of tradables during the 2000-2009 period we can further divide them into two subcategories. The first one consists of those goods that are produced with technological methods which do not improve
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dramatically over time and, more or less, belong to the cultural or natural endowment of the national economy. Their supply and their price are not determined essentially by the evolution of the technological input but, rather, by global demand. Therefore the path of their supply curve is closely correlated with the trend and the cycle of global economy. We call these goods Dutch disease goods. In the case under consideration we deem that this subcategory of the Greek economy comprises the sectors of mining, of international maritime
transportations and of tourism -all moving in a procyclical way with the global economy and following its long run trends. Second subcategory is the one producing goods that we could call Baumol goods. It refers to the branches where productivity improvements are of capital importance and where the producer in order to remain in the market must always operate on the edge of the technological frontier. Those are the manufacturing branches, but also the IT branches of the economy. Baumol goods sector, where learning by doing is the way to operate, can be considered as the part
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of the economy where the level and the strength of endogenous growth can be properly gauged. The statistical evidence suggests that the production of Dutch disease goods in the year 2000 accounted for 9% of the Greek GDP. In the year 2009, their percentage contribution to the GDP was exactly the same: 9%. On the contrary the Baumol goods that in the year 2000 accounted for 16%, in 2009 contracted to 11,5% of Greek GDP. Was that outcome the result of a spectacular growth in productivity in this 10year period, as described by the theory of Baumol effect, or rather was the result of a collapse of the productive capacity of the Greek economy due to the fact that entrepreneurs and workers had deserted manufacturing and advanced technology activities in order to pursue higher profits and remunerations in the sector of non-tradables? Intuitively one can understand that this shrinking of Baumol goods sectors could not be the outcome of enhanced productivity, because in this case the economy would have stood the persecution and would have avoided its current sharp and socially painful major crisis.
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To have a more firm assessment for the meaning of those structural transformations of the Greek economy, we examine the issue under different angles: a) the external balance and current account movements; b) the productivity growth in the industrial sector, which is indicative for the entire productivity growth of the economy; c) international comparisons. The trade balance and the current account, in the first place, not only have remained deficitary during the whole period but, in comparison to the year 2000 they had further deteriorated in the last years of this period (the current account, for instance, from -11% of GDP in 2008 to -14,7% in 2009). As regards productivity in the industry sector, given that accurate data are not available, one needs to look no further that the two comoving indicators, which are competitiveness and technical
composition of the products of the Greek industry. Competitiveness first: for its plummeting during the first period of Greece's eurozone participation, there are an infinite number of studies and papers (for
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overviews and indicators see EC, 2012 and ECB, 2012). Even though competitiveness is not solely a function of productivity but of labour cost as well, no one could seriously claim that productivity in the Greek industry was advancing rapidly when its competitiveness was collapsing. Such a claim would not be compatible with the premises of Baumol theory or any other theory that explains the transition from an economy of goods to an economy of services. Furthermore, the fact that the Greek industry during the period 2000-2009 was simply collapsing, and not advancing with big strides of productivity growth, becomes evident if we consider the knowledge input and the technical ingredient of its products, which during the period 2000-2009 had regressed to the level of other Balkan economies with lower per capita income (Abdon et al, 2010). International comparisons are also revealing. All other European small open economies, which have a higher level of productivity than Greece, display, nevertheless, a higher, and not a lower, percentage of Baumol goods in their GDP, which is tantamount to a proof that the
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flimsiness of the tradables sector in Greece is not the result of extremely advanced productivity.
Table 1 : Share of Baumol Goods in GDP, 2009 Austria Belgium Denmark Finland Greece* Ireland Netherlands
Source: OECD-National Accounts. Note: * With this type of data, Greeces percentage of Baumol goods relative to GDP is slightly different than in the case of NACE tables.
22,5% 16,2% 15,2% 20,3% 12,3% 28,0% 15,5%
It is therefore evident that the low percentage of tradables (and particularly of Baumol goods) in the GDP of Greece is not an indication of high productivity but, on the contrary, of a structural deficiency. Even more, the current severe crisis that the country faces can be interpreted as an expression of its weakness in the tradables sector. For a long enough period i.e. during its first decade of
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participation in the eurozone, excessive public but also private borrowing, with very low interest rates, was overcompensating for the chronic inability of the tradables sector to furnish to the economy the liquidity of the common European currency that was necessary to sustain an hypertrophic consumption pattern. Yet, when the
overborrowing became evident, and at the end of 2009 the market mood changed abruptly, aggregate demand in the Greek economy plummeted and the balance between the two sectors shifted. All of a sudden it became clear that the level of prices of non-tradables was not any more affordable because, in reality, it did not correspond to an analogous level of productivity in the tradables sector, but simply was the effect of artificially high aggregate demand created by the excessive borrowing of the previous period. The current Greek crisis is nothing more than a violent process by which the relative prices of non-tradables to tradables readjust in line with fundamentals. Sadly, the only way that the forces of economy know to do that is through unemployment and liquidations.
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Unfortunately, however, it is not only the non-tradables sector that suffers from the crisis. As a result of the collapse of the banking system, and therefore of the transmission mechanism of the economy, even companies of the tradables sector that in normal situations would be considered as totally safe and healthy, today, as they are completely deprived of any credit, are brought on the brink of bankruptcy. If one wants to use a metaphor to explain the failure of Greek economy this could be the metaphor of an economy that was heavily inflicted by the Dutch disease during a ten years period because of a sudden and mysterious discovery on its soil of a rare and precious commodity that could be exported to the global market generating large profits. But given that the country, believing that the abundance will last eternally, had not taken precautionary measures for the aftermath, it was brought to her knees when, as suddenly and mysteriously as it had appeared, the rare commodity totally disappeared from the soil and evaporated to the air at the end of the ten years period, leaving the economy with a deformed structure, i.e. with a gigantic non-tradables
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sector, that the remaining filthy tradables sector is unable to support and underpin any longer. The Eurozone membership as a Dutch disease factor. Thus, it was clearly a Dutch disease and not a Baumol disease that hit Greece. But then, the question that arises is: what was this particular good or commodity, with such a short life, that generated all this turbulence? Of course, it was not tourism or shipping. Both these sectors, although by their nature contain an element of Dutch disease, they have remained at a constant ratio to GDP throughout the whole period and today represent one of the main hopes of Greek economy for recovery. The commodity that tipped the balance was something else. Actually it was not a tangible good or commodity at all, but rather a virtual quality or even virtue. Namely this commodity was the prerogative for Greece of being a eurozone member during the first decade of the 21st century. Claudio Borios (2012, 2013) theory on the importance of financial cycle for macroeconomic fluctuations befits almost perfectly the case of
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the Greek economy. Due to steadily increasing public and private borrowing from abroad, under the illusion of both lenders and borrowers that a country-member of the European Monetary Union cannot go bankrupt or risk insolvency, economic agents in the Greek economy were operating under an entirely erroneous, but at the same time firm, belief that the level of aggregate demand that they were facing represented genuinely and correctly the level of development of the economy. And, besides that, there was also an additional element facilitating the whole process of the irrational swelling of the nontradables sector, while their relative prices were sending all those wrong signals to economic agents: in spite of the claims of neoclassical theory, comparative advantage by itself is not an adequate driver for automatically positioning a country in the international division of labour. As the Greek experience shows, if you lose your position in the global market (of Baumol goods), even instantly, it is extremely difficult to regain later your previous market niche or to claim another
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satisfying new one at some other step of the ladder. Under those difficulties, and when the alternative for businesses is that much alluring, no motivation for such a strife exists: investors have the opportunity to make the same, or even higher, profit, by engaging in the well protected from external competition, and roaring, internal sector of non-tradables, where neither R-D is required nor Chinese competitor threatens to bring you out of the market. In a way, before the triggering of the global crisis, Greek investors in the non-tradables sector were acting under the same false perceptions as their American counterparts who were dealing with the securitisation of the subprime market: high returns for almost no risk at all. There is also another lesson that one can draw from the recent experience of the Greek economy: although the Greek crisis initially appeared as, and is still considered to be, a fiscal crisis, its severe and prolonged repercussions are due to the fact that beneath its fiscal element there is a more important structural one generated by the irrevocable collapse of its non-tradables sector.
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Here theoretical economists and policymakers alike should take note that in this case the problem with excessive fiscal borrowing is not that much related to a certain theoretical debt threshold and the supposed impediment that the burden of servicing it in the future would constitute to the growth rate of the economy. Actually, at least as regards a small open economy -and probably even one that possesses the safety valve of floating exchange rate- the most important problem is that the procedure of amassing an excessive (public and/or private) debt undoubtedly equates to forming a structurally unbalanced economy with an inherent inability to last longer than the triggering of a liquidity at a first stage, and a solvency immediately after, crisis. This will be the natural outcome of the fact that the excessive borrowing will become excessive demand that will distort the relative prices between tradables and non-tradables at the expense of the former. Hence the economy will be infected with an almost mortal Dutch disease which -though artificial and unnatural as it has nothing to do with real commoditieswill nonetheless be allowed to inflict considerable harm as a result of the
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effects that the idiosyncratic features of non-tradables can have on development and stability of small open economies. Although not the issue of this article, one can hardly resist the temptation to extent the questioning regarding the idiosyncratic features on non-tradables to other national economies as well, beyond Greece. For instance, if we take two medium open European economies as France and Germany, and examine them through this particular analytical prism we could probably conclude that the one that boasts a better overall economic performance is the same that has better tamed its non-tradables sector. June 2013
References: - Abdon A. et al, (2010), Product Complexity and Economic Development, Working Paper no 616, Levy Economics Institute. - Balassa, B. (1964), "The Purchasing Power Parity Doctrine: A Reappraisal, Journal of Political Economy, December.
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- Baumol, W. J. (1967), Macroeconomics of unbalanced growth: the anatomy of urban crisis, American Economic Review, 57. - Borio, C. (2012) The financial cycle and macroeconomics: What have we learnt? Working Papers No 395, Bank for International Settlements. - Borio, C, (2013), Macroeconomics and the financial cycle: Hamlet without the Prince?, Vox. - EC (2012) European Competitiveness Report 2012, Reaping the Benefits of Globalization, Commission Staff Working Document SWD(2012), 299 final. - ECB (2012) Competitiveness and External Imbalances within the Euro area, Occasional Paper series, no 139 / December 2012. - Kuznets, S. (1966), Modern Economic Growth: Rate, Structure, and Spread. New Haven, Conn. Yale University Press. - Samuelson, P.A. (1964), "Theoretical Notes Problems", Review of Economics and Statistics, 46. on Trade
- Manganelli, G. (2000), Value added, employment, remuneration and productivity, Eurostat.
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Christos A. Ioannou & Dimitrios A. Ioannou, Greece: Victim of Excessive Austerity or of Severe "Dutch Disease"? June 2013

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Greece: victim of excessive austerity or of severe Dutch disease?

Christos A. Ioannou1 and Dimitrios A. Ioannou2

2000-2011. Source: Hellenic Statistical Authority (EL STAT).

22,5% 16,2% 15,2% 20,3% 12,3% 28,0% 15,5%

- Manganelli, G. (2000), Value added, employment, remuneration and productivity, Eurostat.

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