Out of control
When an economy goes wrong, look for a financial problem. That’s the lesson from the seemingly endless Greek crisis and the boom and recent bust in Chinese stocks.
It’s true that Greece suffers from a raft of economic woes typical of middle-income nations, including weak governance, inadequate investment and prosperity-sapping corruption. But it was the financial system which enabled the country’s government and people to live dangerously beyond their means.
In the six years before the crisis started in 2011, Athens’ average current account deficit was 12 percent of GDP. Foreign lenders funded the shortfall, in effect providing close to one of every eight euros spent by Greeks. The result is 311 billion euros of debt this year, by the International Monetary Fund’s estimate, or a whopping 170 percent of GDP. No wonder the IMF thinks some of that needs to be written off.
From the creditors’ perspective, most of the money was spent foolishly. They should, however, have expected that in such a poorly organised country. Another contributing factor was the false confidence instilled by the standard structure of debt instruments. Fixed interest rates and firm deadlines for repayment hid the real nature of loans to the Greek government and banks. They looked like low-risk financial transactions, but they were, in reality, permanent transfers of real resources.
Eventually, the lenders bolted. The Greeks faced demands for repayments of old loans and a sharp decline in purchasing power. A GDP reduction of 12 percent was almost unavoidable, since the trade deficit could no longer be financed. The actual plunge in output was about twice as big, in large part because the financial pressure on the government was so intense.
In a more sensible financial system, far less credit would have been extended, and the sudden evaporation of new funding would have been far less traumatic. Imagine, for example, that investors had instead provided something like preferred equity: permanent transfers with interest-like dividends that vary according to the borrower’s economic circumstances. Such structures would tie finance much more closely to economic reality.
Investors’ rashness should not be underestimated, so there might still have been a Greek financing bubble. Still, equity-like investments invite more careful initial scrutiny than debt, which promises known interest rates and repayment dates. Besides, stockholders cannot cause trouble by demanding their money back when they want to get out.
The current turmoil in the Chinese stock market is a reminder that shares can also attract their own financial unreality. On July 15, the Shanghai Stock Exchange Composite Index closed more than 80 percent higher than a year earlier – but more than 25 percent down from its early June peak. In economic terms, both the boom and the partial bust are essentially illusory.
As yet, the gyrations have had no clear effect on China’s economy. Official data on Wednesday put annualised GDP growth in the second quarter at a still healthy 7 percent. The Chinese are lucky. In more financially developed countries, bubbly stock markets lead to wasteful investments in trendy industries while sharp selloffs can damage the economy by shaking the confidence of investors and everyone who listens to them moan about the disappearance of their paper gains.
Even so, the Chinese authorities seem to think the stock market slide puts the country at risk. After having pretty much ignored the runup, they have intervened heavily to keep the fall from accelerating.
The one-sided regulatory effort is typical. Government interests generally get sucked into the enthusiasm when financial systems are inspiring unsustainable confidence, even though they are distorting the real economy. In Greece, the willingness to put huge amounts of money into the obviously weak economy was welcomed as a demonstration of belief in the euro zone.
The authorities do, though, tend to respond to financial busts. After the global financial crisis of 2008, there was talk about the need for fundamental changes to financial arrangements. That has not happened. From Brussels to Beijing, the powers-that-be look lost.
Incompetence and the financial industry’s excessive political influence may be issues, but the main problem is more conceptual. Regulators and the regulated alike fail to recognise the danger of letting finance diverge too far from the real economy.
The continued reliance on fixed-rate loans with fixed maturities is a prime example. Such instruments may have been the least bad approach in pre-modern economies, where inflation was rare, investment funds were scarce and harder to move around, and information was scanty. Now, however, it’s clear the financial system needs more durable and flexible instruments. A restructured Greek financing could be a great test case.
The Chinese economy, meanwhile, would be safer if equity markets attracted fewer gamblers. That would not be hard to arrange, with an appropriate mix of taxes and interventions. However, the authorities need to discard any residual faith that financial markets are self-regulating. They’d do well instead to treat finance as an unruly servant of the real economy – one with a tendency to run wild.