THE VAROUFAKIS EFFECT

Rarely has a new government done so much damage in just one year. And rarely has a finance minister done so well for himself after having harmed his own country so badly within just six months in office. One year ago, the radical left swept to power in Athens. With the Syriza party and its leader Alexis Tsipras, the economist Yanis Varoufakis surged to global prominence as the new Greek finance minister promising to do things differently.

Six months later, Varoufakis had to yield to reality. After leaving office in July 2015, he now excels as a speaker on the global lecture circuit, touting his tale of his valiant fight for economic reason and debt relief.

Or so the story goes. The actual record is quite different.

The sad story of Greece starts in 2009 when the country ran up a fiscal deficit of 14% of its GDP, a profligacy that exceeded even that of the US with a deficit of 10% that year. As markets took fright, Greece had to ask for help in 2010. Under the pressure of crisis, Greece slashed its fiscal deficit, its external deficit and its labour costs faster than almost any other country in the Western world from 2010 onwards. It also legislated some serious structural reforms.

In some key respects, the Greek adjustment programme was flawed. It focussed too much on suppressing demand through front-loaded fiscal tightening rather than on raising supply through fast labour, product and service market reforms. In the fiscal sphere, Greece and its external supervisors choose to hike taxes instead of broadening the tax base. Like other countries with weak administrative capacities, Greece would have needed simpler rather than higher taxes in order to improve economic efficiency, growth potential and the tax intake.

As a result of these flaws, Greece went through far more pain than necessary. Nonetheless, the harsh adjustment programme did work in the end. Having reached the turnaround stage in 2013, the Greek economy started to recover over the course of 2014. By late 2014, Greek corporate confidence had rebounded so fast that it even exceeded that of Spain. Greece was on course for a solid rebound from its deep crisis.

Then came Tsipras and Varoufakis. In December 2014, the leaders of the radical left refused to help elect a figurehead president for the country. With this procedural trick, they forced early general elections for January 2015. With the rise of political uncertainty in late 2014, capital started to flee the country. After Syriza won the elections on 25 January 2015 and formed an oddball coalition with some right-wing nationalists, the populists confirmed the worst fears fast.

With threats to reverse many reforms and a confrontational approach towards the only willing lenders Greece had, they drove ever more money out of the country. Until the end of the tenure of Yanis Varoufakis as finance minister in mid-2015, capital flight through the banking system as recorded in Greece’s balances in the Target2 payments system of the European System of Central Bank reached €66 billion, equivalent to 37% of Greece’s GDP. In the process, the radicals in power in Athens bankrupted the banking system until the banks had to be closed for a while in July 2015.

No country can withstand such a blow. But for a place that had just emerged from one of the worst adjustment recession on record in Western economies, the antics of the radical amateurs in Athens proved to be a costly disaster. Rarely before has corporate confidence plunged so fast and so far that it did in Greece in the first half of 2015.

As the Greek economy started to crumble, prime minister Tsipras finally came to his senses in July 2015. He ousted Varoufakis and started to cooperate with his country’s lenders instead.

The overall damage which the six months of radical left policies under finance minister Varoufakis have inflicted on Greece is dramatic. Instead of enjoying a firming upswing like Spain, the Greek economy fell back into recession over the course of 2015. The outlook for 2016 is still bleak. As a result, Greek GDP at the end of 2016 could be roughly 7.5% below what it would have been if Greece had remained on the Spanish-style recovery track.

In addition, lower tax revenues and extra spending will likely lead to a cumulative fiscal shortfall of some €9 billion for 2015 and 2016 relative to a baseline of unchanged policies and the absence of a political confidence shock. The government is trying to hide the full extent of the damage by not paying many of its suppliers. Unfortunately, the resulting squeeze on many Greek companies is damaging the economy and hence the country’s tax base even further.

Furthermore, Greece had to recapitalise the badly weakened banks. While it managed to raise some outside capital for this, it did so by diluting the public sector’s share in the banking system badly. As a result, Greece can no longer hope for substantial revenues from a future privatisation of banks after a return to economic growth. The overall current and likely future fiscal hit from the damage to the banking system probably amounts to at least €12 billion.

Because of the misguided policies of the first half of 2015, the Greek debt-to-GDP ratio will likely around 28 percentage points higher by the end of 2016 than it would have been otherwise, including the loss from foregone privatisation revenues. Rarely have so few months been so expensive for the public purse than the six months of finance minister Varoufakis. This counting of the fiscal costs still abstracts from the human misery caused by Greece’s relapse into recession.

Of course, history moves on. After Greece ratified a new agreement with its international lenders in the summer of 2015, corporate confidence recovered somewhat. But shattered trust is difficult to rebuild. Even if a chastened Greek government without Varoufakis now stays roughly on the course agreed with its lenders, the road ahead will be rocky. Business investment will remain tepid for a while after such a near-death experience. Unfortunately, we cannot even rule out a new Greek crisis. Due to the renewed recession, the social situation will take significantly longer before it can improve.

The Greek experience should provide a stark warning to other governments thinking of reform reversals. In a still fragile situation, policy mistakes that shatter confidence can be very costly indeed.

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