Why Nations Fail

First of all, I would like to thank the organizers for their invitation to participate in such a distinguished panel to discuss the very challenging topic “why nations fail,” a topic that has puzzled both economists and politicians for many decades.

I am an economist, who served as a Deputy Minister, Alternate Minister and finally as a Minister for two and a half years at the Greek Ministry of Finance at a very critical juncture.

It was at a time when the global financial crisis had been transferred to Europe, Greek government bonds came under speculative attack, Greece lost access to capital markets and signed its first economic adjustment programme with the EU, the IMF and the ECB.

Today, I would like to share with you my views on the puzzle “why nations fail” based on our experience in Greece where, after a deep and prolonged depression that started in 2008, real GDP fell by 26%, unemployment rate is at 25%, pushing many people into poverty and increasing income inequality.

These are clear signs of a failure and although it is hard to consider Greece as a failed state, as it still stands within the group of the 30 most developed nations, there is always the risk of being trapped into a prolonged stagnation and deflation.

This will definitely cause Greece to lose its place among the 30 wealthiest nations and it will trap large segments of its population in chronic unemployment and poverty.

Today, I would like to argue that the economic problems of Greece are the immediate result mainly of an institutional failure along the lines proposed four years ago by Daron Acemoglu and James A. Robinson in their well-known book “Why Nations Fail”.

The authors argue that the key differentiator between countries is not capital, or culture, or geographical location or the existence of a team of technocrats that would advise benevolent politicians, but “institutions.”

Nations thrive when they develop “inclusive” political and economic institutions, and they fail when those institutions become “extractive” and concentrate power and opportunity in the hands of only a few.

“Inclusive economic institutions that enforce property rights, create a level playing field, and encourage investments in new technologies and skills are more conducive to economic growth than extractive economic institutions that are structured to extract resources from the many by the few,” they write.

In the case of Greece, economic institutions and other institutions such as social security and social partners were definitely not inclusive but extractive and this despite the fact that political institutions were inclusive.

The Greek political system up to 2009 was dominated by two parties and also exhibited one of the most polarized and divisive political cultures in Europe.

This may explain why political parties failed to introduce the much needed structural changes and protected extractive economic institutions that led at some point to the collapse of the Greek economy.

In order to understand how Greece has been trapped in stagnation as a result of its institutions’ failure I will try to answer two questions:

1)       How did Greece manage in 2009 to be in such an economic mess nine years after joining the European Monetary Union; and

2)       Why is Greece the only Eurozone country that is still under a programme and trapped in a recession for more than eight years?

Let me start with the first question.

Almost 20 years ago, a significant majority of Greek economists and the major political parties came to the conclusion that it would be to the benefit of Greece to join Economic and Monetary Union.

They did understand at the time that there was an urgent need to introduce politically-difficult structural changes. Their expectation was that by joining the EMU Greece would be keen to introduce the necessary changes through peer pressure.

However, nine years after joining the Euro Area, Greece was trapped in an unsustainable economic path with high twin deficits (specifically fiscal and current account deficits), high debt-to-GDP ratio and a deep recession.

The debt problem was initiated by the fiscal irresponsibility of the years before the emergence of the global crisis.

In almost every year until 2009, the government was running a deficit. In fact, a deficit that was increasing year after year post-2006.

As a result, while Greece joined the Eurozone with a debt-to-GDP ratio below 100% and despite an average annual growth rate of around 3.5% and extremely low interest rates in the nine year period 2000-9, the debt-to-GDP ratio rose to 127% in 2009.

In that year, the government deficit reached 15.3% of GDP and the current account deficit was at 12.5% of GDP.

In the spring of 2010, Greece lost access to capital markets and requested financial support from its European partners.

Europe established a special support mechanism along with the IMF.

In return for this financial support, Greece accepted to implement an Economic Adjustment Programme involving tough austerity and structural reforms.

With hindsight, an obvious question would be:

Was there no «alert mechanism» either at a country or at the European Union level to prevent the emergence of these economic imbalances which were not sustainable within a monetary union?

Here is where both institutions and markets failed to prevent these imbalances from emerging.

The major political parties and the economic elite failed to understand the complexities associated with monetary union membership and the implications of globalization.

Year after year, governments, both conservative and socialist, were presenting Parliament budgets with very ambitious fiscal targets.

Few majority MPs if any, were ready to raise doubts on the underlying assumptions and reject the budget on those grounds.

The opposition parties, as a rule, always rejected the budget, as did professional unions and professional associations arguing that it doesn’t support growth and social cohesion and that it is very restrictive i.e they were asking for even higher spending.

To understand why Greece failed to keep its public finances in order, we have to concentrate on the institutional framework for the budgetary process.

The European Commission in 2007 found that Greece had the weakest budgetary procedures among the 18 countries examined.

Before the 2009 crisis, almost a third of the general government revenues and expenditures were outside the budgetary process.

Government ministers acted and spent money as semi-autonomous state agents.

The political parties in their effort to win popular support were ready to introduce new social or investment programmes boosting public spending and introducing tax cuts at the same time, irrespectively of the economic cycle.

This is why Greece experienced deficits even during years of high growth.

Between 2001-2009, fiscal deficits were typically at least 70-80% higher than their targets.

Greece’s failure to keep its public finances in order was matched by a failure of European institutions, the very institutions responsible to assess the fiscal stance of Eurozone countries within the context of the Stability and Growth Pact.

Markets also failed to realize that the economic problems of Greece were severe and structural.

This is clear from the fact that until 2008, markets were lending Greece at rates close to those of triple-A Germany.

It was only after the global financial crisis of 2008 that markets started to question the fiscal position of Greece.

Greece’s government bonds spreads vis-a-vis Germany started to widen markedly.

By spring 2009 they stood around the level that prevailed before Greece joined EMU.

By April 2010, the spread was at 600 bps and Greece lost access to capital markets and had to sign an Economic Adjustment Programme.

In conclusion, Greek political and economic elites in the 90’s decided that Greece should join EMU in order to address Greece’s institutional failures with the hope that the new challenges Greece would face would bring about the reform of institutions.

However, as the Euro Area institutional framework was itself weak and incomplete, the Eurozone failed to trigger or enforce the transformation of the extractive Greek economic institutions.

At the same time, the two major parties of Greece and the small parties of the left opposed the transformation of the economic institutions that would facilitate the Greek economy to become an outward oriented economy.

In the view of many, clientelism is the main cause of the Greek crisis. Politicians were elected on the basis of promises for public-sector jobs and they were favoring an increase of the size of the public sector and disregarded efficiency issues.

At the same time, we had an electoral system favoring the alternance of the two largest parties that were both reluctant to introduce necessary reforms to facilitate creation of new wealth.

The regular alternation in power of the two rival parties made possible the distribution of political rents to society in an orderly and democratic way but also in a very expensive way, from a fiscal point of view.

Now moving to my second question:

2) Why is Greece the only Eurozone country that is still under a programme and trapped in a recession for more than eight years?

Out of the four Eurozone countries that signed adjustment programmes, Greece is the only country still under a programme, six years after signing the first adjustment programme in 2010.

This is despite the fact that fiscal consolidation was pretty much achieved already by the end of 2014. Greece has also balanced its chronic current account deficit.

Then how come Greece didn’t manage to get access to capital markets?

There are economic and political reasons that can explain Greece’s failure.

In the case of Greece, the initial macroeconomic imbalances were the worst in the Euro Area.

Greece within 5 years had to cut the fiscal deficit by 12 bps of GDP by introducing measures up to 18 bps of GDP.

Fiscal policy was extremely restrictive, a lot more than any other program country, in an environment of tight credit. As a result, recession deepened further and unemployment soared to 27%.

Markets therefore questioned the economy’s ability to grow again in such an environment, and more importantly they questioned the country’s ability to service its debt without growth.

In fact, the debt sustainability issue and the continuing fear of a Grexit were the two most important factors that prevented Greece from regaining market access.

A second reason relates to the structure of the Greek economy, which is a more closed economy, with consumption representing almost 70% of GDP.

Exports were only 20% of GDP and could not carry enough counter-weight to the reduction of domestic aggregate demand.

There is a big underground economy, many closed professions (lawyers, notaries, pharmacists etc) and many oligopolistic markets (dairy industry, oil industry etc) and economic oligarchs play a large role as they try to fortify extractive economic institutions. All these are obstacles to an immediate export-oriented growth strategy.

However, if we want to understand why Greece is still under programme, one has to focus on the constraints the political system imposes on the implementation of the adjustment programme.

From the very beginning, there was lack of political consensus on the need to correct economic imbalances and address the institutional failures.

This led to “lack of ownership” of the Programme over the whole 2010-2016 period even when conservatives came to power after the 2012 elections and currently with the new coalition government between leftists Syriza and populist right-wing Independent Greeks.

Hence we suffered from a lack of full and timely implementation of voted reforms as members of parliament were more concerned on raising their chances to get re-elected as MPs.

Between 2010-2011, the then governing party, PASOK, in which I participated, introduced a number of structural changes on product, services and labour markets.

As these measures have a huge cost, especially in a period of deep recession, the public support for the adjustment programme was not secured.

The political cost became evident in the 2012 national elections.

In the May and June 2012 elections PASOK paid a high cost as it lost almost ¾ of its share of vote of 2009.

Finally, Greece turned out to be a special case because although its economy was stabilized and began growing in 2014, uncertainty on continued EMU participation was raised by political developments in 2015.

The January 2015 elections brought a new coalition government of Syriza and Independent Greeks – which gambled in a protracted stand-off with the EU and wasted precious time in interminable discussions heightening uncertainty.

As a result the economy moved back to stagnation and they were forced to introduce capital controls in order to prevent the collapse of the Greek banking system.

In conclusion, Greece’s failure was mainly the result of the failure of the major political parties to reach a consensus on an adjustment programme that had to be implemented in order to regain access to capital markets.

From 2010, Greek political parties were being asked to implement a series of reforms that they themselves hadn’t shown the willingness to introduce in the past.

The Greek political system remains very confrontational and there is a lack of a consensus culture.

After the signing of the first programme, opposition parties failed – or were unwilling – to understand the severity of the crisis.

So instead, accused the government for agreeing with institutional creditors to sign the “wrong prescription” for the economy, giving too much emphasis on austerity and not on growth.

Within few years, austerity policies provoked a drastic change in the country’s political landscape.

PASOK, one of the two parties dominating Greek politics experienced a sharp electoral decline.

ND, the other large party suffered also a major decline.

The winners were: Syriza and Independent Greeks a nationalist–populist party that had split from ND.

These two parties that form the ruling coalition government today were elected with the promise to preserve extractive economic institutions.

It’s not a surprise that since 2010, we have had four elections (May and June 2012, January and September 2016) and one referendum, six PMs, two of them heading interim governments and nine Ministers of Finance.

So with regard to the question if growth can resume, I would say that I am rather skeptical.

Probably, this will not happen as long as the current government remains hostile to the idea of opening up the Greek economy and attracting private investment.

What is the lesson we can learn from the Greek experience as we try to answer the question “why nations fail”?

Greece’s failure is the outcome of a long process during which populism alternated with modernizing reformism.

The failure to make needed structural reforms in key areas such as pensions, justice, education, health, and public administration became a common characteristic of all governments in Greece.

Structural reforms were opposed by special interests in society and never fully implemented. Politicians and political parties who sought to introduce them were punished at the polls.

In countries where a polarized two-party system prevails, to achieve a sustainable growth path with social cohesion, it is necessary to transform their political institutions that will foster a pro-reformist political environment.

This is not an easy task and it will only take place when citizens realize that introducing promptly structural changes with an eye in social cohesion is the answer to their problems and not the cause of their problems.

Thank you for your attention.