A Current Account and Budget Deficit Affair The Greek Paradigm

Written By George Dedemadis

For: Professor E. HelleinerCourse: Pols 4290.03ADue: 6 May 1996

York University

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An economy of small size that is still developing can sometimes be subject to different

economic laws of international trade than those that govern larger countries. To see

whether or not this holds for certain macroeconomic variables in Greece, the first step

would be to develop and explain the generally accepted economic theory concerning the

field. From the national income and savings-investment identities of a closed economy,

the analysis will move to a more acceptable and desired model of an open economy.

Following this, the nature of the current account balance will be explored. As a last part

of the Theoretical Economic Model, the relation that has been found to hold in large

economies between the current account balance and the government budget deficit will

be examined. With the theoretical foundations in place, an overview of the Greek

economy will be given. A brief history of that nations produce, concentrating on the

exportable goods, shall be engaged. The nature of the Greek production possibilities

have dictated that its inhabitants resort to trade for wealth. As a result of this, a shipping

industry has developed and thrived there throughout the centuries. Along with maritime

related income, in more recent decades sizable payments have been received from the

tourist industry and also private remittances from emigrants. These three “invisible

payments” have kept the current account deficit of Greece from wretching its own

economy. As a final point, a recently developed economic regression involving the

current account balance and the government budget deficit based on data from the Greek

economy will be presented. The regression shows that there is a relation between the

current account and government budget deficits akin to that given in conventional

economic theory. Deducting from all of the above, it will be shown that in the Greek

economy a higher current account deficit causes a higher government budget deficit.

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Theoretical Economic Model

There has already been formed a solid economic theory around the relation of

government budget and current account deficits. In this analysis, the model used by

Krugman and Obstfeld in their International Economics: Theory and Policy is utilized.

To create a proper understanding, the definition of the variables is given first:

Let:

S := Total Savings in the Economy (National)

S p:= Private Savings

S g := Government Savings

Y := National Income [or Gross National Product (GNP)]

C := Consumption in the Economy (Private)

G:= Government Spending on Goods and Services

T := Taxes collected by Government (Federal and Provincial)

I := Investment

EX := Exports

IM := Imports

CA := Current Account

The above are of primary importance to the study at hand, as they are crucial for

establishing the relation sought here. Although the chief concern is the current account,

the national income is defined first, both for reasons of simplicity and necessity. Given

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that Y denotes national income, then it is assumed that for a closed economy, i.e., an

economy that does not engage in any foreign trade at all, it holds that:

Y C I G ()1

The above relation simply says that in a closed economy, national income is an aggregate

of consumption (C), investment (I), and government spending (G). Y holds a positive

relation with all the above, so that if any one of the variables on the right-hand side of the

equation increases, then Y increases also. In this simple closed economy, the only way to

create new wealth is to create new capital. It may be shown that this may only be done

through savings. By definition national savings in this economy are:

S Y C G (

And since:

Y C I G I Y C G (

It follows that:

S I (

Thus it is established that in a closed economy, i.e., one that is not open to foreign trade,

savings equal investment. It is obvious that new capital is only created through

investment, and consequently savings are the only method to acquire wealth. After

having established this simpler and somewhat unrealistic model, the basics of the

national income accounting for a closed economy is used to develop a model for an open

economy that will produce the relationship central to this analysis.

The primary result of an open economy national income accounting framework is that

savings no longer equal investment. When one opens an economy to international trade,

1 All properties are numbered with letters of the Greek alphabet for ease in future reference, and also to avoid repetition in the writing of properties. They are of course numbered in alphabetical order: and so on.

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of both goods and financial instruments (it can be proven that financial instruments can

be seen as a future promise to pay real goods), then one must consider the impact of

exports (EX) and imports (IM) on that country’s wealth. It is obvious that when a nation

manufactures goods for exports and then sells them, it adds to it’s GNP. On the other

hand, when a country buys goods from foreigners and domestic wealth is sent abroad,

then a direct result of this is a reduction in national income. With this logic alone, as it is

not necessary for the purpose of this analysis to prove the validity of the following

formula, the national income identity for an open economy is:

Y C I G EX IM (

The signs given to the additional two variable at the end of the equation tell us how Y

responds to EX and IM. When exports (EX) are increased, then Y increases also; this

would simply be a direct relation. Conversely, when imports (IM) increase then Y

decreases; a straightforward inverse relation. Giving algebraic examples of property (

is a more rigorous treatment than this analysis requires. The reader will have to accept

this property as valid on face value in order to proceed. The next step in the construction

of an open economy model is the development of the current account balance.

The current account balance determines if the economy’s difference between exports

and imports is positive or negative. Already having denoted the current account as CA,

its definition in mathematical terms is:

CA EX IM (

The current account (CA) has a direct relation with exports (EX) and an inverse relation

with imports (IM). It is very rare for a country to exactly balance its current account,

i.e., for it to be that EX = IM. More often it occurs that one of the variables on the right

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hand side of property ( is greater than the other in magnitude. When exports exceed

imports, i.e., EX > IM, the country experiences a current account surplus. It is more

unfortunate for the economy when its imports exceed exports, and it has to suffer a

current account deficit. The next step in the development of this model is the overt

statement of the relation of the current account to the national income. By substituting

property ( into property () and then manipulating the resulting formula, it holds that:

CA Y C I G ( ) ()

The above equation shows that a country may only exceed its domestic wealth by

borrowing abroad. When a country runs a current account deficit, it lowers it’s net

foreign wealth. The opposite occurs when it runs a surplus. By foreign wealth it is

meant the amount of wealth that the country holds abroad; this is primarily in the form of

foreign financial instruments that the country holds, or the magnitude of a surplus it has

run with foreign countries in the past. So it is obvious that the current account influences

national income Y. A more profound relation can be found when the current account is

tied directly to savings.

The current account is another method by which an economy can increase it’s net

wealth, and this has a repercussion on the savings-investment equivalence. Recall

property () of a closed economy, where savings equal investment. In an open economy,

the precise type that is central to this analysis, the mentioned property no longer holds.

When we take into consideration the national savings property, ()2, and the current

account definition, then the result is:

S I CA ()

2 The national savings property again is: S = Y - C - G

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This simply says that “An open economy can save either by building up its capital stock

or by acquiring foreign wealth, but a closed economy can save only by building up its

capital stock.”3 Thus it is established that the current account has a substantial effect on

the national income, and it will also be proved later that it must have a direct effect on

the government economic policy of the country in question. In order to determine the

latter mentioned relation, the national savings must be broken down and analyzed.

The total savings in an economy can be separated into private and government savings.

The first, private savings, is simply that part of disposable income that is not consumed.

In mathematical terms, this is given as:

S Y T Cp ()

In layman terms, the above means that private savings are equal to national income

minus taxes minus consumption. National income minus taxes is referred to as

disposable income. Government savings are somewhat simpler, as they are simply taxes

minus government expenditures. In algebraic form:

S T Gg ()

When the two types of savings described in properties (and () are combined, they

yield national savings. More specifically:

S S Sp g ()

Y C G Y T C T G

The above is only a necessary step towards an equivalence that is desired here. With the

above equation, and remembering that S I CA S Sp g , then it can be deducted that:

S I CA Sp g

3 Paul R. Krugman and Maurice Obstfeld, International Economics: Theory and Policy (New York: HarperCollins College Publishers, 1994), p. 312.

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I CA T G

I CA G T ()

It is identity (that this analysis centers on when examining the Greek economy in the

following pages. Therefore it is crucial to understand its every component. It has

already been established what the role of the current account balance (CA) and the

investment component (I) are. The final term in the brackets on the right-hand side of

the equation are of greater importance even. To those who have an elementary

knowledge of economics, it becomes apparent that the term (G-T) is nothing other than

the government budget deficit. When government expenditures exceed its tax

revenues, then the government must be increasing its debt by issuing more of it

domestically and/or to foreigners. It is the case where the increase in government debt is

a direct result of a current account deficit that is of importance here. Identity () can be

manipulated to show emphatically just that:

CA S I G Tp ( )

The above revised identity is referred to as the “Twin Deficits”. In this form, the

identity shows overtly that when the government budget deficit increases G T , then

the current account deficit also increases; i.e., CA . The effect works both ways, as

when the current account deficit increases, then the government budget deficit must also

increase. With the empirical evidence available, one would discover that the relation is

translucent rather than completely transparent. That is to say, other variables do affect

the direction of the government and current account deficits. The most obvious of these

are the private savings and investment variables that are included in identity .

Despite this, for the most part the direction of the marginal differences of the current

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account and government budget deficits is the same for most of the data available on the

major industrialized economies.4 Due to the nature of the differences between economies

of small and large size, it is conceivable to argue that the “Twin Deficits” phenomenon is

different for small countries. The following part of this analysis concentrates on the

composition of the economy of Greece.

Overview of the Greek Economy

The relation that Greece and the god of wealth, Ploutos5, have had is not one of the

most favoured tales in the country mentioned. Greece has been a frugal land since the

outset of its known history. One reason for this is its geographical composition. As one

commentator has written:

The reader will be familiar with the general configuration of Greece- a land of limestone mountains, narrow valleys, long gulfs, few riversand many islands - the surviving eminences of a drowned-mountain

4 On pages 315-317 of their International Economics: Theory and Policy, Krugman and Obstfeld compare the economic data of the United States of America and of Japan relevant to identity . Their analysis using the mentioned data concludes that in both countries , the “Twin Deficits” Equation does indeed hold despite arguments by some to the contrary. It is understood that the correlation between the current account and government budget deficits is not perfect. However, it is sufficient.5 The god of wealth, Ploutos, should not be confused with the god of the underworld, Ploutonas; even though most Greeks would probably tell you that the latter one has been kinder to them than the former. In modern Greek, the word ploutos means wealth when translated into English.

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system, as a glance at the map at once suggests. There are few plains, - not large ones, but extremely important in the economy and history of the country. Of these, some are coastal, like the narrow and fertile plain of Achaea that runs along the southern coast of the Gulf; otherslie inland, like Lacedaemon (Sparta); perhaps most entirely barred from the sea by mountains, like the plains of Thessaly and Boeotia. The Boeotian plain is particularly lush, and with a heavy atmosphere; ‘Boeotianpig’, the more nimble-witted Athenians used to call their neighbors.6

From the above one forms an image of a mountainous country, with not much for the

agricultural production that other more spacious and flat countries in the European Union

are capable of. A more exact idea can be formed from another commentators words,

“Approximately three-fourths of the land is rocky and mountainous.”7 To add to the fact

that the land on which crops may be grown is limited, that same land has been cultivated

for the past three thousand years continuously. This has left the soil much weaker than in

some other more pristine lands, such as that of Germany.

Despite this evidence that would point to a bias in the economic nature contrary to a

land-intensive sort, the Greek economy was predominantly reliant on its agricultural

sector for the production of real goods until the 1974 to 1979 period. In the post-war

period, until about 1969, the agricultural sector was responsible for nearly one-fourth of

the total increase in economic product.8 After the military dictatorship of Colonel

Papadopoulos fell in 1974, this contribution to the GNP by the agricultural sector began

to decline9. It was only then that the percent of the employed labour force as a percent of

6 H. D. F. Kitto, The Greeks (London: Penguin Books Ltd., 1991), p. 28.7 Eric N. Baklanoff, ed., Mediterranean Europe and the Common Market: Studies of Economic Growth and Integration (University: University of Alabama Press, 1976), p. 50.8 Lawrence H. Shaw, Postwar Growth in Greek Agricultural Production: A Study in Sectoral output Change (Athens: Center of Planning and Economic Research, 1969), p. 389.9 The “Dictatorship of the Colonels”, led by Colonel George Papadopoulos, ruled Greece from the time of their coup-d’etat in the spring of 1967 until the fall of their regime in 1974. It is noteworthy to mention that the beginning of the dictatorships decline was sparked by a student-led revolt centered at the Metsovion Polytechnic University in Athens, in November of 1973.

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the total labour force was not greatest in the agricultural sector. The latest data in terms

of those percentages (for 1980-1989) shows that the employment by sector is as follows:

Period 1980-1989 10

Agricultural Sector Industrial Sector Service Sector 28.5% 28.3% 43.1%

The shift away from the agricultural bias has not been a staggering one, at least not one

that would be reminiscent of an industrial revolution. As is seen in the preceding table,

the industrial sector is almost at par with the agricultural sector. The numbers employed

in the industrial sector have remained almost constant for the past thirty years. Instead, it

has been the service sector that has aggrandized to large proportions. The two industries

that have the most to do with this are the shipping and tourist industries, both of them

being of a service nature.

The Greek economy has been dependent on trade since antiquity, and this

phenomenon continues today with shipping and the tourist industry being the most

significant “invisible” exportables. When one views a map of Greece and considers its

position relative to the rest of the world, one discovers that it is at the corner of three

continents and surrounded by the sea. Trade was an endeavour that Greeks took part in

because of necessity rather than pleasure. The land having already been described as

frugal, trade was the only exodus into wealth that was possible. The main staples that

were traded then continue to be trade today. For millennia now, wine, olives, olive-oil

and raisins from Greece have seen their way to Europe, Africa, Asia.11 When the

10 Giulio Sapelli, Southern Europe Since 1945: Tradition and Modernity in Portugal, Spain, Italy, Greece and Turkey (London: Longman Group Limited, 1995), p. 200.11 Corinthian vases and urns were also a very popular tradable in antiquity, but with the advent of such products as Tupperware they have fallen into disfavour.

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agricultural products of the homeland were stretched to their profit-bearing limits, the

ships would carry the cargo of others for a price. Also, goods would be bought for as

low a price as possible and then sold much more dearly in another market where they

were more scarce. The centuries from the time that the first merchant ship sailed from

Argos until today have not seen this affair cease for a moment. Since 1945, the number

of merchant ships flying under a Greek flag has rocketed. Under the Trumman Doctrine,

the Marshall Plan and other financial assistance from the United States for the

reconstruction of Europe, the fleets that exist today were launched into the waters of the

Aegean.12 Today, if one includes all the Greek owned ships that are flying under foreign

flags (countries like Panama have much lower port-duties than Greece, and the incentive

to pay less taxes is sometimes greater than the patriot sentiment of some) then it would

be no exaggeration to say that Greece has the largest merchant-marine fleet in the world.

Yet, the many sailors that leave for abroad yearn to return to their native land. Perhaps

one factor that makes them long for the dry hillsides and sandy beaches of Greece are the

sun and the beauty of the place. In this century, these attractions of the frugal land has

brought millions of visitors to its shores as well.

In the years following 1960, Greece experienced a boom in its tourist industry that has

only recently began to contract. The natural beauty of Greece is one that makes it a

holiday paradise in the long summers that it has. Despite the small size of the country,

due to the convoluted formation of its coast and the number of its islands, Greece has one

of the largest coastlines of any European country. The temperature is in the high

12 There was a plan in that time period where the shipowners would receive a loan to acquire maritime capital from the United States, that was guaranteed by the Greek government. The Greek government in turn was receiving large international transfers of funds from the United States, so it is the topic of an entire other analysis to determine who really paid for the converted liberty-type ships that made the tycoons of the Onassis vein.

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twenties Celsius as early as April, and does not fall below that level until October. In

any industrialized country, whether it be in North America or northern Europe, one will

see billboards advertising the allure of Greece; in every travel agency one will find

corresponding brochures and trip-packages as well.13 The number of ancient and

mediaeval sites that dot the Greek landscape also act as a lure to those who wish to

savour a taste of the past. Due to these factors the tourist industry in Greece has

outpaced almost all else in growth over the past three decades. An indicative statistic of

this event is reflected in the growth of the bank loans to the tourist industry for new

capital, such as buildings, automobile and motorcycle rentals, etc. It is an impressive

pattern, one worth exhibiting here.

Government Long-term Financing Institutions: Changes in Outstanding Lending and Their Structure by Sector 14

1953-1960 1960-1965 1965-1970 1970-1975 1953-1975Economic Mil. % Mil. % Mil. % Mil. % Mil. %Sector drs. drs. drs. drs. drs. .

Tourism 213 25.7 557 41.4 1,150 23.7 4,226 36.2 6,146 32.9

The above shows clearly that there has been an impressive increase in the amount of

development in the tourist industry over that time span. If this trend has not matched that

magnitude in recent years, it most certainly has not been reversed completely. At any

rate, there is a large number people employed in tourist related businesses and

13 One could argue that over the past couple of decades at least, this has been the result of a concerted effort of the Greek Ministry of Tourism and the EOT (- Hellenic Organization of Tourism).14 D. J. Halikias, Money and Credit in a Developing Economy: The Greek Case (New York: New York University Press, 1978), p. 296.

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organizations. It contributes a sizable amount to the nations GNP, without a doubt. It is

the two “invisibles” mentioned along with private remittances from the diaspora15 are

what keep the Greek current account deficit form completely drowning.

The current account deficit is kept to lower levels than it otherwise would be due to

the revenues from the shipping and tourist industries, and private remittances from the

diaspora. The Greek current account deficit was at -$3.4 billion (U.S.) in the fourth

quarter of 1995.16 If the Greek economy only accounted for the manufactured or

agricultural goods, that figure could have been at least twenty percent higher. The

figures for the current account deficit have improved over the years, due to reasons that

were beyond the reach of Greece in the past.17 Despite these recent improvements, the

fact remains that there has always been a substantial gap in the trade balance. As one

author expressed:

At that time Greek exports paid for about 70.5 percent of the value ofimports. Tobacco, raisins, olives, olive oil, and wine constituted themost important Greek exports. A large part of the remaining balance-of-trade account was paid by invisible income (e.g., shipping, and private remittances.)18

The time frame referred to above was immediately preceding the Second World War.

Subsequent to that the gap in the current account has been reduced by tourism, and most

15 The word ‘diaspora’ (means almost literally in English ‘the dispersed’. It refers to the Greeks living abroad, whether they have migrated permanently or not. Over the years, these men and women have sent million of dollars back to Greece, either to support family or to build for themselves a future in the homeland. Thus the term ‘private remittances from the diaspora’.16 “Emerging-Market Indicators.” London: The Economist, March 23 1996, p.106.17 After the fall of the Soviet Union in 1991 and the consequent opening of the former communist bloc in eastern Europe, Greek merchants and businessmen have become reacquainted with what they consider ‘traditional Greek markets’. In Bulgaria alone, over 80% of new investments come from Greece. In smaller proportions, Greeks are also investing in Romania and Russia. The most infamous example of this circulating among the Greeks, is the Vardinogiannis family opening a petroleum refinery for their corporation Motor-Oil in the former Soviet Union.18 Eric N. Baklanoff, ed., Mediterranean Europe and the Common Market: Studies of Economic Growth and Integration (University: The University of Alabama Press), p. 51.

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recently the opening of new markets. However, as was mentioned before, this constant

trade deficit and consequent current account deficit that has plagued the Greek economy

remains. In the years 1987 to 1989, the Bank of Greece reports that the Greek economy

has seen its current account deficit fluctuate but never go above the break-even mark.

The rise and fall of the current account have been primarily due to the pulsations of the

three mentioned “invisibles”, according to the Governor of the Bank of Greece in his

Summary of the Annual Report. Now that the nature and movement of the current

account has been thoroughly analyzed, what is its relation to the government budget

deficit?

The government budget deficit of Greece has moved in step with the current account

over the past thirty years. To go into detail of what the government budget of Greece is

composed of, and how it is created, is simply beyond the scope of this analysis. For the

purpose at hand, the regression model developed by Dimitri Stamatakis in his Causes of

Inflation: The Case of Greece is used. The original regression model tracked the relation

of the Consumer Price Index of Greece to the following variables: the monetary base

(M1), the current account deficit (TRA DEF), the government budget deficit (BUD DEF)

and the year (YEAR). The year is not actually included in the equation, but is central to a

time-series regression of this sort. The actual regression equation is:

CPI = 4.00 + 0.168 M1 + 0.00157 TRA DEF + 0.0653 BUD DEF19

This equation, if taken as an identity, can be manipulated to read as (omitting the

coefficients):

19 The general form for a regression equation with three determinant variables is: y 1 1 2 2 3 3 1

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TRA DEF = CPI - M1 - BUD DEF

Note that the relation that the current account bears with the government budget deficit is

just the one that the more established “Twin Deficits” equation in the Theoretical

Economic Model section of this analysis. When the government budget deficit increases,

then the current account deficit increases as well. It is worth noting also that the both the

government budget and current account balance of Greece have been negative for all the

years between 1961 and 1990. Also when one closely examines that data, it is obvious

that even though TRA DEF and BUD DEF have not always moved at the same rate, the

general direction of those flows has been synchronous. The econometric validity of this

particular regression is given by its correlation coefficient (R-squared) and its t-ratio.

The two stand at 98.3% and 1.47 respectively, which are respectable results by any

standard. Having stated that, it is clear that in the Greek economy the current account

deficit and the government budget deficit have a direct relation.

After having given the national income accounting property for a closed economy

where savings equal investment, it is possible to derive the homonymous identity for an

open economy. In an open economy, one sees that there are now exports and imports

that affect GNP. This fact makes it so that savings now equal investment plus the current

account balance. After national savings have been broken into private and government

savings, the “Twin Deficits” equation may be derived. Having the theoretical tool for

the analysis of specific components of the Greek economy, a brief overview shows that it

has been a nation dependent on trade since antiquity. Certain agricultural goods have

remained the staple exports from time immemorable, and continue to be the main

tangible goods that bring foreign wealth into the economy. In addition to this income,

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three “invisible” payments save the Greek economy from further resources escaping

through larger import payments. They are those of the shipping and tourist industries,

and the private remittances from the diaspora. Despite the real exports and “invisibles”,

the Greek current account has assumed the form of a deficit for over three decades now.

The economic regression exhibited earlier showed that the government budget deficit

was moving in the same direction for the most part during those years; needless to say

that it grew every year. It has been shown that in the Greek economy a higher current

account deficit causes a higher government budget deficit.

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