An Institutional Dynamics Model of the Euro zone crisis:
Greece as an Illustrative Example
Domen Zavrl
Postgraduate student at the University of Maribor, Faculty of Organisational Sciences
Kidriéeva cesta 55a, SI-4000 Kranj, Slovenia
E-mail: zavrl.inov@yahoo.com
Co-author:
Miroljub Kljajié
University of Maribor, Faculty of Organisational Sciences
Kidriéeva cesta 55a, SI-4000 Kranj, Slovenia
E-mail: miroljub.kljajic@ fov.uni-mb.si
Abstract
The current turmoil in the financial markets forces us to question the validity and relevance
of the present economic theories. Complex dynamics characterized by bounded rationality
and strong impact of expectations on the markets provides an independent source of
fundamental uncertainty and this one can lead to speculative bubbles in assets markets
triggering growth of public debt. The neoclassical methodology based on logical empiricism
and deductive reasoning has failed to show what is going on in the real world. We will
employ the institutionalist's view and focus on the behavioral aspects of the system modeling
decision making process. We illustrate this approach with a model drawn from the current
Greek sovereign debt crisis and its bailout discussions. The main benefit expected is the
increased realism of the model itself. The discrepancies between theoretical predictions and
observed behavior have had a major negative impact on economic models and system
dynamicists can contribute a significant amount of value to institutional economics.
Key words: Asset Bubble, Financial Crisis, Private Debt, Public Deficit, Financial Crisis,
Bailout, Greece
1. Introduction
The current turmoil in the financial market forces us to question the validity and relevance of
the present theories. Post Keynesian economists have denounced that the mainstream’s
models are inadequate in explaining the origins, nature and effects of financial crisis.
Complex dynamics provides an independent source of fundamental uncertainty and this one,
as discussed by Keynes himself (1936, 1937), can lead to speculative bubbles in assets
markets and to over-reactions both in lender’s and borrower’s attitude toward risk. Keynes
considers the state of confidence as the confidence of the speculators and the confidence of
the lending institutions. Or as stated by Sau (Sau, 2009), under conditions of fundamental
uncertainty the behavior of economic agents is so complex that a formal probabilistic
treatment of expectations is not feasible. Moreover in complex economic systems the
predictability that is so successful for hard sciences does not work, and theories claiming
predictability and computability have misled policy makers and continue to do so. The
relevance of complex dynamics has heen particularly stressed by Rosser (1995; 2001) and
Dugger (1979). Institutionalists believe that cultural anthropology, pragmatic instrumentalism
and placing events within a known pattern (Radzicki, 1990) rather than physics provides the
correct methodological foundations for economics (Radzicki, 1990). On the other hand the
neoclassicals would accept logical empiricism (Caldwell, 1982) and deductive reasoning
(Vienna Circle, 1920s) as their core methodology. Institutional economics separates itself
from classical economics via its evolutionary view of economic change (Hamilton, 1999).
Based on the work of Veblen and Ayres, Hamilton concluded that human nature is goal
seeking and that the restrains are set by their cultural environment. Hamilton (1953, 1999)
explained that the fundamental difference between institutional and classical economics is in
the way that economic change is conceptualized. Institutional or Newtonian change is seen by
Hamilton as taking place within a given social and economic structure while Darwinian, or
evolutionary as occurring when there is an alteration of a society's social and economic
structure itself (Radzicki, 2003). As stated by Radzicki (Radzicki, 2003) the institutional
economics was developed by Quesnay and Smith through Ricardo, Marx and then through
“American institutionalists” Veblen, Commons and Mitchell; Ayres, Galbraith, Schumpeter,
Bulding and Georgescu — Roegen and Ayres. And this route has been influenced by the
cybernetics of Norbert Wiener (1948). Radzicki (1988, 1990a, 1990b), Radzicki and Seville
(1993) and Radzicki and Sterman (1994) showed the similarities between system dynamics
modeling and institutional economics and proposed a synthesis of both methods that would
be more powerful than the sum of the methodologies in isolation.
The main reason why the institutionalists were not successful is that the they have been
missing suitable tools for an analysis of their models. They have also shared same beliefs
with the system dynamicists but they have not been using formal modeling techniques
(Radzicki, 2003). However they see the world from the same perspective as system
dynamicists: they focus on the real world, they acknowledge that the future is uncertain and
they adopt a holistic or system point of view (Holt, 1996).
SD is a methodology developed to analyze and manage complex feedback systems. Taking
advance of this, we developed three part models simulating Greek economy.
The discussion in this paper will be based on the following problems that institutional
economists identified:
= In an uncertain world expectations have significant effects (Arestis, 1992);
uncertainty is present also in decision making process.
= A focus on the real world is important (A restis, 1992).
= Bounded rationality, willpower and self-interest play a crucial role (Thaler,
Mullainathan, 2000).
The solutions are:
Represent the behavior of agents as actually is.
Focus on the effects of expectations in mass psychology theory.
Model bounded rationality.
Unify macroeconomics and microeconomics — derive macroeconomic behavior from
microeconomics.
System dynamics is well suited to address all the stated problems as SD is suitable for
modeling complex systems that portray human behavior and micro — level decision making
as actually is. Moreover unlike the institutional theories SD has a well developed theory of
the dynamics behavior of socioeconomic systems that draws from behavioral decision theory,
psychology, control theory, management sciences and a very intuitive set of modeling tools
and techniques that are used to capture the dynamics behavior of complex systems (Radzicki,
2003).
The objectives of this paper are:
a. Discuss the role of expectations and bounded rationality on model behavior and show
that SD can be used to model real behavior.
b. Analyze the growth of private debt and the transition from private debt to public
deficits that result in high level of sovereign debt.
c. Make scenario analysis on the extemal bailout for Greece and the Euro zone as a
whole.
The remainder of this paper is as follows. The next section provides the Greek case study.
The third section presents a motivating example for this paper in regards to the EU bailout
scenarios for Greece. The fourth concludes the paper.
2. Case Study: Greece and the Euro Zone
The majority of the analysis of the models’ behavior will be conducted on the Greek
economy representing potential trigger for other EU defaults. Greece is at the moment most
likely to default whereas the Greece’s external debt amounts to 123% of national income and
its gaping govemment budget deficit to almost 13% of GDP. But the problem is not only
numbers; it is one of credibility (The Economist, 4th Feb 2010). Thanks to decades of low
investments in statistical capacity, no one trusts the Greek government’s figures nor does
Greece’s default history inspire confidence. Highly leveraged economies, particularly those
in which continual rollover of short-term debt is sustained only by confidence in relatively
illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow
unchecked (Rogoff and Reinhart, 2009). What makes default unpalatable is the fear of
contagion— that if Greece were allowed to go under, the cost of borrowing for other troubled
euro members would shoot up. Portugal, as the sell-off on February 3" suggests, is next in
line. Its public-debt ratio is 77% and rising. Its current-account deficit is almost as big as
Greece’s. Italy has public debt of a similar scale, relative to GDP, to Greece’s; but its budget
deficit is only half as big and its current-account deficit is relatively small. The Italian bond
market is the world’s third-largest. Such a large and liquid market is less vulnerable to
speculative attack than a small one, such as Greece’s or Portugal’s. Ireland is small, too, but
its government has shown itself willing to take unpopular decisions to right its public
finances. The Irish economy is more flexible so its medium-term prospects seem brighter
(The Economist, 4" Feb 2010). And here is Spain. As Nouriel Roubini (New Y ork Times, 5h
Feb, 2010) suggests, Spain is bigger threat to the euro zone than Greece. EU has to act in
order to hedge the spread of defaults from Greece to Portugal, Spain and Italy. Before the EU
or IMF would lay ground for the bailout a scenario analysis has to be made about possible
outcomes.
3. Institutional Dynamics Model: Expectations, Bounded Rationality, Impact
of Asset Bubble on Financial Crisis and Growing Sovereign Debt
Humans make decision in the face of uncertainty following expectations and rules of thumb
in their decision making processes (Radzicki, 2003). Consequently we have to tum to
psychology (Earl, 1989), behavioral economics (Simon, 1979) and decision making literature
to understand how individuals make decision in this complex world. Given that dynamic,
nonlinear, feedback systems are unpredictable in principle, particularly in the long-run, and
that economic agents must thus make their decisions about the future in the face of
uncertainty, a logical question to ask is whether or not it is possible to model the way in
which humans actually form their expectations (Radzicki, 2003).
The most successful at developing SD systems that mimic the actual human expectations
formations process has been John Sterman.
According to Mullainathan and Thaler (2005) two main factors have been identified that
cause human decision making to deviate from the rationality: bounded rationality that reflects
cognitive abilities on knowledge that constrains human problem solving and bounded
willpower, which explains why people make choices that are not in their long-run interest.
In the Euro zone the period between 1999 — 2009 has been organized in periods of booms and
busts: the booms years were 1999-2001 and 2005-2007, the remaining years were the bust
year. During boom years private debt increases spectacularly as the individuals were
scarifying their long term interest. The latest boom period of 2005-07 stands out with yearly
additions to private debt amounting on average to 35 percentage points of GDP. This was the
over optimistic period of rising real estate prices. Thus the driving force of the cyclical
behavior of government debt is the boom and bust character of private debt (De Grauwe,
2009).
Average yearly increase in private and public debt in eurozone
(percent of GDP)
fo OS , 10.0%
/
f \/ 8.0%
6.0%
public debt
privete debt
8
H
oS
mm]
0.0% 0.0%
1388-2001 2002-2004 2008-2007 2008-2008
Figure 1: Average yearly increase in private and public deficit in the Euro zone (Source: De Grauwe, 2009).
During these boom periods, public debt growth dropps to 1 to 2 percentage points of GDP.
The opposite occurs during bust years. Private debt growth slows down and public debt
growth accelerates. A gain the last period of bust (2008-09) stands out. Public debt increased
by 10 percentage points of GDP per year, mirroring the spectacular increase of private debt
during the boom years (but note that the surge of public debt during the bust years of 2008-09
are dwarfed by the private debt surge during the preceding boom years). Greece has been
maintaining very high deficits, not just in recent crisis years, but also during the boom period
of 2004-2006, when its deficit-to-GDP ratio averaged 5.2%; its deficit/GDP accelerated to
7.7% (the highest in Europe) in 2008, and now stands at 13% of GDP. However the behavior
of public debt was still driven by the cyclical character of private debt (Calomiris, 2010) but
there was some extra spending as the Greek authorities have mismanaged their economy and
deceived everybody about the true nature of their budgetary problems (De Grauwe, 2010).
Using the Model showing the rising real estate (RE) prices we can see that the overoptimistic
individuals and some extra spending are to be blamed for the present level of Greek
sovereign debt. In order to understand why the individuals were “blind” and their
expectations kept growing in regards to the real estate prices which caused the real estate
bubble to grow we developed a model that mimicries the expectations of individual investors.
The behavior of the model is diagrammed in Figure 2.
Figure 2 presents a generic model. “Real Estate Expected Price” is modeled as a stock. The
“RE Expected Price” influences “Price” which in turn influences the “Indicated Price” and
the “Change in RE Expected Price”. “Change in RE Expected Price” is representing the
beliefs about the equilibrium price adjust in response to the gap between the “Indicated Price”
and the current belief and adjusts via first order adaptive expectations to the actual price
whereas the “Indicated Prices” is modeled as an individual’s belief about the equilibrium
price and takes the larger value of “Minimum Price” and “Price” (modeled in Vensim PLE
Plus as MAX(“Minimum Price”,”Price”). This is a reinforcing loop marked by R. Moreover
the “RE Expected Price” influences the “Change in RE Expected Prices” and this is a
balancing loop marked by B. In the model there are also other variable measuring “Effect of
Costs on Price” and “Effects of Market Supply on Price”. The model has one reinforcing
loop and one balancing loop. The core of the dynamic hypothesis lies in the tension between
5
the reinforcing and the balancing loop. From our experience we can confirm that the
dominant loop is the reinforcing loop so the real estate prices keep growing. Due to the fact
that this expectation formation process marked by bounded rationality of economic agents is
accomplished without a significant time delay, a system will adjust smoothly to its goal. Once
reality sets in (as realized profits are compared with prior projections), the flimsy foundation
of the expectations means that the re-evaluation is “sudden and catastrophic” (Harvey, 2002).
Meaning that the individuals will not choose the larger value of “Minimum Price” and
“Price” but the smaller value of them, whereas the “Minimum Price” can be considered a
“Maximum Price” as the individuals believe that the “Price” is not set above the
“Construction Cost per RE Unit”. The individual's decision to change his »Indicative Price«
from »Maximum Price« to »Minimum Price« that will settle at the “Construction Cost per RE
Unit” Level triggers a series of defaults. Keynes especially stressed the importance of
prediction in his 1937 article on QJE (Marchionatti, 2009). So he stated: “knowing that our
own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of
the world which is perhaps better informed. The psychology of a society of individuals each
of whom is endeavoring to copy the others leads to what we may strictly term a conventional
judgment” (Keynes, 1937, p. 115). As a consequence the estimations of the investment
opportunities depend on the “judgment of the rest of the world” or with a goal “to confirm
with the behavior of the majority average” (Keynes, 1937). It seems that the financial markets
are first blinded and see no risk, until the wake-up call and then they overreact making the
resolution of the problem more difficult (De Grauwe, 2010).
The bubble burst can be considered as an imperfect substitute for the unavailable exchange
rate devaluation: the Euro currency could not have been devaluated so the prices fell.
RE Sensitivity of Price
O—— | Expected
Price. to RE Costs
Change in RE
ae +
Time to Adjust RE expected Price
Expected Price + B
Effect of
COnstruction Costs
on Price
Construction Cost +
per RE Unit
R
+
em insleate Price Price :
~+—_—
af - = Expected
Minium nce Construction Costs
Sensitivity of Price
Reference Number of to Market Supply
RE units on the Market
ip Effect of Market
Supply on Price eaarees
Market Supply Relative Market pete Initial Price
Share
+
Figure 2: The Process of Growth of Real Estate Price Expectations, with emphasis on why the RE prices kept growing —
Increase of
This hindsight bias erodes the quality of the feedback humans use to sharpen their reasoning
skills. The main problem is that humans try to predict the level of confidence that actually
relies on feedback. Consequently they are following the market psychology and not the long
term returns in all of their (bounded) rational or irrational glory (Radzicki, 2006).
What we have described so far is the way individuals create their expectations and why the
“RE Expected Price” keeps rising. The rising real estate prices result in growing private and
there is a sudden drop in the price. Running the model gives the behavior for “RE Expected
Price” in Sim1 (Figure 2). Model generates a steady growth of a housing prices.
A simulation run begins with “Initial Price” of 100 in 2002 and reaches its peak in October
2007 and then in drops to the “Construction Cost per RE Unit” level.
190.0
as00
1700
p00
eurozone
aso.
FT Eure zone
1300
azo0
Change MAX to MIN
preference
110.0
100.0
2002 2008 2004 2005 2006 2007 2008 2009 2010
Figure 3: Simulation 1, what should happen, given the process in Figure 1 (FT Europe & FT Eurozone)
Inspection of Figure 3 reveals interesting behavior of the model in regards to the RE price
determination. The orthodox economists could not explain the reinforcing loop that derives
from the bound rationality of economic agents. Integration of System Dynamics into the
existing economic model can help explain why the model generates a price spiral, e.g. why
the classical approach models using the utility functions interacting at Nash equilibrium
results cannot predict the real behavior (Nichols, Pavlov, Radzicki, 2006).
Credit squeeze triggered recession and financial crisis. Financial crisis is usually the result of
individuals following certain rules during their decision making process. The markets affect
psychology and psychology affects markets. Also, after an event occurs, humans tend to
overestimate their pre-event knowledge of the outcome. One of the Forrester’s articles in
2008 (Forrester, 2008) argued that financial crisis occurred only because many people
sacrificed long term interests for short term gains. In the recent real estate crisis low interest
rates generated easy credit. The public debt was growing under the influence of private debt.
Next we tun to SD to understand the dynamic behavior of a growing public debt.
The root cause behind the rising debt can be described with the following dynamic
hypotheses: 1. In the boom phases the private debt is high, 2. In order to stimulate economy
in the bust phases Greece could only use the expansionary fiscal policy that results in a larger
deficit (the monetary policy is in the hands of the ECB — in the monetary union the central
bank controls the overall money supply) 3. Greece was spending also extra amount of money
in comparison to other EU members (the reason for that is disputable but can be assigned
either to creative accounting, structural problems, government change) 4. The expansionary
fiscal policy would probably result in a classical model in adverse effects in other countries.
A fiscal expansion in a Newtonian model would push the Greek interest rates up and also
raise the money supply. As a consequence classical model would argue that the income
would rise in Greece. We will argue that this cannot happen and there are two root causes for
that: a. Formation of expectations of speculators / bounded rationality of individuals and b.
Lack of credibility of Greek government. 5. Greek government faced a combination of a
heavy debt burden that cannot be inflated away (because it is denominated in a foreign
currency or in the common euro) and an important fiscal deficit testing the sustainability of
servicing that debt. This in tum stirs market sentiment and widens sovereign spreads —
possibly triggering a self-fulfilling run and a default (only point 5 de la Torre, Levy — Y eati
and Schmukler, 2010). 6. The crisis was also allowed to unfold because of hesitation and
ambiguities by both the Euro zone governments and the ECB. The Euro zone governments
failed to give a clear signal about their readiness to support Greece (De Grauwe, 2010).
Figure 4 is a generic model showing the transition from private debt to public debt. To
understand the model let’s begin with the “GDP”. “GDP” in Figure 4 represents the real gross
domestic product and we measure the error between the real GDP and “Perceived Value of
GDP”. This represents a balancing loop generating (B1) “expectation formation” oscillation.
The main feedback loop is a reinforcing loop (R1) so the GDP keeps growing. If the model
contained only the two loops, the growth of the GDP would be increasing with slight
oscillation around the trend. But the system is not that simple. The striking force behind the
“Private debt” is not the “GDP” but the “Perceived Value of GDP”. “Perceived Value of
GDP” is influence by the formation of expectation that the real estate prices and the economy
in general will keep rising. High “Public Debt” will contribute the decline of the “Perceived
Value of GDP”. Lower “Perceived Value of GDP” will trigger the use of “Expansionary
Fiscal Policy” that force the government to make additional spending and contribute to higher
“Public Debt”. The feedback is thus amplifying the input signal (R2). The “Private Debt”
will depend on the “Perceived Value of GDP” which is falling in a period of crisis. Before in
the boom period the “Expansionary Fiscal Policy” was used but due to high debt this policy is
not available in the bust period where longer financial crisis is expected. The financial crisis
will cause sudden drop of “Perceived Value of GDP” and this will result in falling “Private
Debt” and rising “Public Debt”. Greek government has been namely accumulating the
“Public Debt” even in boom periods, e.g. during the boom period of 2004-2006 its deficit-to-
GDP ratio averaged 5.2%, the same ration accelerated to 7.7% in 2008 and now stands at
13% of GDP. The cumulative effect of these deficits is an outstanding sovereign debt
exceeding 123% of GDP. The reason why this level is unsustainable is because Greece is not
expected to generate very large fiscal surpluses in the coming years. On the contrary Greece
would have to increase its spending to reach higher growth. The spending would probably
provide a transitory boost to the economy but then this effect would dissipate as financial
resource to private sector would be reduced (not in the Financial Model — Hoisington, Hunt,
2009). The high level of Greek sovereign debt has raised concem among the Euro members.
As Adam Smith warned two centuries ago “the practice of funding has gradually enfeebled
8
any state which has adopted it”(in Scott, 2010). The Speculators (modeled in Figure 5) keep
pushing the yields up and make substantial contribution to “Public Debt” increase (R3). The
“RE Expected price” is modeled in Figure 2 and is the indication of overoptimistic or over
pessimistic markets and also the variable that triggers financial crisis. The “Private Debt —
Deficit Spending” representing the amount by which an individuals’ spending exceeds their
income is growing as a result of over optimism. From a system dynamics point of view,
positive and negative feedback loops fight for control of a system's behavior. The »GDP«
and the »Debt« loop are dominant an determine a system's time path. The relationship
between the expenditures and debt has to be properly assessed and will depend on the
national economy and its dependence on the outer world, e.g. its exposure.
+ Error (Reported
Value - Perceived
Value)
Oo «cpp bin)
Change in Q i ; /
GDP hange in
Production ~ 7 Perceived Value
Adjustment + GDP
Time
Expansionary
Fiscal Policy Aggregate Perceived
- Adjustment Time
Public Debt Demand Vale ot (of i
Expenditure A +f
R3 Consumption
Speculators (Model
R2 3) - Passive Bailout
Marginal
Private debt. —— Propensity
Deficit Spending to Consume
RE Expected Price
(Model 1) Overop
& Overpesimism
Figure 4: From Financial Crisis to Sovereign Debt Crisis
It is generally well understood that growth of financial crisis indicator influences growth of
sovereign debt. Especially in Europe the only politics applied in crisis is fiscal policy as the
monetary devaluation of s single country is impossible. Extensive fiscal policy influences the
growth of sovereign debt as shown in Figure 4. Greece is a low productivity country that
relies heavily on Maritime industry and Tourism where the policy makers have been pursuing
debt fueled Keynesian economic policies which result in large sovereign debt and as pointed
out by Irving Fisher (see Fisher’s 1933 “Debt — Deflation Theory of Great Depressions”) EU
and it is well known that the high levels of economic distress result in prolonged economic
crisis. Reinhart and Rogoff (2009) reiterate this old rule and write that once debt becomes
excessive, countries will not find a solution to their problems but will usually go through the
time consuming process of debt repayment and increased spending. Note also that according
to Reinhart and Rogoff (2009) major economic contractions lead to deflation. In the
Aftermath of Financial Crises (2008) Carmen Reinhart and Kenneth Rogoff find that the
outcome of severe financial crises share three characteristics. First, they show that asset
market collapses are deep and prolonged. Second, the aftermath of banking crises is
9
associated with profound declines in output and employment. Third, the real value of
government debt tends to explode. This is what we will explore in the next section.
Greek sovereign debt represents a serious problem. Given the sovereign debt exceeding 123
% of GDP let us assume the average growth of 3% of the real GDP growth and an interest
rate of 6% on Greek government debt. Under these assumptions, given the current level of
Greek sovereign debt, an average surplus of 4.2% of GDP (before interest payments) would
be necessary to avoid sovereign default. With government expenditures other than interest at
about 44% of GDP, and tax receipts at about 40% of GDP, that implies that the government
must either immediately and permanently cut non-interest spending by about 25%, or
immediately and permanently raise taxes by about 28%, or if the two were done in equal
combination, cut non-interest spending and raise taxes each by about 14%. Even being
willing and able to embark on such an ambitious agenda of fiscal reform would not guarantee
success. First, in the short term, Greece has a massive amount of debt coming due. To avoid
default the Greek government must either convince the market immediately that its reform is
credible or convince the European Union to roll over the 53 billion Euros of its debt that
comes due in 2010 (Calomiris, 2010).
In Figure 6 we present the bailout model. The model is designed to explore the dynamic
hypothesis of self rescue from the exploding debt. The rising “Debt” would trigger
“Inflation” in any rising economy providing the “Financial Crisis Switch” would be set to off.
The inflation would cause that the demand for government bonds would drop. The Greek
government would have to reply by placing large number of state bonds on the market.
Rising “interest rate” would result in lower bond prices / higher financing costs. The “Debt”,
“Supply of Government Bonds” and “Inflation” would keep rising without help from abroad
(EU or IMF). The influence of speculators in this loop is marked as “Influence of
speculators” and plays an important role. Many hedge funds were speculating on Greek debt
respectively on their default. With the rising financing costs their betting strategies will
become even more aggressive. This is a reinforcing loop (R1). The inflation would result in
lower real debt (inflation namely lessens the real purchasing power of the masses and can be
considered an indirect tax) so this is a balancing loop (B2). However we do not expect the
inflation to occur — rather deflation . By rising the supply of sovereign bonds, debt can push
bond prices down and yields higher, raising the cost of borrowing and pushing the “Financing
Costs” up. However debt levels are not the sole determinants of risk. Monetary policy,
perceived currency risk, inflation expectations, and risk appetite—which vanished during the
financial crisis—also play important roles (Dadush and Stancil, 2010).mHigher debt can also
raise expectation of tax increases and inflation and is consequently undermining business and
consumer confidence. This will cause “Perceived Value of GDP” to fall and this will result in
the growing “Public Debt” (R2). Growing “Public Debt” will impose the limits to the extra
spending so this is a balancing loop.
If not stopped, the crisis will lead to increases in government bond yields in a significant
number of Euro zone countries. This will put pressure on the governments to sharply contract
fiscal policies, leading to deflationary effects and risking to pull down the Euro zone
economies into a double-dip recession. Such an outcome would make it more difficult for the
Euro zone countries to reduce their budget deficits and debt levels (De Grauwe, 2010).
10
pe] Financing
Costs P avan
erceived Value 0}
ive in kes) @DP Medel 2)
Inflation
nae in
‘CENARIO 1 Passive oe imate OW
ailout - Commitment sme
a of
Adjusted Debt
——™ Public Debt
OS public Debt
<Time> ‘(Model 2)t-1
Deficit - Debt
Growth Rate SCENARIO 2 Active
Bailout - Loans &
Control
Figure 5 : BAILOUT MODEL — Sovereign Debt / Inflation / Financing Costs
But perhaps the most important factor in determining government bond yields—and thus, the
impact of higher debt—is investor confidence in the country’s governance, including, for
example, the integrity and quality of its administration, the independence of its central bank,
and its political cohesion (Dadush and Stancil, 2010). Oras stated by George Akerlof, Nobel
prize laureate “Trust is easily ruined, but to rebuild it takes time.“
Validity of the models
The results suggest that the model as a whole may he valid as it possesses some theoretical
pleasing properties and is also capable of mimicking different aspects of human behaviour.
The validity of the models was appraised as suggested by Peterson (1975, Appendix B) and
Forrester and Senge (1980).
From Figure 2, 4 and 5 it appears that the partial models pass a majority of the tests because
they mimic some of the observed behavior of the economy. Moreover we believe that its
structure and behavior are appropriate for its purpose.
4. Does European have to act or can Greece rescue itself with a EU
commitment to help if needed?
Following are two scenarios for how the crisis may develop over the coming year, with
assessments of their probabilities and implications for financial markets based on the models
modeled in previous sections. The first alternative is the passive bailout. The passive bailout
would mean that the EU would come up with a clear offer of standby loans. So the EU would
not supply aid but the promise of aid. Greek government believes that the commitment would
11
discourage market participant from speculating on Greek bonds and hedge the financing
costs. The Greek goverment is namely claiming that self rescue is possible but that they
might fail because of rising borrowing costs. On the other hand we could argue that Greece
will use the restrictive fiscal policy that will result in lower GDP growth and in further debt.
Greece would namely have to generate surplus in order to cut its debt. The second alternative
is active bailout where EU would grant immediate subsidies and loans to Greece and impose
strict terms.
We will test the two alternative bailout scenarios below:
1. EU makes commitment to help Greece if needed. Greece makes progress towards this
year’s deficit and there is no further rating downgrade. (Passive Bailout).
2. EU / IMF grants to Greece loans and imposes strict regulations (Active Bailout)
There are different places to intervene in a systems / in the economy (replicated from Donella
Meadows, 1999 available: sustainer.org/pubs/Leverage_Points.pds). We will focus on the
following leverage points:
- Constants and parameters (taxes, retirement age, fees)
- Structure change
- The mind or paradigm that the system arises out of (lack of confidence in Greece,
speculators attacks)
4.1. Passive Bailout
- POLICY:
o Change constants and parameters (higher taxes, lower government spending,
cut benefits, lower salaries and wages)
o Change the mind paradigm (loan commitment will discourage speculators)
- RESULT:
o Lower financing costs, discourage speculators and lower public debt in
comparison to the “no loan commitment” scenario.
Financing Costs Speculations
Time (time wea)
Faaning Costs: comin caly
Financing Costs: cures
Speculations“ 00
Speculasone : cuvent
12
Public Debt
GDP
350 eoo
25 550
s
Ses
25 eas
ai
Leer
340 a |
o 1 @ 3.4 5 6 7 8910
Tame (Tes) Toe (Pe)
ODP: nly ube Debt, commirent nly
CDP went, Puble Debt: caret
Figure 6: Financing Costs in Units 100 = pre crisis rate, Speculations (% of all market participants), GDP in billion US
dollars and growth of Public debt in billion US dollars
4.2. EU chooses active bailout
The EU gives emergency aid to Greece to resolve the crisis. It might take a wide range of
steps, from having state-owned financial institutions buy Greek debt to accelerating the
disbursement of routine economic aid to Greece, providing Greece with a debt guarantee, or
establishing a bailout fund. The EU treaty attempts to ban bailouts of euro zone members but
legal obstacles could be circumvented if necessary, perhaps by declaring aid "bilateral"
(Reuters, 18" Feb 2010).
There are at least two reasons why the EU will bailout Greece:
- A large part of Greek bonds are held by European financial institutions, especially
German
- A failure to bail out Greece could trigger contagious effects in sovereign debt market.
Financing Costs
Speculations
200
Units
o t 2 3 4 5 6 7 & 9% 1
‘Tone (ene weit) Tine (ene ust)
Einancing Coss: Joan & contol Speculations: Joan & control
Enancing Coss: current Speculations: current
GDP Public Debt
350 600
us 550
"
g 345
m5
340
GDP oan & control GDP current
Pubic Dett [oan & control
Public Debt: omens
Figure 7: Financing Costs in Units 100 = pre crisis rate, Speculations (% of all market participants), GDP in billion US
dollars and growth of Public debt in billion US dollars
13
- POLICY:
o Change structure of the system (strict regulations and control, drastic changes
in Greek economic and budgetary policies (De Grauwe, 2010))
o Change the mind paradigm (loan commitment will discourage speculators)
- RESULT:
o Lower financing costs, discourage speculators and lower public debt in
comparison to the “no loan commitment” scenario and to the “commitment
only” passive bailout.
o Higher GDP growth in comparison to the passive bailout.
Given that strong economic growth is the best long term debt reduction strategy and that the
global recovery is still dependent on government support, policy makers, particularly those in
the advanced economies worst-hit by the crisis, must maintain stimulus efforts in the short
term (Dadush and Stancil, 2010)
5. Conclusion
As the new “after financial crisis”-era begins to unfold, economists must start using new tools
in order to rethink and redesign the socioeconomic systems. Economics has always relied on
a careful modeling of decision — makers. Nevertheless, the discrepancies between theoretical
predictions and observed behavior have haunted the field for many decades (Brocas, Carillo,
2010) The system dynamicists can contribute a significant amount of value to institutional
economics in the following ways: provide a clearer understanding of feedback, provide a
medium for bringing behavioral theory explicitly into pattem models, helping to define and
expand the corpus of holistic economic theory, offering insights into socioeconomic
evolution and assisting in the production of new pattem models (Radzicki, 1990). Current
economic system are marked by their complexity in which “irrational” individuals are
forming expectations. This type of complexity is not very welcome since this may lead to
speculative dynamics. In this case a positive feedback aggregate beliefs cease to bear a
relationship to realistic possibilities (Su, 2009). There are indeed serious epistemological
problems associated with complex economic systems which imply that there exist serious
bounds on the rationality (Dequech, 2001; Rosser, 2001; Marchionatti, 1999). This can lead
to group dynamics as analyzed by Keynes for the well — known “beauty contest” where each
party tries to guess the average state of expectations of the other parties. So every individual
is more interested in the sentiment than in the fundamentals. If the result of one s decision
depends on the decision taken by others than this would imply that there is a special
interdependence in the market. Interdependence in itself is not a source of fundamental
uncertainty, since it may merely generate complexity in a constant, or predictability changing
environment (Sau, 2009). Everyone has to consider organic interdependence, where the
whole may be more than the sum of its parts. “Organic interdependence creates fundamental
uncertainty in the sense that expectations must be about other people’s expectations and this
spreads fundamental uncertainty” (Dequech, 2001). We also believe that most policy makers
in human systems contribute to the problems they are trying to solve. Many economists have
argued that even if individual consumers suffer from bounded rationality, markets will be set
right who can figure out even the most complex problem. But they were wrong (Thaler,
Sunstein, 2008 / New York Times). Regulators should therefore help people manage
complexity by requiring simplicity from financial instrument creators and strict disclosure
tules and the synthesis of economics and SD will help.
14
“Yet the ability of governments and investors to delude themselves, giving rise to periodic
bouts of euphoria that usually end in tears, seems to have remained a constant.” (Reinhart,
Rogoff, 2009).
It seems that actually the EU cannot choose between bailout and no bailout and cannot
choose between inaction and action, because ultimately the EU will be forced to act. If the
EU comes in earlier and in a more systematic fashion, the cost for everyone will be lower and
the chances of fast recovery stronger (Johnson, 2009).
To put the Greek problem in perspective, loans required to fund half of its 2010 projected
fiscal deficit would amount to about 0.1 percent of the GDP of its Euro area partners. Bearing
in mind the inevitable contagion effects from Greek default onto the major European
economies, and the currency instability as the euro comes under attack, providing support
would only make sense (Dadush and Stancil, 2010).
15
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