Economics: A Greek Tragedy and the Effect on Europe
In February, EU leaders pledged to take “determined and co-ordinated action” to protect Greece from a sovereign-debt default and to avert the contamination of its troubles across the euro area.
The Greek prime minister, Mr Papandreou recently declared the worst was over after Greece successfully raised €5 billion in 7 year bonds on March 29th. However this was at interest rates more than 300 basis points above Germany’s, and the yield on Greek 10-year government bonds has just leapt from 6.5% to above 7%. It unfortunately appears that the worst is far from over, and now the dreaded D-word (default) is circulating among analysts, as the cost of insuring Greece’s bonds is set to surpass that of Iceland’s! And it seems the pain is only just beginning as Greece is on the hook to refinance some €20 billion in April and May. A standby fund of €25 billion has been rumoured(1), with €12 billion from the IMF in swift support, which may be enough to calm markets and enable Greece to roll over its debts. However, this support will only provide a temporary patchup solution, while it will take years to repair its beleaguered public finances.
The standard operating procedure for the IMF as lender of last resort is to impose brutal cuts in public spending as part of the rescue package. However this is normally accompanied by a fairly aggressive devaluing of the currency to slightly ease the pain. Of course in the case of Greece, devaluation is not an option, so the pain will be felt all the deeper and is being accentuated by Germany’s Angela Merkel, who is insisting that the Greeks pay a harsh price for their prior profligacy.
And so to the dreaded D word: Can Greece ride out the current storm without defaulting, and if not what does this mean for the rest of Europe? The facts are straightforward: the government is sitting on €13 billion of cash, which will see off April, but requires a further €10-12 billion in May for refinancing maturing debts and funding the budget deficit. Following which, their funding requirement drops down to a much more manageable €25 billion evenly spread throughout the remainder of the year. As a last-ditch effort before a full scale bailout is required, the Greek finance minister will go to the US at the end of April and attempt to raise $5-10 billion of dollar denominated bonds. Target investors will be emerging market funds, but it is questionable how much support they will provide (or at what price) when genuine emerging markets offer significantly better growth prospects. Furthermore, even if we assume Greece does somehow survive the spring, and then the remainder of 2010, what happens next year? It would take an economic miracle to reverse Greece’s public finances in a matter of months.
So, how bad would default be? In 2001 Argentina defaulted on $81.8 billion of sovereign debt, leading to a sharp devaluation of the peso and GDP in free fall, losing a massive 10.9% that year. It has been locked out of international capital markets ever since. Also, it is not just the public sector that badly suffers - an IMF study has found that default leads to a 40% decline in external credit to private companies in the defaulting country. And of course if Greece does default, the cost of credit will inevitably rise for other euro zone countries with beleaguered public finances (Ireland and Portugal notably), but even member states that are in better shape (think Germany) are also likely to feel some pain. So for these reasons, it may yet be in Angela Merkel’s best interests to defer judgement on an errant member, and instead rally the club to offer a realistic bailout strategy, albeit with harsh conditions meted out.
At the beginning of 2010 British political discussion centred around what type of prime minister David Cameron would potentially become: would he step up to the challenge with Thatcherite zeal or struggle with the bitter circumstances he was due to inherit. Today a more pressing question emerges: does Cameron have what it takes to be the next man to move into Number 10? He has made it clear to the media that nothing but an outright majority will count as a victory, and he has hinted at a potential re-election if he does not win his outright majority the first time round. However, the real danger for Cameron is that he does not win a victory at all like in 1992 when an unpopular conservative government and prime minister held onto power during a recession. Perhaps the most acute danger for the UK is that Gordon Brown remains in power, but presiding over a hung parliament. Unlike Cameron, Brown would likely consider a hung parliament in which Labour held the most seats as a formidable victory against the backdrop of 13 years of Labour power after being the most unpopular prime minister on record. If this is the outcome in a couple of months time, Brown will likely hang onto power with all his bulk, and the UK government might begin to resemble that of some of its European counterparties, stagnating under the weight of the cross-party deals necessary to turn rhetoric into legislation.
The next few years of British politics, regardless of which party is at the helm, will be dominated by an era of budget austerity (as in much of the developed world), as public finances are repaired. This will be done through a combination of spending cuts and tax hikes. Political ideology will determine which of these two dishes the ruling party focuses on, but here the academic evidence is reasonably clear: fiscal adjustments that rely on spending cuts are more sustainable and friendlier to growth than those that rely on tax hikes. As mentioned in our opening article, since 2000 the UK government’s share of GDP has risen from 37% to 52% today. In parts of the north it is higher than it was in the Eastern Bloc countries under Communist regimes, and this is only set to get worse with an ageing population dependent on ever greater levels of state healthcare. It does not require a leap of faith to extrapolate which path an incumbent government may go down.
The eagle and the dragon
Decoupling was the buzz word a year ago: could China survive without American consumers eating up their exports? As China continues to grow at a meteoric pace, the answer is a patent yes. However a question of decoupling persists, but in reverse: can America prosper without Chinese consumption? The last two years have brought about radical change to American consumers: for the first time in a couple of decades they are forced to live within their means (in the absence of asset bubbles serving as cash machines). This means American firms will have to sell more goods to the rest of the world than ever before. A couple of years ago this might have seemed a tall order, but fast forward to today and a weakening dollar coupled with strong growth in other countries makes this look more likely. So what we are now seeing is a huge global opportunity, albeit with a global rebalancing that might have seemed unthinkable a few years ago. The basic point is that if American consumption is not replaced by consumption in the rest of the world, then the global economy (at its most simple) will stagnate. Alternatively, if America can export more, and global consumption can be maintained accordingly, the world will prosper. This will require policy responses from both the developed and developing worlds that embrace this type of philosophy. Though it is understandable for the West to be anxious of the rise of the developing world, it is also important to remember the raw statistics here. Chinese GDP per capita in 2009 was $3,500(2) against $46,500(2) in America and consumption as a percentage of GDP is about 35% in China and about 70% in the US. China clearly has a long way to go before it can really be considered a threat to American prosperity, and arguably quite the reverse is true.
- Supplement: On the April 11th, euro zone finance ministers agreed to make available a package of up to €30bn in loans to Greece.
- International Monetary Fund, World Economic Outlook Database, October 2009. Current Prices, USD.
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