The new IMF-EU bailout package for Greece adds a further 11 percent of GDP of spending cuts and tax rises. A fiscal tightening of this magnitude is the economic equivalence of suicide.
In the latest (April) edition of Signpost Schema, we included a Focus article which made the point that Greece was by no means the only EMU country with significant problems ahead – not just with regard to public finances but also concerning competitiveness.
Over the weekend, policymakers attempted not just to stem the tide, but to turn things around – hoping that a Є110 billion joint IMF-EU bail-out package for Greece would be sufficiently large to convince market participants not to bet on a rescheduling or default occurring. The ECB stepped in too on Sunday, announcing that it would change its collateral requirements – so as to continue to take Greek government bonds no matter what the ratings agencies think of them. (Even though the latter define them as “junk”, the ECB will treat them as being as valuable as their Bund counterparts.) By acting “big”, the authorities clearly hoped not just to rescue Greece but to stop EMU unravelling.
After an initial positive reaction to the proposals – which are not yet ticked up by all member governments, and so could theoretically still run into the sand – today investors again took to their heels, showing little appetite to hold Greek assets. More worryingly, other periphery country bond and CDS markets moved in such a way as to suggest a quite powerful bout of contagion. Portuguese 5-year CDS spreads, for example, jumped 82 basis points to 366bp. Spanish ones rose nearly 50bp.
One reason for the market gyrations is residual uncertainty concerning whether or not the package will indeed be passed or not. (We suspect that it will.) Another more important reason is the fact that, on top of the 6 1/2 % of GDP of fiscal tightening that the Greek authorities had already pushed through, the package over the weekend is projected to add a further 11 percent of GDP of spending cuts and tax rises.*
A fiscal tightening of this magnitude is the economic equivalence of suicide. A severe, and long-lasting, recession is now inevitable. The IMF-EU package anticipates a 4% drop in Greek GDP this year and a further near 2 1/2 % drop in 2011. Only in 2012 is it expected that the economy begins to lift, and then by a miserable 1% or so. Realistically, at best the economy might manage to return to current levels of output again in 2015 or 2016. At worst, it might be more like a decade down the road before Greeks manage to restore current living standards.
For the rest of Europe’s policymakers, the big issue is what to do now. Just watch and wait? (And hope or pray.) Or, might a step or two down the same path trodden by the Greeks raise credibility in their fiscal and structural reform efforts? For the Portuguese prime minister, Jose Socrates, there is no doubt that action is required; hence his announcement over the weekend that Portugal will bring forward its planned 2011 fiscal tightening to this year. In itself, these measures are fairly small beer, at less than a tenth of what Greece is planning in relation to GDP. But, it may be a first step down a slippery slope if the Greek package fails to assuage market concerns. So, just as with hemlock – which used to be used as medicine by the Greeks for treating such ailments as arthritis – it is a dangerous treatment to use, as the difference between a therapeutic and toxic dose is very small. As the wikipedia entry on hemlock points out, one of the side-effects of even a small overdose is that it can be followed by depression.**
* This is an IMF estimate. See http://www.imf.org/external/np/sec/pr/2010/pr10176.htm
** See http://en.wikipedia.org/wiki/Conium