By Dimitris Kontogiannis

Greece is facing a much bigger than projected drop in output – bordering on depression – next year after the troika and the government opted to frontload austerity measures in the 2013 budget. In this regard, all bets are off since the negative impact from the economic contraction will outweigh any positives from the improvement in the fiscal and current account balance, with the ensuing political fallout likely complicating the situation.

In the Greek saga, the country’s creditors continue to accuse successive governments of non-cooperation and delays in the implementation of structural reforms agreed in the May 2010 and March 2012 memorandums. On the other hand, the Greeks accuse the troika and their hard-line creditors of excessive austerity. Both sides are right but beggars can’t be choosers, so the Greeks are at a disadvantage.

We have argued that excessive austerity has emerged as the biggest threat to the economic policy program by causing unnecessary pain and accelerating reform fatigue. We have also argued that frontloading the austerity measures in 2013 will heighten the political risk domestically and may lead to unthinkable configurations and consequences. However, we did not think that the political risk would manifest itself so soon with the coalition government divided over the labor reforms.

We also opined that Greece may not obtain access to bond markets in 2015-2016 even if it manages to meet its budget deficit targets. This is because the primary surplus required to make the public debt sustainable is set too high at 4.5 percent of GDP. This will hamper economic growth and make it extremely difficult, if not impossible, to drive the debt-to-GDP ratio below 120 percent in 2020. In this context, political initiatives are needed to slash the debt-to-GDP ratio to much lower levels so market confidence is regained and the country can start funding its needs through capital markets.

A small demonstration of the adverse debt dynamics comes from this year. Greece appears to be on its way to beat the general government budget deficit – estimated at 12.9 billion euros compared to the target of 13.7 billion – and slightly improve the primary budget deficit goal of 2.47 billion euros according to the 2013 draft budget. The country has also seen its public debt slashed considerably after the completion of the debt write-down earlier this year. So, the stock of public debt is seen falling to 340 billion euros from 355 billion in 2011. Yet the debt ratio is expected to go up to 175.6 percent of GDP this year from 170.6 percent last year due to the larger-than-projected drop in GDP.

Unfortunately, frontloading the austerity measures will make the projected drop of real GDP by 4.5 percent seem optimistic, we think. This conclusion is based on the following estimates, also shared by other economists. First, we have the negative impact from last year’s labor market reforms, which is put at 1 percent of GDP or about 1.9 billion.

Moreover, the adverse effect from the bigger-than-expected recession in 2012 and other austerity measures taken in the last two years – i.e. taxes, widely known as carry-over – is likely to amount to 2 percent of GDP or 3.8 billion euros. Others estimate the carry-over effect at 2.5 percent of GDP or 4.75 billion euros. The two combined will reduce GDP by about 3 percent or 5.7 billion.

The story does not end there. The additional austerity measures in the 2013 budget amount to approximately 11 billion euros. Some 2 billion will come from revenues and around 9 billion euros from spending cuts. Applying a fiscal multiplier of 0.25 on the above revenue figure translates into subtracting 500 million from this year’s GDP.

In addition, some 12.5 billion euros will have to be subtracted from the GDP assuming a fiscal multiplier of 1.4 on the above spending cuts. Therefore, the combined impact from fiscal austerity measures is estimated at 13 billion euros. If the 5.7 billion euros from the previously mentioned effects are added, some 18.7 billion will have to be factored out from this year’s GDP.

On the other hand, there should be a positive impact on next year’s GDP from the external account, as imports fall further and exports rise. The government estimates the positive effect at 2.25 percent of GDP or 4.28 billion euros. Another unknown variable is investment spending. The government estimates it will fall again, though in single digits, in 2013. We will assume that it will remain the same.

So, what do we get if we add it all up? The drop should be around 14.4 billion euros, so GDP will end up at around 179.5 billion in end-2013 compared to an estimated 194 billion this year, meaning a drop of around 7.5 percent in nominal terms. Of course, the drop could be bigger than 7.5 percent in real terms if Greece experiences deflation next year as it is the official forecast.

Some may argue that the fiscal multipliers used should be lower, as we guess the troika and the Finance Ministry are doing. However, we disagree given the extraordinary state of the Greek economy, which faces both fiscal and monetary tightening amid a growing liquidity squeeze.

It is noted that others – i.e. analysts at Eurobank – estimate that the fiscal multipliers applied to salary and pension cuts exceed 2.0, meaning the drop in GDP should be even higher from this source. A recent International Monetary Fund study supports this argument, stating that the actual short-term fiscal multipliers may be higher, in the range of 0.9 to 1.7, since the start of the Great Recession compared to 0.5 on average before.

If we are right – and we honestly hope we are not – the Greek economy will experience a much bigger than the projected contraction of 4.5 percent next year. It is hard to see how this will not fan the flames of social discontent and political turmoil.