A year on, mild fiscal adjustment is set to acquire a harsher twist

Revised stability program, due tomorrow, will certainly contain higher indirect taxes

By Dimitris Kontogiannis - Kathimerini English Edition

What a difference a year can make: In March 2004, the newly elected conservative government, fresh from its landslide victory against the Socialists, was confident it would be able to deliver on its pre-election projection of 5.0 percent GDP growth while also managing to keep the budget deficit below the 3.0 percent of GDP threshold.

A year later, the same government finds itself in a much more difficult position: Economic growth appears to be slowing, unemployment is on the rise and the government is being pressured by the EU to bring last year’s huge budge deficit below 4.0 percent of GDP en route to less than 3.0 percent in 2006. Can it do it? The odds may be against it at present but there is no reason to doubt the goals can be attained if the government does what it should have done all along — formulate an economic plan with set timetables and act decisively. Its revised stability program, to be presented officially tomorrow, is a good starting point.

Greece has not been good at sticking to the macroeconomic projections of the various stability plans it presented to the EU in the past. So, there is no reason to expect it will be different this time around. However, one should take into account that things may indeed be different this time, as Greece is under EU supervision over its fiscal imbalances and faces stiff penalties if it fails to deliver. This, of course, does not guarantee that the country’s revised stability blueprint will not have the fate of its predecessors, but certainly means the chances of a repeat are slim.

Based on official leaks to the press, the new stability program will seal the death of the 2005 budget by admitting that the main government objective for this year is to reduce the budget deficit to between 3.5 and 3.7 percent of GDP, compared to 2.8 percent in the budget voted on in Parliament in December. The program sets a 2.8 to 2.9 percent of GDP budget deficit target in 2006. To do so, the plan reportedly employs three scenarios to reach the same deficit targets and relies heavily on GDP growth rates in excess of 3.0 percent. In addition, it places more emphasis on raising tax revenues than on cutting spending to meet the 3.5-3.7 percent of GDP goal this year. The emphasis on revenue enhancement to cope with the sizable budget gap is called political and economic realism by some pundits and proof of statism by others.

According to the latter, the unwillingness of subsequent governments to take measures to reduce the large public sector and accept the ensuing political cost helps explain the greater weight placed on revenues.

Even should the government announce an increase in taxes on tobacco, liquor and some other items and perhaps opt to levy an 18 percent value added tax (VAT) on a number of goods and services to which 8.0 percent VAT had previously been applied, it would be wrong to conclude the government’s top economic brass has deviated from its previous pledge to stick to the policy of “mild economic adjustment.” Of course, some cabinet members will have violated their pre-election promise of not raising taxes to tackle fiscal imbalances but this has not been taken seriously since US President George Bush’s famous phrase “read my lips: no new taxes” was discredited.

There is no guarantee though that the government’s economic team will be able to streamline public finances and still stick to the “mild adjustment” approach. Cuts in EU structural funds, which are considered essential for maintaining high GDP growth in the 2005-2008 period, cannot be ruled out. Already pundits take them for granted, focusing their attention on the magnitude of the cuts. The cuts may derail some EU co-financed projects at a time the government is trying to attract private investment spending to take up the slack for the reduced public investment budget.

Still, Greece may be able to avoid the trap by setting in motion in the second half of the year some large foreign direct investment projects delayed by red tape for years.

Even if Greece succeeds in keeping investment spending going strong and gets a lift from tourism to attain GDP growth rates in excess of 3.0 percent, it will not be able to avoid the pinch of higher bond yields when it borrows. Starting with the US Federal Reserve’s policy of gradually raising the key funds rate to 2.75 percent recently and the accompanying statement on evident pressures on inflation, long-term bond yields have been on the rise lately, prompting some to proclaim the beginning of the bond bear market. This means the cost of borrowing for sovereigns and corporations will go up. So, even should eurozone bonds outperform, the cost of borrowing for countries such as Greece is likely to increase.

In addition, it is generally accepted that the reforms agreed to at the latest EU summit, leading to a looser Stability and Growth Pact, increasing the chances of sub-optimal fiscal policies. This is mixed news for Greece. On one hand, it can count on greater flexibility in the interpretation of the 3.0 percent of GDP rule two years’ down the road to pursue a less restrictive than otherwise fiscal policy. On the other hand, it will find out firsthand that markets penalize eurozone countries with greater budget gaps, while the ECB may be more inclined to raise its key official interest rate than before. Moreover, markets may demand bigger spreads over the benchmark for bonds issued by non-core countries, such as Greece, under the new Stability and Growth Pact.

The combination of higher global bond yields and the looser Stability Pact is likely to raise the cost of borrowing for Greece, making fiscal adjustment more demanding. Given Greece’s high interest bill, this development should not be overlooked. Nevertheless, the government has no option but to stick to its revised stability program and enrich it with more supply side reforms, including a timetable for privatizations, and budget spending growth controls to honor its EU commitment and avoid the vicious cycle of raising taxes to cut the budget deficit only to find out it slashed GDP growth.