New policy mix is required

Greece, the European Union and the International Monetary Fund are wasting precious time by not recognizing that kicking the can down the road does not lead anywhere but more painful solutions for the people in this country.

The strategy of postponing important decisions in hope of gaining time so that things get better later on does not apparently work.

As a matter of fact, the delay has made things worse. Greece needs to fine-tune the fiscal strategy by taking into consideration the economic recession and adhering to structural reforms.

By all accounts, the government has failed to live up to some of the obligations assumed under the economic policy program known as the memorandum it signed last May in exchange for a bailout loan of 110 billion euros.

According to high-level EU officials, the government is long on promises and short on delivering when the time for a review comes after a strong start last summer.

Some cabinet members have tried to water down legislation introducing structural reforms and in some cases forget to sign the ministerial decrees to implement the agreed-upon reforms.

These tactics have infuriated some EU officials abroad but everybody knows that structural changes will bear fruit in the medium to long term.

Although these reforms are very important for the economy, the key to forming market expectations and sentiment in the short run has been the reduction of the budget deficit according to plan.

The fact that last year?s budget deficit was revised upward to 10.5 percent of gross domestic product compared to an estimated 7.9 percent when the 2011 draft budget came out last October did little to convince the markets that Greece has implemented a strong policy package designed to reduce its huge public debt over time.

It is no coincidence that the markets had taken the 10-year bond yield over Germany below 700 basis points at the time compared to more than 1,200 points today.

Of course, as we have argued before, the EU is partly to be blamed for the re-widening of Greek spreads because of the implicit condition of a debt restructuring for countries entering the ESM (European Stability Mechanism) from mid-2013.

According to the original plan, Greece?s public funding needs are supposed to be fully covered till March-April 2012, provided the country broadly adheres to the general government deficit reduction target of about 7 billion euros this year, taking the gap down to about 17 billion from around 24 billion in 2010.

It is apparently evident to the Greek officials, the team of international lenders known as the troika and others that meeting this target would be extremely difficult this year as the economy has nosedived, increasing the likelihood of social unrest if more austerity measures are implemented.

This means the country may need extra funding earlier than April 2012, that is, another loan in 2011. We believe the urgency of the high-level talks in Luxembourg last Friday in the presence of the Greek finance minister reflect this reality.

Whether the EU can provide new funding from the temporary mechanism EFSF (the European Financial Stability Facility), overcoming political objections elsewhere with or without Greece proceeding with a voluntary restructuring in the form of a maturity extension of its debt expiring in 2012 or/and 2013 in the coming months remains to be seen.

Greece has reached this situation because of a poor mix of inadequate primary spending cuts and heavy tax hikes to reduce the budget deficit in the first place, with the troika?s blessing.

Perhaps, its is not a coincidence that a banker who a few months ago pointed out to the troika the need for closing down state corporations and laying off redundant personnel at state entities was rebuffed with the argument that this would have made the recession worse and perhaps caused social unrest.

A few months later, more than 200,000 employees in the private sector have been fired and the recession seems to have deepened, undermining the country?s hopes of returning to international markets.

It is very unfortunate that the program has to be implemented under these circumstances.

Still, the best course of action is to change the fiscal policy mix by letting Greece slip on meeting its tax revenue target and refocusing the efforts on more spending cuts while facilitating the funding of this year?s ensuing gap one way or another, that is, EFSF funding or/and a voluntary maturity extension of the debt.

It seems sensible to let Greece try to secure the voluntary participation of a good number of its bondholders to roll over the bond maturities expiring in 2012 and beyond and cover the rest with EFSF funding if a Brady-type bond solution is ruled out.

In other words, the Greek government should be held responsible for implementing all structural economic measures agreed to but the country should be given some breathing room in terms of missing the deficit target to the extent that is justified by the economic recession.

This way, Greece will not have kicked the can down the road and the troika will have tried to correct its early mistake of putting more weight than needed on tax revenue generating measures to secure the deficit reduction which has brought a good deal of the private sector to its knees and has left the huge and unproductive public sector virtually unscathed.

In this regard, the 2012-15 macroeconomic program budget deficit targets should not be abandoned.