Despite the melodrama surrounding the vote for Greece?s medium-term fiscal plan in Parliament this week, we are confident that the government will be able to harness enough support from the socialist deputies to pass it. However, the government and the rest of the local political elite cannot escape answering the following: Are they willing to severely downsize the bloated and corrupt public sector or are they going to let it drive the Greek economy down to default. The omens are not good.
It is widely agreed that the Greek economy will have to grow at satisfactory rates for many, many years, borrow at interest rates well below the nominal GDP growth rate during the same period and produce large primary budget surpluses in the order of 6 percent of GDP to be able to reduce its huge public debt to around 100 percent of GDP in 20 years or so.
The markets obviously do not think this is possible, meaning the Greek debt is not sustainable, and have rushed to jack up bond yield spreads and spreads on Greek CDS (Credit Default Swaps) to stratospheric levels. Some may say markets are not always right and tend to correct their mistakes in a sharp, quick way if they are convinced to the contrary. But they are right, and there are some recent historic precedents to support this view.
The cost of insuring against an Icelandic default was the highest in the world in October 2008 when its three banks failed with CDS on five-year debt trading at 1,473 basis points compared to some 300 basis points or less recently. Ukraine had seen the cost of its five-year CDS shoot up to more than 1,300 basis points a few years ago, if we cast our minds back, but receded to around 500 basis points.
So, there is hope that Greece may be able to turn the corner and do what many in the markets and EU governments think is unthinkable at this point that is, not to restructure its public debt. However, the problems of this country are quite different from those of Iceland or Ukraine.
From a simplistic point of view, Greece spent much more than it produced for decades and this showed up in the twin deficits of the current account balance and the general government budget balance, amassing a huge amount of public debt.
So, all it would take for government and central bank policy makers to correct this imbalance was a comprehensive package of fiscal and reform measures aiming at compressing aggregate consumption while encouraging investment expenditure and exports of goods and services.
With consumption spending averaging above 88 percent of GDP since the early 1990s, all it had to do was to ensure that nominal GDP growth outpaced consumption expenditure growth by far. At the same time, they need to introduce a wide array of structural reforms, ranging from the ailing social security system to barriers of entry in tens of professions, the liberalization of the energy and labor markets and others to boost aggregate supply and make the economy more efficient and extroverted. This did not happen.
The same goal could have been attained much easier by focusing on the root of many of the above problems, namely the bloated public sector.
Here we have to trust those who say seeking a job in the public sector was not every Greek?s dream before the late Andreas Papandreou, the father of the current prime minister, came to power with the socialist PASOK party in 1981.
In other words, it has not been always in the Greeks? DNA to seek the security of the public sector before then. Needless to say, this, along with the intensity of the current economic crisis, may be a card in the hands of the few in Greece who argue in favor of downsizing the public sector to address both the budget deficit and the lack of international competitiveness.
However, what we see in the medium-term fiscal plan pushed forward by its official creditors and the complementary package of austerity measures to close the estimated gap and reach this year?s budget deficit goal of 7.4 percent of GDP, is another strong dose of tax hikes.
Going the easier route
This shows that the government wants to tackle the budget deficit by adopting measures that aim at generating more revenues rather than going for spending cuts. The government obviously finds it easier on a political level to penalize the private sector where trade unions and therefore opposition are not as strong and are more fragmented, than to do the same in the public sector, among whose labor unions some of its staunchest supporters can be found.
By doing so, the government is likely to find out along with the rest of us that the economy will get gradually weaker in coming months since the healthier private sector will suffer more, sowing greater social discontent. If this is accompanied by the usual approach of dragging its feet when it comes to privatizations and structural reforms, the public sector will also pay a heavier price, but it will be too late since this will be the consequence of the whole economy being in really dire straights.
Unfortunately, little can be done now that the government, with the blessing of our official creditors, has sought to deal with the fiscal mess by raising marginal tax rates again. By choosing to preserve the bloated public sector, the government has opted for a path. If there is any hope left, this lies with frontloading EU structural funds, privatizations and the sale of public property to soothe the pain but it is difficult to say whether this will be enough or who is going to execute them down the road.