Taking care of both twin deficits

In tackling Greece?s twin deficits, policymakers and pundits seem to focus more on the large general government budget deficit and much less on the current account deficit. They may be right if one assumes slashing the budget deficit will also lead to a much smaller current account deficit. However, this is not exactly the case here.

It is known that participation in the eurozone eliminated Greece?s foreign exchange risk and all related transaction costs, brought the lowest lending rates in generations and cut the country?s borrowing rates by reducing the risk premium demanded by capital markets.

This development underpinned the double-digit credit growth that helped boost domestic consumption and investment, and therefore domestic demand, making Greece the fastest growing economy in the euro league after Ireland.

At the same time, the country did not take advantage of the significantly lower borrowing rates and the ensuing interest budget savings to close the fiscal gap. In fact, Greece paid some 20 basis points more than Germany to borrow funds for 10 years at some point in the last decade.

Successive Greek governments took advantage of the lack of market discipline and growth to spend freely and create more jobs in the public sector to get more votes to increase their chances of being reelected. The global financial crisis in 2008 undercut the country?s growth drive and started unmasking the state of public finances.

The general government budget deficit skyrocketed to a revised 15.8 percent of gross domestic product in 2009, helped by the two elections held that year, from about 3.7 percent the year before Greece formally joined the eurozone in 2001. The budget deficit shrank further to about 10.6 percent in 2010 and may end up around 9.5 percent of GDP in 2011.

During the same period, the current account deficit, which includes the balance of trade, income and current transfers, widened to about 11 percent of GDP in 2009 from 7.7 percent of GDP in 2000. It should be noted that the current account deficit reached a record high at 14.7 percent of GDP in 2008. It fell to about 10.5 percent of GDP in 2010 and is likely to fall between 9 and 10 percent in 2011.

By just looking at the figures, one may conclude that there is a relationship between the changes in the fiscal balance and the current account balance during this period. However, one should notice two things:

First, this is definitely not a one-to-one relationship. The budget deficit rose almost fourfold between 2000 and 2009, but the current account gap almost doubled between 2000 and 2008, and rose by about 43 percent between 2000 and 2009. Second, this is a unique period for Greece in the sense that its economy is fully exposed to the effects of European financial unification.

The current account balance of a country that is able to borrow at lower interest rates compared to its trading peers will most likely deteriorate. This is more so if the same country grows faster than its trading partners since it spends more on imports even if the marginal propensity to import, that is, the change in import expenditure with a change in disposable income, remains the same.

Greece?s economic adjustment program formulated by the so-called troika — representatives of the EU, the IMF and the ECB — aims to cut the general government budget deficit drastically and in so doing it helps compress the current account deficit. It does so by transferring resources from the private sector to the public via higher taxes and instituting spending cuts, in some cases across-the-board, which undermine productivity.

The negative impact of the barrage of austerity measures on economic activity has also contributed to the improvement of the current account deficit since the Greek GDP contracts at the same time its trading partners? either grow or contract at a lesser pace.

Of course, the program has also counted on the implementation of structural reforms in input and output markets to make the economy more competitive. But the Greek side has tried its best to delay and even cancel some reforms when some powerful vested groups are affected.

In preparing the new economic program, the troika insists on reforms in the labor market with the intention of fighting unemployment and making Greek exports more competitive abroad. But instead of insisting on the proper functioning of labor markets so that wages are settled in a more competitive way, it appears to go further. It wants the annual wage bill to be settled in an administrative manner at a lower level to reverse the loss of Greece?s international competitiveness based on calculations of unit labor costs versus its peers in the last decade or so. It is the appreciation of the real effective exchange rate we referred to last week.

The combination of a significantly smaller budget deficit — assuming it will be so in 2012 — and the administratively engineered pay cuts in the private sector should help the current account deficit narrow further in 2012.

However, one should be very careful because the current account balance is affected by the fiscal budget outcome as well as the gap between private sector savings and investments.

If the government and the troika are to adopt policy measures that cut the budget deficit but also reduce private savings, the net result on the Greek current account deficit may be small. So, the right policy mix should aim at both slashing the budget deficit and helping prop up private savings, but this becomes more difficult when you introduce wage cuts irrespective of market and sector conditions.

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