Frontloading plan risks stability

German Chancellor Angela Merkel?s visit to Athens on Tuesday is expected to confirm widespread market expectations that Greece will remain in the eurozone for at least another year. Yet frontloading the fiscal adjustment to meet the deficit target in 2014 as the troika seems to be insisting on may bring about political instability next year, undermining the economic program.

Merkel may not be the most popular foreign politician in Greece since the vast majority of the population associates the long list of austerity measures and the five-year recession with her overall stance during the debt crisis. This is despite the fact Germany has been Greece?s biggest creditor in the eurozone.

But she is also viewed as the key decision maker in the eurozone who calls the shots for Greece and other debt-ridden countries. So, her visit to Athens is welcomed by the local government, business and others who read into Merkel?s relatively recent rhetoric a determination to keep the euroland intact.

Almost all of them seem to link the chancellor?s policies and tactics with the German elections next fall and its plans for the eurozone. This is why they reckon Greece has probably bought another year to make things happen and change its dismal image in Germany and elsewhere, assuming it does what is necessary.

But sticking to the adjustment economic program Greece signed earlier this year with its international creditors is not as easy as outsiders assume. Having taken austerity measures equal to 49 billion euros or about 24 of GDP since May 2010, the government is finding it difficult to take an additional 16 billion euros or 8 percent of GDP in 2013-14.

It may be easy for creditors to demand Greece honors its loan agreement, but it is politically and socially difficult for any government to implement austerity measures of such scope. This is even more so when the jobless rate exceeds 24 percent and more than half of the youth is unemployed. On the other hand, this is the price to pay for staying in the euro when politicians do not want layoffs in the bloated public sector.

Critics usually point to Greece?s failure to implement various reforms, such as liberalizing the energy sector, as the main reason behind the protracted recession. It is true the delays and the lack of accord with the troika on the specific measures making up the 13.5-billion-euro package have put off the disbursement of 31.3 billion euros, further contributing to the economic malaise.

But even if Greece implemented all structural reforms, it is doubtful it could spare itself from the protracted recession. This is the case since the effect of the fiscal drag is felt fast while the positive impact from the reforms is usually realized gradually in the medium to long term.

With the country?s access to world markets blocked and its small export base, only privatizations and related investments along with speeding up the absorption of EU funds could mitigate the effect of the fiscal consolidation. But talk of Greece?s euro exit by German politicians and others, along with inherent domestic weaknesses, have compounded the problems facing the sell-off program. So it is almost sure the country will miss the privatization target of 3.2 billion euros this year.

Still, the biggest obstacle to the stabilization of the economy remains the sizable fiscal adjustment. The troika seems to be pushing for the frontloading of austerity measures approaching 9 billion euros in 2013. If one also takes into account the restrictive effect of labor market reforms adopted in February on household spending and lingering effects from the past, the economy may shrink by 5 percent in 2013 and fail to recover before 2015.

It is true the measures may turn the primary budget deficit, which does not include interest on debt, into a surplus next year despite a drop in output. However, one cannot also take lightly the heightened risk of social unrest and a moratorium on tax and social insurance payments by the public.

Moreover, it is certain the political forces which are critical of the adjustment program will gain ground, with the leftist SYRIZA party likely to overtake conservative New Democracy in the polls. Political analysts and market participants seem to agree SYRIZA is likely to extend its lead over the conservatives as time goes by and the measures bite harder. They also expect the other two coalition partners, PASOK and Democratic Left, to lose ground as well.

In addition, many think the coalition government will continue to have the support of the majority in Parliament even after experiencing some defections, since the alternative will be SYRIZA in power. Yet popular discontent with the coalition government?s economic policies may help push SYRIZA?s lead over ND to more than five percentage points next summer and even close to 10 percentage points a year from now.

Some bankers and others think such a large lead could undermine the government?s ability to carry on with the reforms and the implementation of the remaining painful measures from the package of 13.5 billion euros in 2014. In a polarizing situation, there is even a scenario putting the extreme-right Golden Dawn party in second place, above ND.

So, if the bulk of the measures is frontloaded in 2013, political instability is likely to set in as SYRIZA overtakes ND and then widens its lead to high single digits. Of course, this does not take into account signs of a more moderate policy stance by SYRIZA and its commitment to Greece?s eurozone membership.

Still, there is a real possibility that frontloading the fiscal adjustment in 2013 may indeed lead to political instability in the country. This is another argument in favor of spreading the austerity measures over four years instead of two, to give the economy some breathing space. However, the resulting funding gap has to be filled and the sustainability of the public debt to be addressed, requiring a political decision by Merkel, French President Francois Hollande and the others.

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