Fiscal consolidation and external rebalancing may be necessary for Greece’s return to sustainable growth though it is mostly based on the sharp drop of domestic demand that is driving high unemployment. It is therefore questionable how long this adjustment can continue without society losing patience and the political system being tested. Key to avoiding an undesirable outcome is both the encouragement of growth import by core eurozone countries and the deployment of credit to domestic healthy companies, following the recapitalization of local banks.
There is no question that Greece was living beyond its means for a long time, making a contraction in output inevitable for achieving an internal and external balance. However, it is also clear that the contraction has overshot the official and private estimates repeatedly on diving consumer and domestic investment spending in the last few years. The loss in output caused by the collapse of domestic demand has pushed the unemployment rate to the record territory of 27 percent and undercut living standards via a 25 percent drop in per capita GDP. Of course, Greece is not alone in the euro periphery camp but it is definitely the country that has been hit the worst.
The fiscal and external adjustment is enormous by any means and appears to be continuing according to fresh data but the economic and social costs are also huge. Current plans call for more progress on the fiscal front so that revenues exceed primary expenditures by 4 to 4.5 percent of GDP in 2016 to make the Greek public debt sustainable in the medium- to long-term. It is therefore reasonable to find ways for rebalancing that rely less on the drop of domestic demand.
Undoubtedly, a recurring primary budget surplus is one of the necessary conditions for the stabilization of the economy and the country’s return to capital markets for the first time since 2010. The signs are encouraging after last year’s general government primary deficit turned out to be smaller than projected, at around 1 percent of GDP. Moreover, the state budget’s primary surplus of 508 million euros in the first quarter compares well with last year’s deficit of 338 million euros and the deficit target of 2.33 billion over the same period this year. It is a trend that should also be reflected in the general government budget balance, which incorporates the state budget, when the final figures are released. Although it is still too early, we would not be surprised if the primary surplus of the general government stood between 0.8 and 1.5 percent of GDP in 2013.
In addition, the external balance continued to improve in the first two months of 2013, following last year’s impressive narrowing of the current account deficit to 2.9 percent of GDP from about 10 percent in 2011. The deficit fell by 59 percent or 1.5 billion to 1.1 billion euros in the first two months of the year on significant declines in the trade and the income account deficits, indicating that a balanced current account may be within reach. Also, unit labor costs – a measure of competitiveness for many analysts – continue to slide on high unemployment and overall dismal labor market conditions.
But internal devaluation has yet to compress retail prices, hurting the purchasing power of households, already suffering from widespread tax increases, pay cuts and high jobless rates in the private sector. It is difficult to calculate the human cost of the ongoing social dislocation of the country’s adjustment process. However, it is safe to say that relying on the drop of domestic demand to rebalance Greece’s internal and external accounts may not be socially and politically sustainable in the medium-term.
To facilitate Greece’s and other southern countries’ adjustment without undermining political consensus and boosting euroskepticism, the core eurozone countries will have to understand the importance of encouraging imports via more accommodative income policies to reduce their large current account surpluses. If they don’t, it is likely that the markets will do it by driving up the value of the euro, which would kill export growth and plunge both core and non-core countries into recession.
Also, the ECB will have to take action to counter signs of fatigue in economic indicators, such as the PMIs, and perhaps introduce unconventional policies to help channel more credit into small and medium-sized (SMEs) companies. This is more important in southern countries, like Greece, where SMEs constitute the backbone of the economy.
In Greece, many private sector companies are suffocating because the state prioritizes the payment of civil servants wages and pensions, and funding the deficits of state entities, allowing domestic arrears to accumulate. This is supposed to change this year with arrears being gradually paid off. But bankers and others question whether the recapitalization of local banks will lead to looser credit conditions. In other words, they doubt whether credit will flow to cash-starved companies as banks will still face large funding gaps – the loans are usually much bigger than deposits – while the recession continues to erode the quality of their loans. This issue has to be tackled, perhaps with some help from the European Investment Bank and others, because the economy cannot grow during a credit crunch.
Greece cannot rely forever on the contraction of domestic demand to rebalance its internal and external accounts because it is not politically and socially sustainable. The core countries can help by encouraging import growth while innovative ways may have to be found for local banks to channel credit into SMEs and other domestic financially healthy companies.