Type of fiscal consolidationcould be key for economy

Greece has so far managed to weather the storm of the international economic crisis better than its peers in the eurozone but runs the risk of entering a protracted period of weak GDP growth rates if the right mix of economic policy is not put in place by the next government. The decision of Prime Minister Costas Karamanlis to call early general elections on October 4 did not surprise the pundits. Karamanlis knew that the political damage from the unpopular economic measures that had to be taken this fall to cut next year’s budget deficit would have been much greater if he waited for the early elections to be held next February or March. Of course, Karamanlis is right when he says a protracted pre-election period would not have been good for the economy but it is obvious that political calculations weighed more than anything else in his decision, with the conservative New Democracy party already trailing PASOK in various polls. There is no doubt that the most worrisome aspect of the present economic slowdown is the widening of the general government deficit to a projected 6 percent of GDP or more at the end of June. The deficit was supposed to recede closer to 5 percent of GDP by the end of the year, since many payments were made early on and tax revenues from various sources such as the real estate tax and the one-off tax on those who earned more than 60,000 euros in 2007 were to be collected in the second half. However, if Greek political history is of any guidance and the socialists win, the budget deficit will most likely end up at 8 percent of GDP or higher this year. This will be the case for two reasons. First, the state tax mechanism usually paralyzes in the run-up to elections and a few months after the poll. Second, the new party coming to power usually tries to burden the deficit of the previous administration as much as possible so it makes their budget figures looks better. There is no doubt that the biggest challenge for the new government will be to achieve fiscal consolidation without hurting economic growth. According to finance ministry officials, this year’s budget deficit would have ended up at 3.7 percent of GDP if the economy grew by 1.1 percent. If these calculations are correct, it shows that a good deal of the fiscal deterioration is due to the cyclical downturn of the economy. Therefore, the budget deficit would have fallen below the 3 percent of GDP threshold if the economy grew at its potential – that is, somewhere between 2.8 and 4 percent. Although the Greek economy is expected to benefit from a projected mild pick-up in the eurozone economy next year, the impact is not likely to be significant. So, any positive contribution to GDP growth from net exports is likely to come from import payments falling faster than export receipts. This means the key to growth is mainly private consumption and investment spending. Private consumption is a big question mark because lending is likely to pick up slightly but salaries and wages are unlikely to rise as much as in 2009 and 2008. Moreover, the rise in unemployment, the cuts in overtime work and the likelihood of flexible work hours being introduced in many private enterprises will definitely contain spending. On the other hand, the apparent rise in tax evasion helps consumption. The latter will also be helped by the elimination of uncertainty and the consequent boost in consumer sentiment that political and economic stability brings. In this context, it is very important what form fiscal consolidation will take. If it relies on increasing taxes on income earners, excise taxes and generally consumption taxes will definitely place a burden on private consumption, which accounts for more than 70 percent of Greek GDP and hurts economic growth. This, in turn, will have a lesser impact on the budget deficit since the budget and the economy are inextricably linked. Assuming an increase in public investment spending, stabilization in residential investment activity after two straight years of significant losses and a pick-up in public-private partnership initiatives, one would expect investment spending to stabilize next year. Taking all the above into consideration, one may reach the conclusion that the measures leading to fiscal consolidation should take into account their impact on private consumption and investment spending if they are to succeed. Additional measures to reform the economy, such as opening up sectors and professions to competition, may also have an indirect impact on growth by boosting business confidence, although their biggest impact will be felt in the medium term.