How the new government can find a way out of the recession

With the budget deficit heading toward 9 percent of gross domestic product (GDP) or higher on the back of an economy dipping into recession for the first time since 1993 and the traditional inertia of the tax collection mechanism prior to general elections, the new government will have its task cut out. When these words were written, it was not clear which party had won the elections and whether PASOK, the strong favorite to win, had secured a relatively comfortable majority in parliament. The latter makes quite a difference in a country such as Greece where consensus decision-making is not just time-consuming but usually also ineffective. In a recent interview, conservative Finance Minister Yiannis Papathanassiou suggested the budget deficit could go as high as 8 percent of GDP if the state failed to collect money from various taxes, including one on real estate property. Assuming it collected this money, the budget gap would eventually stand at 6 percent of GDP, he said. However, even Papathanassiou’s sober projection may turn out to be quite optimistic if the country fails to get about 3 billion euros of EU funds earmarked for the 2009 public investment budget (PIB). Greece had received some 300 million euros at the end of the first half of the year out of 3.5 billion euros for the year. Realistically speaking, the state will collect a portion of the taxes owed and real GDP will shrink by about 0.5 to 1.2 percent this year. But it will be lucky if it manages to receive 2 billion euros from the EU for PIB projects, when it is falling behind in the collection of other taxes. Moreover, if PASOK indeed forms the new government, it can be expected to continue the Greek tradition of burdening the previous government’s budget with all kinds of expenditures to make next year’s budget look much better in comparison and start with a clean slate. So, one would expect some 1 billion euros of extra expenditures to be added to this year’s budget, for which the conservatives are responsible. Assuming PASOK makes good on its promise to borrow between 8 and 12 billion euros to pay off state debts owed to various construction, pharmaceutical companies and doctors, the 2009 budget deficit is expected to be augmented by 1.5 percentage points of GDP. At the end of the day, Greece is expected to show a budget deficit in excess of 9.5 and perhaps 10 percent of GDP in 2009, which is a long way off the target of 3.7 percent of GDP. It will be the biggest divergence between the actual and the projected deficit target in decades. Under normal circumstances, a deficit as high as the one estimated above would have scared off international buyers of Greek government bonds but this is not the case this time around. In conditions of ample liquidity, with an average budget deficit-to-GDP ratio of around 8 percent projected for most EU countries in 2009 and with markets knowing that the European Central Bank (ECB) and the European Commission will rush to rescue Greece, the country will have no problem raising the money it needs, albeit at higher spreads vis-a-vis Germany. However, the new Greek government should not confuse the notion of buying time through borrowing with the necessary fiscal adjustment. Throughout the election campaign, PASOK was more tight-lipped than the conservatives in outlining the exact measures it would take to boost GDP growth and, at the same time, cut the budget deficit. All we know is that it plans to prop up the economy in 2010 by spending an extra 2.5 to 3 billion euros while reducing the budget deficit by double this amount or more. It will be a fine balancing act that can only succeed if certain factors are at play simultaneously. First, the global economy, and especially that of the eurozone and neighboring countries, will have to recover in 2010 and the rally in asset markets must continue on the heels of robust risk appetite and liquidity glut. Also, the ECB will have to delay any interest rate hike until the second half of the year, while bond yields must not rise significantly. Second, the new government will have to show it is in charge of the economy and means business when it comes to fiscal consolidation and boosting consumer and business confidence. So, in addition to combating tax evasion, collecting overdue taxes and reining in spending, it will have to increase some special consumption taxes and value-added tax to raise money quickly to satisfy the markets and the Commission. Hopefully, everything will turn out well. But if just one of the above factors fails to materialize, the country may see a more protracted recession of the type most Greeks are not accustomed to.