Greece’s ability to meet the budget targets set out in the EU/IMF agreement depends on the impact of fiscal retrenchment on economic activity. The adjustment of the private sector to the fiscal consolidation will play a key role in this respect but at this point the external sector appears to stealing the show. Many analysts, commentators and others think the cost of fiscal consolidation for the Greek economy is likely to be much greater than projected in the country’s 2010-2014 agreement with the EU/IMF, endangering the attainment of the targets. The implementation of the program is required for Greece to access 110 billion euros in loans from eurozone countries and the IMF. The agreement foresees a contraction in Greek gross domestic product of 4.0 percent in 2010 and 2.6 percent in 2011, after falling more than 2 percent in 2009, as the country aims to cut its general government budget deficit to 8.1 percent of GDP in 2010 and 7.6 percent in 2011, from an estimated 13.6 percent last year. In other words, the Greek economy is forecast to shrink by about 6.6 percent cumulatively in the 2010-2011 period as it cuts its budget deficit by some six percentage points to 7.6 percent of GDP in 2011. The behavior of the private sector is very important as it may counterbalance or reinforce the negative impact on the economy from the cuts in budget spending and higher taxes. This is easy to see, since total income must equal total expenditure in the economy as a whole in any fiscal year. That is, if the public sector consumes above its income, it will have a deficit, which must be offset by savings in the private sector and/or a reduction in the current account deficit. It is true that past instances of fiscal retrenchment in Europe show that private-sector savings fell by a few percentage points over the five years following the beginning of the fiscal consolidation. This softened the recessionary impact of budget cuts as consumers and businesses spent a higher proportion of their income. But the private sector was not highly indebted at the time, monetary policy was very accommodative to partly neutralize the impact of the strict fiscal policy and the national currency could be devalued to boost demand for exports. However, things are a bit different today and this applies not just to Greece but to other economies in Southern Europe. Of course, there is no national currency to devalue to boost external demand, although the weakening of the euro puts Greece and the others on a better footing. Credit conditions appear to be tighter in Greece as ECB funding has become the only source of financing for local banks. Moreover, some segments of the private sector, especially small businesses and low-income consumers appear to have more debt than they should. Still, the indebtedness of the Greek private sector is much smaller than in other southern eurozone countries. So, what is the conclusion if one assumes a moderate rise in unemployment, a mild contraction in personal income and a moderate drop in corporate profits this year and perhaps next? It is not likely that the private sector will bring down its savings rate to counterbalance the restrictive impact of fiscal consolidation on the economy. If this is the case, then Greece will have to seek a way out via an improvement in international competitiveness and/or a sharp reduction in imports. The government is trying to press ahead with significant structural economic reforms in the ailing social security system and other sectors of the economy, with little success so far. These reforms will undoubtedly bear fruit for the economy in due course but it may take more than one or two years for this to happen. Since the extra help from a weaker euro may not be that great to boost competitiveness, the adjustment to fiscal consolidation may come from the external sector – in other words, a sharp reduction in the current account deficit via sizable cuts in imports as a result of a drop in domestic demand. By all accounts, this is what appears to be happening in the Greek economy at this point. That is, the sharp drop in imports and the narrowing of the current account deficit appear to be the major factors counterbalancing the impact of fiscal consolidation on the Greek economy. Of course, there is nothing wrong with this, except that everything points to a deeper recession for the Greek economy, if the adjustment to fiscal constraints comes almost exclusively from this source. Undoubtedly, it is still too early to pronounce judgement on the impact of fiscal consolidation on the economy. However, it looks increasingly likely that the adjustment to fiscal retrenchment will come from a sharp drop in imports, rather than a pick-up in consumer and private-business spending. At this point, the only hope for the private sector is to help consumers become bolder and spend more of their income when they realize that the 2010 budget deficit target has been met and their job outlook stabilizes at some point in the first half of 2011.