Targets could deepen the recession


Negotiations between Greece and its lenders for a new bailout are expected to start soon. Whether the talks can bear fruit well before August 20, when the country is due to pay some 3.2 billion euros to the ECB, remains to be seen. One of the most demanding tasks will be to agree on the fiscal targets and the accompanying austerity measures to attain them. In this respect, it is important that the lenders recognize the influence of economic activity on budgetary policy and set the targets so as to avoid a painful, drawn-out adjustment process that leads to a debt trap.

According to the lenders’ last offer on the second bailout program, which expired at the end June, Greece has to meet a primary surplus equal to 1 percent of gross domestic product (GDP) this year, 2 percent in 2016, 3 percent in 2017 and 3.5 percent in 2018. These targets are much lower than the initial ones of 3 percent this year and around 4.5 percent in 2016 and beyond, which were thought by many to be unrealistic. Of course, by lowering the targets, the country’s borrowing needs increase going forward, meaning additional funding is required, other things being equal, adding to the public debt.

In designing the new three-year program, the creditors will have to recognize that past austerity programs have aggravated the economic situation and become self-defeating as they helped produce bigger headline budget deficits. Although concessionary lending terms, such as a multi-year interest deferral and low interest rates, have kept annual debt servicing costs low for the time being, they have also driven the debt-to-GDP ratio to very high levels and ultimately to a debt trap. It is reminded that the IMF and others project the Greek debt ratio to reach 200 percent of GDP in a few years if left unchecked given the sharp deterioration of Greece’s economic outlook.

In other words, the lenders as well as the Greek side will have to agree on a simple truth. Actual government budget balances are influenced by government decisions but also by other factors beyond the direct control of the fiscal authority. Fluctuations in economic activity is prominent among these factors. Therefore, fiscal policy will have to take into account the impact of economic fluctuations on the budget outcome in determining the magnitude of the additional effort. In other words, actual budget balances need to be corrected for the cyclical influences to determine the real underlying fiscal stance before asking for new austerity measures.

The Greek economy is now projected to shrink between 2 and 4 percent in 2015 and remain in recession next year after a brief lull last year. With capital controls in place, it is hard to see how this can change. If the primary budget targets are not adjusted further downwards, it is likely Greece will have to intensify the fiscal consolidation effort during a downturn, likely leading to a bigger loss of output, requiring more measures and so on as the vicious cycle goes on.

For example, it could be that the lenders estimate a primary budget deficit instead of a surplus equal to 1 percent of GDP this year even after including the additional revenues from value-added tax (VAT) and the increased healthcare levies on main and supplementary pensions. In this case, they may ask for additional tax measures of 1.8 billion euros (1 percent of GDP) or more to meet just this year’s goal. However, no action would be required if the lenders targeted the structural, primary budget surplus, which takes into account the effect of the ups and downs in economic activity on the actual budget.

Some economists have cautioned against the use of single indicators, such as the structural balance, in determining a country’s fiscal policy stance, arguing it can be misleading. For example, Blanchard and Buiter have argued that the effect of a change in government expenditures or/and taxes on the real economy can be different although their effect on the budget may be similar. Others have raised measurement issues. Nevertheless, the European Commission calculates the structural budget balances based on potential and trend GDP with Greece’s structural primary surplus estimated at 2.8 percent of potential GDP in 2015 and 1.8 percent in 2016.

Moreover, let’s not forget that the breakdown of the budget balance into cyclical and structural components is already used in the eurozone. Under the Fiscal Compact or Fiscal Stability Treaty, an intergovernmental treaty, a balanced budget is defined as a general budget deficit of less than 3 percent of GDP and a structural deficit of less than a country’s medium-term budgetary objective. The latter can be set to 0.5 percent of GDP, at most, for countries with a debt-to-GDP ratio greater than 60 percent. It goes up to 1 percent of GDP, at most, for countries with debt ratios above the 60 percent limit.

Of course, it is not realistic to expect that the lenders will target the structural, primary budget surplus instead of the headline primary surplus. It is reasonable though to expect that the structural balance is taken into account when reviewing the fiscal targets in the third bailout program to make them more realistic and economically sound. The Greek side should remind them of it.