How will Greek tragedy end?

By: Wolfgang Münchau

Greek tragedies do not end well, and this one won't either. This week's much trumpeted deficit-reduction plan by George Papandreou, Greek prime minister, was a huge disappointment. He slapped a 90 per cent on bonuses. I have no problem with a bonus tax, but this has nothing to do with the Greek fiscal situation. He also decided to cut the number of board members in public companies. Again, this may or may not be justified, but it has nothing to do with the crisis. Freezing the wages of a small group of well-paid civil servants may be a just thing to do, or not. But it won’t make a dent. 

Greece will have a budget deficit of 12.6 per cent of gross domestic product this year. The actual number will probably be higher, because the official estimate is based on some optimistic budgetary assumptions. We are more likely heading for a number near 14 per cent. The rating agency Fitch has calculated that on present policies – that includes the 2010 budget of the present government – Greece is headed for a debt-to-GDP ratio of 130 per cent.

(Short update: S&P has also downgraded now, as they, too, distrust the Greek government's opaque deficit-reduction measures.)

So unless Mr Papandreou does something more radical than impose a bonus tax, there is a very high probability that the country will experience financial distress. The strong activity in the market for credit default swaps – financial instruments that offer insurance against the default of some underlying security – is an indication that investors are betting on default. As the prices of Greek CDS increase, so do the interest rates the Greek government will have to pay to finance its new debts. Default can quickly become a self-fulfilling prophecy.

 

Now there is a case to be argued that such betting should be outlawed. I am actually sympathetic to the notion of a ban of CDS trades, for which there are no underlying securities. But as long as this regime persists, Greece is facing a danger that is both clear and present.

 

To combat the threat of state insolvency, Greece will need to adopt three strategies in parallel. The first, and most important, is a significant cut in public spending. Within that category, the two most important items is a cut – or at the very least a nominal freeze – in wage costs for all public sector workers. Another measure is pension reform. Greece is the OECD country with the least sustainable pension system. Without those cuts, bankruptcy is hardly avoidable.

 

The second priority should be to widen the tax base. Mr Papandreou has talked about that. It would mean that 600,000 companies, where the owner is declaring smaller taxable revenue than his employees will have to be asked to contribute to society a little more. And yes, there is plenty of corruption and tax evasion, but then it is never a good idea to put the hoped-for receipts from a political campaign against crime into a forward-looking budget plan. It is best to treat it as a windfall, if and when the situation arises.

 

The third priority is to stimulate growth through structural reforms. Good deficit reductions plans rely both on savings as well as policies to stimulate future growth. Naturally, a deficit-to-GDP ratio can be reduced mathematically in only two ways – either through a smaller deficit, or larger GDP. Furthermore, if you increase your GDP, the government receives more tax revenues that would reduce the deficit further. So this can be a virtuous process. Papandreou said he wanted to encourage a dialogue about opening up the professions to more competition. This is a good idea, but he wants to go through the social partners, which means that reforms are certain to be delayed, watered down and blocked. If Mr Papandreou wants to impress investors, rating agencies and his European partners, at the very least, he needs to produce a verifiable programme to increase potential output.

 

Greece is not in a position where it has the luxury to choose between those three strategies, and pick some politically acceptable berries. It needs to implement all three, in full.

 

So what is going to happen next? One scenario is that the markets force the issue, triggering a payment default by Greece. Alternatively, we might go through a game of institutional ping-pong, with Greece submitting a deficit-reduction plan in January, the European Commission rejecting it as insufficient, culminate in a penalty procedure under the stability and growth pact. One way or the other, we will get to the point where Greece will not be in a position to fund its extravagant budget gap. At the point, the rest of the euro area will be forced to bail out.

 

The uncertain thing is what will happen then? Will we, and should we impose conditions? How do we monitor this? Will this not trigger moral hazard elsewhere, as other countries might draw the lesson that you always get bailed out, no matter what?

 

This is a fine mess, as Laurel and Hardy used to say.

 

munchau@eurointelligence.com

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