Why The Ratings Agencies Are Right And George Papaconstantinou Is Wrong

The Greek government is having a hard time of it at the moment. Only today the Finance Ministry issued a statement that it was ready to "intensify its efforts to restore the viability of fiscal and economic trends in Greece" in response to the Moody's decision to downgrade the country's credit rating, while just one week ago the Finance Minister was accusing Standard & Poor's of failing to "assess correctly" new moves by Athens to tackle its swollen budget deficit - echoing a similar response from Spanish Prime Minister José Luis Rodriguez Zapatero. George Papaconstantinou's critical outburst followed the earlier downgrade decision by the rating agency of the nation's long-term sovereign debt. Today, the Greek Government got the answer they should have expected, since Moody's effectively followed the path of the other two main agencies (Fitch already have the Hellenic Republic on BBB+) and downgraded Greece to A2 from A1. The move means Greek debt is one step closer to being cut off from eligibility as ECB collateral, since Moody's have put the rating on negative outlook, which means they consider a further downgrade more likely than an upgrade over the next twelve to eighteen months, while the ECB are scheduled to revert to the pre-crisis criteria of only accepting Sovereign Bonds which retain at least one A- from one of the main ratings agencies as collateral for lending. Certainly Lucas Papademos, ECB vice president, said last week that the ECB would not change plans to tighten its collateral rules in December 2010 simply to accommodate Greece.

My reading of the situation is that Greece now has till December 2010 to convince the Ratings Agencies, the EU Commission and the ECB that they mean business and have a viable plan, or they are off to the IMF. And in fact I am not very optimistic they can comply with this constraint. Moody's takes a rather different view however.

“Moody’s believes that Greece is extremely unlikely to face short-term liquidity/refinancing problems unless the European Central Bank decides to take the unusual step of making the sovereign debt of a member state ineligible as collateral for bank repurchase operations — a risk that we consider very remote,” according to Arnaud Mares, Senior Vice President in Moody’s Sovereign Risk Group.

What I can't see is how the ECB can credibly avoid taking this step, since when it announced back in 2005 that it would not accept collateral without the A- rating, it was exactly this sort of situation it had in mind. Any backtracking now would be perceived by markets which are becoming extremely nervous about the topic of long term sovereign risk as a sign of weakness, one which was likely to open the door to more fiscal abuse in other states, and indeed it would be a decision which would be hard to understand for voters in Germany and France who may at some stage be asked to chip-in, and sort the growing mess out. So, indeed, I can't see how the ECB could credibly afford to not implement its threat.

Reading between the lines in the EU Commission documentation at this point, I would say that EU institutions are steadily trying to put a procedure with teeth in place in order to avoid the need to send countries to the IMF, but this institutional hardening may not come in time to save Greece from humiliation. I believe that while there is not a complete consensus at this point, the eventuality of sending a eurozone member state over to Washington, while not being desireable, and being a sign of weakness, would in fact be seen as a lesser evil to that of allowing the situation to deteriorate further. It will have escaped no one's notice that Spain is very much in the early stages of a similar procedure, with any slippage in deficit targets putting the country straight back into the Excess Deficits Procedure with a fast-track enhancement, and what I feel no one wants to see happen is the situation in Spain deteriorating to the point it has now reached in Greece.

We should also not fail to notice that Greece also had to raise 2 billion euros in debt via a private placement with banks last week, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this given the degree of policy coordination which must exist behind the scenes, since they are the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months, since only last year it was imagined that the Eurozone in and of itself gave protection from this kind of financing crisis, which was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that while the ECB could keep protecting Greece from trouble till the cows come home, they cannot simply keep financing unsustainable external deficits and retain credibility (see this post for more background on all this). In this sense the financial crisis has now "leaked" into the Eurozone. And this has implications I would have thought, for countries like Estonia, who see eurozone membership as a "save all". And obviously, the EU authorities badly need to plug this hole in their armour, or the entire concept of the eurosystem can be placed at risk, which is why I think we won't see an explicit slackening in the minimum acceptable rating criteria.


Fiscal Restraint No Longer Enough

On Wednesday last week S&P reduced Greece's sovereign rating from A- to BBB+, and explicitly stated the measures announced the previous Monday were "unlikely on their own to lead to a sustainable reduction in the public debt". Moody’s add their weight to this and stress that the Greece's longer-term sovereign risks have only partly been offset by the government’s announced policy response. Fitch Ratings cut Greek debt to BBB+ on December 8.


George Papaconstantinou, finance minister, responded in fighting spirit, and is quoted as saying "we don't think this [the S&P rating downgrade] reflects the efforts the new government is making to stabilise public finances which had derailed" - a reference to a collapse in revenue collection and excessive spending under the previous government. "It didn't take into consideration and didn't assess correctly what is happening at this point." But the whole point is that it was not only Greek finances which became derailed over the last decade, but the whole economic model on which Greek society has been based, and it is this derailment which needs to be fixed, and it is in this context that the measures which have been proposed fail to convince.

Strangely many analysts seem to think today's decision by Moody's offers respite, and almost aid and comfort, to a hard pressed Greek government, simply because they only downgraded by one notch. Certainly Greek bond markets rallied sharply on the news, and the benchmark 10-year Greek government bonds jumped in price, pushing their yields down 22 basis points to 5.724 per cent, while 2-year yields fell 10bp to 3.359 per cent. This left the spread between German and Greek 10-year yields – a widely followed measure of european sovereign risk – at 2.5 percentage points, its lowest since last Thursday.




Basically such observers seem to have been worried that if Moody's downgraded Greece into 'B' territory, as Fitch and S&P have already done, then Greek banks would no longer be able to exchange Greek government debt for cash in ECB refinancing operations. But I feel that these observers have - as is so often the case - gotten ahead of themselves. It was never really probable or credible that Moody's would go the whole hog in one foul swoop. The ECB strategy of cajoling Greece into making changes rests on the "carrot and stick" approach, and it is hard to see how the stick would work, if the carrot was suddenly removed. But remember, the threat is still there, since as I say, the outlook is still negative, and as Moody's themselves point out "the question of whether the negative outlook will evolve into a stable outlook or into a further downgrade will depend on the Greek government’s plan being followed through — as demonstrated for instance by a sustained increase in tax revenues and/or the effectiveness in reining-in expenditure".


It's Long Term Liabilities and Low Growth That Are The Real Problem


Prime Minister George Papandreou had vowed “radical” measures to fix Greece’s finances, and Finance Minister Papaconstantinou lifted the 2010 deficit-reduction target to 4 percentage points from 3.6 percentage points. That would lower the deficit to 8.7 percent of gross domestic product, still almost three times the EU limit of 3 percent, but a sizeable chunk of reduction for one single year, and a reduction which will almost certainly ensure that Greece remains mired in recession for most of 2010.

Moody's however, seem to be focused on much longer term issues, like demography:

The combination of a global post-crisis environment that is less favourable to Greek public finance dynamics (with increased risk discrimination and muted global demand) and an equally challenging domestic environment (with accelerating demographic pressure on public finances in coming years) will make any fiscal adjustment increasingly difficult and costly to postpone.

Basically Greece is one of the EU countries which will be most severely affected by the ageing process, as can be seen in the two comparative pyramids below. Simply put, in the space of thirty years it will move from being a society with a preponderance of young people to being one, where the over 50s predominate (the charts come from the US Census Bureau IDB population data base).




The principal reason for this dramatic shift has been the sharp fall in Greece's underlying fertility rate.

This, and increasing life expectancy mean that the median population age is projected to rise rapidly, making Greece - with a median age of over 45 - one of the oldest European societies (as well as civizations) by 2020.




The older cohorts of the Greek Labour force will start retiring at a rapid pace after 2015, without an offsetting inflow among the younger cohorts. Total population is projected to peak in 2017 at over 11 million, and than to decline gradually to just around 10 million by the late-2050s. Working-age population will in fact peak in 2010, before declining somewhat faster than overall population. The structure of the population thus gradually shifts to more dependents (especially elderly). The dependency rate increases over time, implying additional pressures on pensions, health, and other entitlements. As can be seen in the chart below, without those much needed pension reforms, Greek pensions will consume a far higher proportion of national output in the years to come than the average level for the rest of the EU 15.



So the Greek crisis is about much more than short term fiscal deficit issues, it is about the long term sustainability of a whole economic and demographic model. As such, Moody's are surely right, the short term liquidity problems undoubtedly have solutions, and it is the long term solvency ones we should be concerned about. During the years of easy borrowing, Greek industry became very uncompetitive, and Greek society dependent on imports. As a result the external debt went up and up, and currently stands at about 160% of GDP (gross) and 85% of GDP (net). Meanwhile Europe's leaders are caught between trying to reassure financial markets Greece won’t default on its debt while at the same time keep up pressure on the country to put its house in order. German Chancellor Angela Merkel said on December 10 Europe has a “responsibility” to help Greece. The following say, European Central Bank President Jean-Claude Trichet said the country must take “courageous action.” Both things are needed, but how I wish those responsible for policymaking in Greece would show more awareness of just how complicated this is going to be, for all of us.

Other background posts to this situation are:

Europe Needs Action Not Words From The Greek Finance Minister

So What's It All About, Costas?

The Velocity Of Modern Financial Crises

That Which The ECB Hath Separated, Let No Man Join Together Again!

It's All Greek To Me

Podcast On The Present State Of The Spanish Economy

Caveat emptor, Spanish-based blogger Mathew Bennett and I have started doing podcasts, and you can find the first one here. At this point in time we are concentrating on Spain. Among the points we cover are:

- How does what’s happened in Dubai affect the economic situation in Greece, Spain and the EU?

- Are left- or right-wing political parties causing or solving more problems during the recess...ion?

- Will the Germans, the French or the EU be able to bailout several European countries at the same time if there are several sovereign defaults?

- Are the ECB and the EU trying to pre-empt the IMF in Greece and Spain?

- What are the underlying structural problems with the eurozone funding plan?

- Why is the ECB channelling funds through monetary and financial institutions to buy up government debt in the eurozone?

- How the ECB is trying to use a carrot and stick approach with eurozone governments to control national government deficits and public policy?

- Is IMF intervention now inevitable in Greece?

- Will the ECB will try to play politics and pressure Zapatero in the run up to the 2012 general elections in Spain?

- Is the situation in Spain similar to the situation in Greece?

- Why don’t Zapatero and the Spanish government seem to be reacting?

- Why is there no coherent plan to get Spain back on its feet?

- What is going on with Spanish banks?

- Will unemployment in Spain reach 25% by the end of 2010?

- Which is more important in Spanish economics: image or hard data?

- Will it be possible for the Spanish government to reduce the deficit from over 10% of GDP to less than 3% by 2012 or 2013?

- What state will the Spanish economy be in by the end of 2010?

- What will happen to Spain when the ECB raises eurozone interest rates?

- Might Spain soon be in a worse economic position than Greece?

- What are the ratings agencies trying to achieve with their warnings on Spain?

- Why won’t the Spanish government tell the Spanish people the truth about what’s going on with the Spanish economy?

- Is José Luis Zapatero really the biggest problem for the Spanish economy right now?

Obviously many of these points run parallel to those raised in my recent post "Why Standard and Poor’s Are Right To Worry About Spanish Finances", but maybe, if you have 40 minutes or so to spare, you might enjoy listening to them being made in Podcast format.

Europe Needs Action Not Words From The Greek Finance Minister

“Today our biggest deficit is that of credibility.In the last years Greece lost all traces of credibility, which is why international institutions, partners want to see actions.” Greek Prime Minister George Papandreou

As the Economist points out, and as I personally can confirm (since I am constantly having to alter and update my excel sheets), Greek government statistics are notoriously unreliable - indeed, I would say that along with the Bulgarians the Greek statistical agencies are the joint worst in the entire EU. But rarely can the numbers have seemed more erratic and subject to such sharp revisions as they have been in recent months. Following the election of the new government in October (who obviously decided to get as much of the bad news out of the way as quickly as possible) we suddenly learnt that far from having been being "spared" the worst of the global economic contraction, the Greek economy in fact entered a period of negative growth in the first quarter of 2009 (shrinking by 0.5% on the quarter instead of growing by 0.3% as the stats office had previously "estimated") wherein it is has subsequently remained. And of course given the size of the correction the Greek economy is now entering it is likely the economy will stay in this mode for some considerable time to come. And as if that wasn't shocking enough, the forecast for this year’s budget deficit more than doubled overnight, from 6% to 12.7% of GDP.

But this problem has a history, and quite a long one. The 2008 general government deficit as notified by the Greek authorities on 21 October to the EU Commission was put at 7.75% of GDP (up by 2.75% percentage points from the earlier estimate of 5% sent in April). But even this version was found to be deficient, and Eurostat specifically expressed reservations about the figures, largely due to the inclusion of a one-off capital expenditure item of around 1.25 percentage points of GDP mainly connected with public hospitals arrears to paramedical and pharmaceutical suppliers.

Moving forward, the official public deficit estimate for 2009 stands at 12.75% of GDP, as compared with the agreed budgetary target of 3.7% of GDP included in the January 2009 update of the EU stability programme. The EU Commission also estimate (in their November forecast) that under a no-policy-change scenario assumption and on the back of the discontinuation of the one-off expenditure item which has in fact been repeated in 2009, the headline deficit is set to remain above 12% of GDP in 2010 and then to continue to increase, exceeding 12.75% of GDP by 2011.

Both falling revenue-to-GDP and rising expenditure-to-GDP ratios will contribute to the anticipated fiscal deterioration. The economic downturn, coupled with high budget deficits, is expected to push debt higher, from 113% of GDP in 2009 to over 135% of GDP by 2011, thus weakening the already fragile sustainability of Greek public finances in the long term.

A Sorry History Of Repeated Failure To Comply

The timeline on this problem looks something like this:

i) On the basis of the data notified by the Greek authorities to the EU Commission in October 2008 the Commission, on 18 February 2009, adopted an Article 104(3) report for Greece on 18 February 2009. Subsequently, and in accordance with Article 104(4), the Economic and Financial Committee formulated an opinion on the Commission report on 27 February 2009.

ii) On 24 March 2009 the Commission, having taken into account its report under Article 104(3) and the opinion of the Economic and Financial Committee under Article 104(4), addressed to the Council, in accordance with Article 104(5), its opinion that an excessive deficit existed in Greece.

iii) On 27 April 2009, following a recommendation by the Commission, the Council decided, in accordance with Article 104(6) of the Treaty, that an excessive deficit existed in Greece in 2007 and 2008. At the same time, and in accordance with Article 104(7) the Council, addressed recommendations to Greece to put an end to the present excessive deficit situation by 2010, by bringing the general government deficit below 3% of GDP in a credible and sustainable manner.

The Council further recommended that the Greek authorities should

(i) strengthen the fiscal adjustment in 2009 through permanent measures, mainly on the expenditure side, including by implementing the measures already announced;

(ii) implement additional permanent measures in 2010, in order to bring the headline deficit clearly below the 3 % of GDP reference value by the end of the year;

(iii) continue efforts to control factors other than net borrowing, which contribute to the change in debt levels, with a view to ensuring that the government gross debt ratio diminishes sufficiently and approaches the reference value at a satisfactory pace; and

(iv) continue efforts to improve the collection and processing of statistical data and in particular general government data".

The Council established a deadline of 27 October 2009 for Greece to take effective action and to specify the measures deemed sufficient to ensure adequate progress towards the correction of the excessive deficit by 2010.

In support of its action the Council noted that a budgetary correction in Greece....

"is also crucial for recovering competitiveness losses and addressing the existing external imbalances. To this end, the Greek authorities should implement permanent measures, including the recently announced measures to control current primary expenditure, including public wages; and urgently implement structural reforms. In particular, the Greek authorities should ensure that fiscal consolidation measures are also geared towards enhancing the quality of public finances within the framework of a comprehensive reform programme, while strengthening the binding nature of its budgetary framework, improving monitoring of the budget execution and swiftly implementing policies to further reforming the tax administration".

That is to say, in depth reforms, and not simply cosmetics are called for.

Following their 11 November ruling the European Commission sent a large delegation of experts to Athens to assess the situation for themselves on the spot, amid strong rumours circulating Athens that the EU was not willing to approve the government's 2010 9.4% of GDP deficit first draft. In reponse to the evident EU reservations the Greek finance ministry circulated on November 20 what they called their revised "final" 2010 budget, with a projected deficit of 9.1% of GDP. But the patience of the EU had by that time become exhausted, and on November 30 2009 the Council of the European Union resolved Greece has not taken effective action in response to the Council Recommendation of 27 April 2009 within the period laid down in that Recommendation.

So we now move on to the next stage of the process, within which the Greek government will again be given a period of time (two months) to advance convincing measures, and another period of time (a minimum of four months and a maximum 16 months) to start to take the required measures (in 4 months) and give unequivocal evidence that they are credibly implementing them (within a maximum of 16, but my reading is that this process could be drawn to a close at any point before then if there were sufficient effidence that agreed steps were not being taken).

The relevant clause governing all this is to be found in Article Seven of the Council Regulation No 1467/97 of 7 July 1997, and runs as follows:

If a participating Member State fails to act in compliance with the successive decisions of the Council in accordance with Article 104(7) and (9) of the Treaty, the decision of the Council to impose sanctions, in accordance with Article 104(11), shall be taken as a rule within sixteen months of the reporting dates established in Article 4(2) and (3) of Regulation (EC) No 3605/93. In case Article 3(5) or 5(2) of this Regulation is applied, the sixteen-month deadline is amended accordingly. An expedited procedure shall be used in the case of a deliberately planned deficit which the Council decides is excessive.

If the country again fails to comply sanctions will be implemented, but my feeling is that this result would be the least important of the consequences. If the Greek government once again fails to live up to its reponsibility, then the internal disciplinary procedures of the Union will have failed, and my guess is Greece would be sent, cap in hand, over to Washington to ask for help from the IMF. If an IMF programme fails to work, well, let's leave that one for another day.......


Papandreou Fails To Convince

Evidently Greek politicians have come under continuous pressure in recent weeks, and Finance Minister George Papaconstantinou has been doing his best to convince the outside world that he means business. In a statement of intent issued at the end of last week he declared that "the fiscal priority for 2010 is a significant reduction of the deficit as a percentage of GDP and containing the increase in public debt which undermine the immediate and long term future of our country."

Prime Minister Pampandreou went further in a speech on Monday in which he spoke of his government's plans to cut the budget deficit from 12.7 per cent to 3 per cent of gross domestic product, the eurozone limit. Greece, he said, was “determined to send a strong message internationally: that we will move ahead with streamlining the economy and promoting a new model for growth.”

Fine words these, although the actual details available leave us far from clear about the precise nature of the deep seated reforms the Greek government is actually contemplating, or the extent to which they realise that significant wage and price deflation will be necessary if the are to restore competitiveness.

The decision to bring forward by several weeks the announcement of the government economic strategy underlines the new sense of urgency which now surrounds policymaking, and comes in response to a 10-day battering of Greek bonds and falling share prices on the Athens bourse. Yet it seems the investing community - the key players in the Greek democratic system now - remain unconvinced, since the yield on the Greek 10-year bond climbed on Tuesday morning 24 basis points to hit 5.70 percent, while the 30-year yield rose 15 basis points to 6.23 percent. Thus the extra yield, or spread, investors demand to hold 10-year Greek bonds instead of German bund equivalents widened 24 basis point to reach 253 basis points, the highest level since April 2.



Mr Papaconstantinou, has effectively been given the objective of reducing the deficit by 3.3% of GDP next year. The reduction is likely to come mainly from increasing revenues (asking businesses, for example, to pay a one-off extra 10% tax on last year’s profits) rather than from spending cuts, although this approach is unlikely to satisfy the Commission, who want long term structural shifts.

In an attempt to head off just this kind of pressure from the European Commission Mr Papaconstantinou has stated he will immediately tackle the structural reforms issue. Among ideas being currently touted are steadily raising the retirement age to 65 for women, opening up a range of “closed” services (from notaries to taxi drivers) to improve competitiveness and introducing five-year rolling budgets for ministries (to curb pre-election spending).

Yet despite the fact that Greek Prime Minister Papandreou promised on Monday that his government will, over the next three months, take all those decisions which "have not been taken for decades", plenty of grounds for scepticism still remain. Mr Papandreou's said many choices will be “painful,” though he pledged to protect poorer and middle-income Greeks. Unfortunately the speech was short on real detail, while the little we have is not impressive.

Talk about obtaining capital to reduce debt via securitization of income from the state’s tax on major property holdings sounds incredibly like simply taking some of the debt off the balance sheet to me, but I'm sure Eurostat will have their say when the time comes.

Whether the announced measures will be enough to satisfy the EU Commission remains unclear. In particular Mr Papandreou's reluctance to follow the example of Ireland, which announced a 4 billion euro correction of its 2010 budget with public sector salary cuts of five to 15%, has had a lukewarm reception from analysts and commentators alike. Greece faces mounting pressure from markets and its European partners to follow Ireland and adopt stronger fiscal measures such as a public sector pay freeze, a ban on civil service hiring and hikes in indirect taxes, to restore competitiveness as well as bring the deficit under control.

In a detailed and useful summary of the present Greek tragedy Kerin Hope and Ralph Atkins quote Yiannis Stournaras, a former chief economic adviser at the finance ministry and now a professor at Athens University as saying: “Wage cuts may not be needed, because the economy isn’t projected to shrink significantly next year, but there should be an immediate freeze on salaries and recruitment,”

This is an indication of how far one discourse is away from the other. The EU Commission is demanding serious and sustained structural reform. I fear even the most recent of Greek governments only sees a short term problem of deficit reduction, and herein lies the danger, not only for the citizens of Greece themselves, but for all of us who live in the eurozone. This time the situation is for real, and I only wish I could believe that Mr Papaconstantinou and Mr Papandreou were aware of that fact. From this point on there is nowhere left to hide.

So What's It All About, Costas?

All the recent critical attention which has been directed towards Greece of late might seem surprising to some (or part of a global anti-PIGS conspiracy, to others) since, on the face of it, the Greek economy had managed over the last decade to appear to be something of a success story. Indeed the economy did clock-up a more than respectable growth rate, and the country even seemed to be well on the road to economic convergence with its richer neighbours, with GDP growing at an average annual rate of around 4.25% between 2000 and 2007, as compared with a 2% average for the euro area as a whole.



In particular there was a sharp acceleration in the growth rate in the early years of this century, stimulated in part by preparations for the Olympic games. As a result, living standards, measured in terms of GDP per capita in purchasing power standards (PPS), rose from 84.25% of the EU-27 average in 1997 to almost 95% in 2007. But as we all now know, and as many a Greek philosopher has often told us, "seeming" is not the same thing at all as being, and the current Greek case is no exception. Behind this wonderful facade, all was far from being as it should have been.

This was the case, not only in terms of the rather questionable data which was being sent out for external consumption - although, it should be noted, not everything was completely phoney, since Greeks today are surely much better off than they were in 2000 - but also in terms of a failure to explain how this rather spectacular change in fortune was achieved, or how the sustainability of the model on which it was based was to be ensured. As Titus Maccius Plautus reputedly put it, I am a rich man for just as long as I don't have to pay back my debts, and of debts in Greece there were plenty, especially in the public sector.

So the growth we saw in the first eight years of this century was hardly normal, since it was based on a model of growing indebtedness which was always going to fail one day or another. One consequence of this is that no one really knows what "trend" growth in Greece would look like at this point (the same goes for those other two Eurozone "star performers" Spain and Ireland) since we don't really know how much of recent growth was valid, and how much was due to overheating, and we won't really start to get a clear picture till we see what the downside is, and how far it runs.

In an earlier post I suggested that while Greek Sovereign Debt was far from dead at this point, in the long run it was almost surely dead. Here, and in the posts which follow I will try and explain why I think that is the case.

Twin Deficit Problem


Thus the very positive initial impression becomes rapidly tarnished when you start to think about the fact that, despite all the supercharged growth, the average Greek general government deficit remained over the EU Stability and Growth Pact 3% of GDP limit during the entire period (hitting a maximum of 7.5% of GDP in 2004, see chart below).

Given that the Stability and Growth Pact philosophy is effectively one having a 3% average target, with resources being accumulated during the good years to allow space for stimulus programmes which involve larger deficits during the bad ones, this state of affairs seems to be astonishing. The accident was just waiting to happen, since having overrun the allowance with growth which was over 2 percentage points above the average, there was no spare capacity left to be deployed during the downturn, Greece will now join a number of key East European economies - notably Hungary and Latvia - in being forced to impose a contractionary fiscal policy during what surely about to be the country's most serious economic downturn since the early 1980s. Ouch!

But in addition to this immediate, and acutely painful, problem, the consequences of all those years of excessive government spending have most definitely not been benign, and in this post, and those that follow I will focus on three of them.

i) The accumulating government stock of debt, which according to the last EU Commission forecast is set to reach 135% of GDP by 2011.



ii) The inflationary pressures to which the Greek economy was subjected by the decision to press the fiscal accelerator right down to the floor (hit the pedal to the metal) well beyond long term sustainable capacity, with the consequent loss of competitiveness this involved. Greek inflation was seldom above the EU 16 average during the critical years, and this neglect, of course does not come free.



In particular the loss of competitiveness with Germany is very evident.



(iii) The huge external deficit (current account deficit of 15% of GDP) which was the result of this massive overheating of domestic demand, and the large external debt which has been accumulated as a consequence. It is this external debt problem which makes Greece so vulnerable to financial crisis at this point, and it is this which differentiates the Greek case (and the Portuguese and Spanish ones) from, say the Italian one, since while in Italy government debt position is not that much better than the Greek one, most of the debt is actually held by Italians, and while Italy's savers are content to continue funding their country (that famous "home bias") Italy will not be so vulnerable to pressure from external investors.




In fact the Greek external balance has deteriorated rapidly from 1997 onwards, with the current account deficit reaching 14% of GDP in 2007, declining slightly to 12.75% of GDP in 2008. The principal culprit was the growing deficit in the trade balance, which rose to 17% of GDP in 2008 (almost 4 percentage points over the level in 1997). In particular goods exports were disappointingly weak, while import growth was strong, in line with buoyant domestic demand. Trade in services, on the other hand, went in the opposite direction. The balance of services exports improved, attaining a surplus of more than 8% of GDP in 2008, 2 percentage points higher than in 1997. However, this improvement fell far short of compensating for the deterioration in the goods trade balance.

So let us be clear. It is this situation Greece has to correct. Greek society needs to lower the level of national indetedness, and the only way to do this is through an export surplus. But obtaining an export surplus implies the restoration of competitiveness to Greek industry. Greece needs to implement a significant internal devaluation, without this correcting the fiscal deficit will only involve playing around with the tip of the iceberg, and default in the longer term will become inevitable.

The Velocity Of Modern Financial Crises

Jean-Claude Trichet, European Central Bank president, noted when speaking in Cambridge last Thurdsay that the speed at which financial disruption can spread had “accelerated tremendously over the past few decades”. While debt crises in the 1980s occurred over years, the effects of the Lehman collapse “spread around the world in the course of half-days”.

As Ralph Atkins pointed out, the Greek government is but the latest to learn that in the modern world you can be catapulted from relative obscurity to global prominence in a matter of hours. Everyone can be famous for five minutes, as Andy Warhol said, but this kind of fame most of us could well live without.

Faced with the assessment by Ratings Agency Standard and Poor's that Spain's economic and financial situation was deteriorating, the Spanish Prime Minister Jose Luis Rodriguez Zapatero simply limited himself to an outright rejection of such negative economic forecasts, declaring the naysayers to be wrong in the light of the -to him - self-evident fact that Spain was just about, at this very moment, to emerge from the recession which has now bedevilled it for so many months. Indeed he even went as far as to say they were wrong, since he he could find no reason why Standard & Poor's should downgrade Spain's long-term sovereign debt rating, "From our perspective there are no reasons for it, firstly because of the strength of the country (and) because the public accounts are solvent," he told the Onda Cero radio station. Standard and Poor's in fact argued that "The downgrade ... reflects our expectations that public finances will suffer in tandem with the expected decline in Spain's growth prospects", a viewpoint with which few external observers would disagree.

Indeed, Spain's representative on the ECB governing council Jose Manuel Gonzalez-Paramo told the Spanish press agency EFE, in an interview widely quoted in Spanish media, that he, himself, found the S&P opinion hard to disagree with: "The ECB is not taking issue with whether Standard & Poor's should cut Spain's rating, but the report that accompanies this warning is hard to deny....I'm convinced that Spanish authorities share this analysis and will do whatever is needed to avoid S&P's negative outlook resulting in a change in rating," he said.

Had Mr Zapatero found it within his repertoire to be able to express similar sentiments I am sure he would have done more to convince the world at large that he is aware of the problem, and is willing to take the necessary action. As it is, he simply leaves the impression that what just happened in Greece will eventually and inevitably happen in Spain, with all the suddenness and lightning-strike velocity M Trichet was warning about. What we seem to be facing is what Gabriel Garcia Marquez once called the Chronicle of a Death Foretold.

So what do the rest of us do, simply sit back and watch that "accident waiting to happen" actually happen? Angela Merkel may have other thoughts, since speaking in Bonn last Thursday she indicated that she, at least, was of the opinion pressure could be brought to bear on the national parliaments of countries with looming budgetary difficulties.

"If, for example, there are problems with the Stability and Growth Pact in one country and it can only be solved by having social reforms carried out in this country, then of course the question arises, what influence does Europe have on national parliaments to see to it that Europe is not stopped.....This is going to be a very difficult task because of course national parliaments certainly don't wish to be told what to do. We must be aware of such problems in the next few years."

Well, if such pressure can be brought it most certainly now should be. And not over the next few years, but rather, if M Trichet is to be believed, during the coming weeks and months. Lightning may well not strike twice in the same place, but it most certainly can strike twice.

A New Version of the Weak Euro Meme

Well, having been so lavishing in my praise of Ralph Atkins in recent posts, perhaps it is time for the administration of a gentle "rapapolvo" (otherwise, you know Ralph, people might start to talk), and just to hand he offers me the ideal opportunity to "discrepar". A little instability is, it appears, a dangerous thing, but not, it seems entirely and unequivocally dangerous:

True, Greece’s plight has weakened the euro, which has ended this week back down at levels last seen in early November. A weaker euro, however, will help boost eurozone growth - and thus come as a relief to eurozone policymakers. A little instability is not necessarily all bad.

Now, with all the other pressing topics I currently have on my plate I would normally have quietly passed this one by, had it not been for the fact that earlier in the week, over at the Economist, they came up with a similar "saving grace" for a partial Greek default.

How badly the euro’s standing would be hurt by a default would depend on the state of public finances elsewhere: if America were struggling too, the dollar might not seem an attractive bolthole. If the current struggles with a strong euro are any guide, euro members might even half welcome a tarnished currency.

I can think of a thousand and one different ways in which the euro might lose some of its current strong value, I can even imagine a goodly number of those which might be decidedly positive, but what I can't for the life of me accept is that one of them would be the sort of economic, financial and political chaos which we may now be about to see in Greece.

That Which The ECB Hath Separated, Let No Man Join Together Again!

In a recent post on the FT Money Supply Blog the ever perceptive Frank Atkins made the following, very interesting, observation which, I think, goes a long way towards helping us all understand what exactly the thinking is which lies behind the ECB's current strategy for its handling of the Eurozone economy.

One of the subtleties of yesterday’s complex package from the European Central Bank was that it attempted to re-assert the principle of “separation”. When the financial storm broke in August 2007, the ECB insisted, doggedly, that emergency financial market liquidity injections were not related to its monetary policy. That remained firmly aimed at controlling inflation and still very much determined the level at which it set the main policy interest rate. Indeed, in July last year the ECB famously raised the interest rate to 4.25 per cent because inflation appeared to be getting out of control.

The separation that is being talked about here is not then a matrimonial one, nor is it a Montesquieu type notion of a necessary and sufficient separation of powers between Brussels and Frankfurt, rather what is involved is a separation, which is customarily made by the ECB, between monetary policy and liquidity provision. Now all of this may seem rather obscure, and it is, but it is also, I will argue here, rather central to understanding what the ECB is up to, or trying hard to be up to, at the present moment in time, and why what it seems to be giving with one hand it also seems to be taking away with the other.

For over a month now the ECB has been busily trying to lay down, before an ever observant corps of financial journalists, the main lines of its exit strategy from the emergency liquidity provisions introduced in the midst of the financial crisis. The first significant decision was the raising of the collateral standards for asset backed securities - from March 1 2010 the bank “will require at least two ratings from an accepted external credit assessment institution for all” asset- backed securities submitted as collateral, according to the press release of 20 November.

It is important to note that, at this point in time, the ruling only applies to asset backed securities, and the ECB has yet to formally confirm that the temporary relaxation of the collateral criteria as applied to government bonds for the duration of the financial crisis will be withdrawn as planned at the end of 2010. This, of course, has become far more than an academic question following this weeks decision by Fitch Ratings to cut the ranking of Greek sovereign debt to BBB+. What this means, effectively, is that should the two other major ratings follow suit (a not improbable scenario) then the ECB will no longer be able to accept Greek bonds as collateral, since while the ECB is currently accepting bonds with a minimum BBB- rating, this gesture is surely going to be phased out as the enhanced liquidity support is withdrawn . As things stand, as of 2011 at least one A- will be the minimum level required.

More significantly for many perhaps, this month’s ECB meeting also saw the ECB move to scale back its emergency lending to the banking sector in a way that clears the path for a move back to variable rate tenders later in the year and leaves policy makers free to raise rates as needed. The bank announced that this months 12-month tender would be the last and indicated that the 6-month tenders would also be axed after 31 March. The 12-month tender would also be offered at what amounts to a floating rate that would be indexed to future changes in the ECB’s main refinancing rate in a way which means it is impossible to discern in advance any particular intention about the level of the main refinancing rate. At the same time they indicated that the weekly, 1 month and 3 month financing tenders would remain in place on a fixed interest rate full allotment basis for as long as necessary, and at least until April 13, which means that while enhanced bank financing is being slowly phased out, it is still in place, and there is no definitive date yet for the complete termination of the programme.

Basically this all seems fairly logical, and yet, as Frank Atkins asks, one obvious question remains, which is why the it should be the case that the ECB is so intent on implementing its “exit strategy” when, surely, given the seriousness of the problems which are still to be resolved in some key Eurozone economies, one might have thought they should continue to implement some sort of ultra-loose monetary policy just like their counterparts in the Bank of Japan, the US Federal Reserve, or the Bank of England?

Well, part of the key to unravelling the apparent dilemma the recent move presents is possibly to be found in a response ECB President Jean-Claude Trichet gave in answer to questions put to him by journalists after the last meeting. “We are not" he was at pains to say "signalling anything in terms of a hardening of our monetary policy - absolutely nothing,” So here we have it, as Frank Atkins suggests, the ECB is applying a straight principle of separation between monetary policy and liquidity provision (although I doubt that many financial journalists are quite as perceptive as Frank Atkins evidently is). Monetary policy remains as loose as it ever was, with the key refinancing rate staying firmly at the 1% level (hardly suprising in the context of the fragility of most Eurozone economies) while the enhanced liquidity provision is being systematically withdrawn. Now why should this be?

Greek Abuses


Well, one of the principal problems the ECB currently faces is the use which is being made of all that ever so generous enhanced liquidity ECB funding by Greek banks. According to analysts at Goldman Sachs Greek banks have been making very extensive use of the ECB liquidity provision. They estimate that at the end of the third quarter of this year, the four major Greek banks (Alpha, Eurobank, National Bank of Greece, and Piraeus) had availed themselves of some €28.3 billion in liquidity provision, down admittedly from the €42.3 billion they were soaking up at the end of the second quarter, but still way over the percentage of Greek participation in ECB capital. And even this reduction comes, it should be remembered, aftered the Central Bank of Greece directed local lenders to scale back their reliance on cheap funding from the European Central Bank.

Yet, as Goldman Sachs point out, such extensive use of the ECB exceptional liquidity provision might seem rather counterintuitive given that the loan to deposit ratio within the Greek banking system is pretty low (between 98% and 122% for the four major banks) and the liquidity position of the banks thus appears very sound. So why the hell do they need so much money you may ask?

Well, using ECB facilities made sense for Greek banks for a number of reasons. In the first place, ECB funding is relatively cheaper for Greek banks than for their European peers since the ECB makes no adjustment to the rates charged for the perceived higher risk of the Greek banks. As Goldman Sachs point out a Greek bank operating in Greece pays the same price as a French bank in France, even though the French bank operates in a lower risk environment and should, in theory, be able to finance at lower rates in the market. But this is what enhanced liquidity support is all about, if only those responsible for the financial and economic administration of Greece understood the situation.

Secondly, the current spreads on Greek government bonds (around 200 base points over German 10 year equivalents) offer Greek banks an exceptional arbitrage opportunity, since by taking advantage of the uniform ECB liquidity rate Greek banks can buy higher Greek government bonds with a much higher yield than the government bonds which their French or German counterparts buy. Regardless of the risk implied through by the Greek CDS spread, Greek government bonds carry a zero risk weighting when calculating riskweighted assets for capital purposes. So for Greek banks this arbitrage carries no capital impact whatsoever. That is to say the Greek banks have been doing very nicely indeed out of the Greek sovereign embarassment, than you very much. Hence it is not difficult to understand the ECB's growing sense of outrage with the situation.

On top of this we need to add the growing frustration of the ECB and EU Commission on finding that the Greek government not only had not taken advantage of these liquidity advantages to introduce effective policy action to stop the deterioration of Greek government finances, but in fact had gone in precisely the opposite direction, greatly exceeding in spending decisions all their earlier promises and guarantess. Finance Minister Papaconstantinou's final 2010 budget plan, as presented to parliament on November 20, made plain that the financial situation is much worse than anticpated, and that the government now aims to reduce the fiscal deficit from 12.7% of GDP this year to 9.1% of GDP next year. In the earlier draft, as made available to the EU Commission when it determined that Greece had taken insufficient action in 2009, the objective was 9.4% of GDP for this year. The Commission calculates that under unchanged policies, the Greek deficit would be 12.2% of GDP in 2010 with government debt at around 120.8% of GDP, up from 113.4% this year.

So to be absolutely clear, the Greek banks have been making money from arbitrage on ECB exceptional liquidity funding and in the proces financing the Greek government to carry out spending programmes while at the same time basically hoodwinking the European Commission about what it was they were actually up to. That is to say, the ECB has been effectively paying to lead the EU Commission straight down the garden path.

And In Spain Things Aren't Much Different

According to Bank of Spain data, Spanish banks were receiving approximately 82 billion euros in longer term financing from the ECB as of last September.



And, as in Greece, a large chunk of this money has been being immediately recycled to finance a ballooning government deficit, one which, as in Greece, is expected to hit 12% of GDP this year.



So the ECB has been providing, indirectly, funding to Spain's government in a bid to help Spain try to withstand the hefty economic crisis it is faced with, and this government spending (along with the significant drop in interest and loan payments produced by the 1% interest rate which impacts Spanish loans and mortgages) has given strong support to Spanish domestic demand. But after years of structural distortion, Spain's manufacturing sector is, let us remember, massively uncompetitive.



In fact, Spain's manufacturing sector was contracting in November at the fastest rate in any of the 26 countries included in the JP Morgan Global Manufacturing PMI survey.



And where, then,could we imagine that all this money which is being used to prop up demand has gone? Well, we could imagine couldn't we. On buying imports, that's where a big chunk of it has gone, even as Spain's unemployment queues grow longer and longer. After falling for several months, September's goods trade deficit was up again, and has in fact it has been rising since last August. So let's spell this out again - Spanish banks wer receiving a total of 82.5 billion euros in liquidity funding via your open market operations in September, up from 49.1 billion euros in September 2008, and this money, far from having a positive impact, has been going to sustain the unsustainable.



At the same time, Banco de España data show that over the same time period Spanish bank funding of government borrowing rose from around 300 billion euros to around 400 billion euros, while the monthly goods trade deficit increased from 2 billion euros to 5 billion euros between July and September 2009, and the September current account deficit bounced back to a rate of roughly 4.5% of GDP from the July low of around 2% (see chart below). So where, we might ask oursleves is the "correction" here? This kind of monetary and fiscal support on the part of the ECB is entirely justified and understandable, if it is really to give a cushion to countries like Spain and Greece to make a painful transition. But if the money is simply used to sustain the unsustainable, and even is used to make the situation worse, then what really is the ECB supposed to do?




It must be worrying ECB decision makers like hell that the enhanced liquidity provision which is being facilitated from the ECB is, in the context of the very low level of international competitiveness of a good part of Spanish industry and services following the distortions produced by the property bubble, having the rather perverse and completely unintended consequence of funding a rise in Spanish imports (thus putting ever more Spaniards in the domestic sector out of work) via the demand injection which is being administered by the Spanish government?


Monsieur Trichet Is Not Amused

Exactly these sort of concerns were put directly to Monsieur Trichet in his quarterly appearance before the Economic and Monetary Affairs Committe of the European Parliament last Monday by the Catalan MEP (and member of Convergencia Democràtica de Catalunya ) Ramon Tremosa. Here is is question:

Monsieur Trichet, there are countries in the Eurozone that are starting to recover and some others, like Spain, in which the absence of reforms will condemn them to remain in recession for the coming months.

In France, for instance, household lending and house purchases are now growing, while in Spain lending to households continues to decrease, and the housing market remains flat and lifeless. Therefore,

1.- Are you worried by such apparent diversity within the Eurozone?

2.- In your opinion, what practical implications such divergence will have for the conduct of monetary policy at the ECB?

Under a "European divergence" scenario, it could happen that the "Optimum Currency Area" assumptions wouldn´t be valid anymore, and that an "average" monetary policy would start being harmful instead.

For example, if some European countries (like Germany or France) start having positive inflation rates, while others (like Spain, Greece, Portugal or Ireland) continue in deflation, implementing an "average" monetary policy could be harmful: especially if the monetary policy, due to the high weight of the French and German economies, leads to the "average" monetary policy becoming slightly restrictive. This would lead to further rounds of deflation in the "deflationary" countries.

3.- Has the ECB a plan to cope specifically with this issue? Or will the ECB continue with the "average" monetary policy it has exercised until now?

Monsieur Trichet was not amused. In a strongly worded reply that was given extensive coverage in the Spanish press (but barely received a mention in the English language one), he told Ramon Tremosa in no uncertain terms that there would be no second chance for the banks, "There is not one Euro for Spain, and another for the other countries. There is only one Euro, one rate of interest, and one exchange rate".

So, the carving knives are now out. The ECB has been put in an impossible position, and intends to act as it sees fit. The lions share of the responsibility now rests on the shoulders of Europe's political leaders. Only this afternoon Angela Merkel came to the temporary rescue of an increasingly besieged Greece, by pointing out that healthier members of the euro zone aren't prepared to abandon Greece and other heavily indebted countries in the currency union. Worthy remarks, and absolutely to the point. But how far is it the responsibility of richer and economically healthy states to continually come to the rescue of those who insist on doing nothing to improve their own situation? On precisely the same day Spanish Prime Minister Jose Luis Rodriguez Zapatero came out fighting, and rejected all rejected negative economic forecasts that currently surround Spain, saying for the umpteenth time that Spain was about to emerge from recession. How much more in denial is it possible to be, and how much longer must the future of all Europeans continue to be put at risk by head in the sand statements like this?

It's All Greek To Me

In the long run we are all dead. But as someone else famously put it: we ain't dead yet, and in the space between these two undeniable truths move forex traders, financial markets and a host of other would be economic participants. The financial press is full right now of headline catching stories about how Greece is at imminent risk of sovereign default. The German newspaper Die Welt even had a lengthy piece this weekend with the catchy title After Dubai, Who Will Be Next (the answer is obvious isn't, otherwise what is the point of the question). One has the impression of a Europe filled to the brim with financial journalists busily rumaging the entrails, in search of the least glimmer of light which will confirm that something decisive and earthshattering might actually happen (soon), what with the German Der Spiegel announcing at the weekend that Greece's growing public deficit problem is to be an item on the agenda at the next Governing Council meeting of the European Central Bank on December 17 (surely the big news would be if it wasn't going to be there), and Bloomberg's Maria Petrakis telling us that Greek Prime Minister George Papandreou is toiling away in what many might consider was a vain attempt to "convince investors he can tackle the worst fiscal crisis in 15 years".

To add even more theatricality to the "drama" groups of protestors predictably battled it out with police on Athen's streets, in marches that were ostensibly to commenorate the death of a young teenager in last years riots. Even the normally staid and prudent Economist throws its weight in behind the charge with a piece whose title tells it all: "Default Lines" (perhaps the words "in the sand" could have been thrown in to add a bit more tension), which goes so far as to suggest that a partial Greek default might even be welcomed by some Eurozone member states, since it might take some of the heat off a hard pressed euro.

As if to add a little more spice to the story, Standard and Poor's decided to pick this Monday to announce it was putting Greece's A- long-term sovereign credit rating on Credit Watch with negative implications, with the unusual little "extra" that it gave the Greek government only 60 days, as opposed to the customary 90, to respond with adequate information to avoid the decision of downgrading to BBB+ (a level which if it was generalised across the rating agencies would imply that Greek Bonds would no longer be eligible as collateral at the ECB once the temporary relaxation of normal criteria which accompanies the extraordinary liqidity measures is withdrawn - although who really knows when this is likely to be). Naturally bondholders were not slow in reacting to the news and the spread on the 10-year Greek/German bond yield widened again, to 201 basis points from the 174 basis points level of late last Friday.

Actually, this is far from the first time that investors and journalists have been getting excited about the default risk on Greek public debt. In fact that very same Spiegel had an article headlined Greece Teeters on the Brink of Bankruptcy as far back as last April (that's a hell of a lot of "teetering" that has been going on), while the ever interesting Willem Buiter had a lengthy and influential blog post back in January on the worthy topic of whether or not it was structurally possible for a member state to default on its sovereign debt and remain in the eurozone (his conclusion was that it was, and in fact I don't disagree with him).

But gentlemen are we not getting rather ahead of ourselves. As I said at the start, in the long run Greek Sovereign debt may be dead than the deadest of ducks, but it ain't dead yet, nor is it likely to be in the most immediate future, there is far too much at stake for all of us for this to simply be allowed to happen, "sin mas". In fact it was the much more cautious Moody's who made the relevant points here in a press release issued last Wednesday where it argued forcefully that investors' fears that the Greek government may be exposed to a liquidity crisis in the short term are totally misplaced.

Now words here do matter, Moody's are completely right, the Greek government will not be exposed to a liquidity crisis in the short term (as opposed to a sabre rattling threat of one from the ECB among others), but this does not mean that they do not face a solvency issue in the longer term. That is, in the longer term I am absolutely sure that Greek public finances are deader than that proverbial dodo, the thing is, the long run simply hasn't arrived yet.

Let Moody's talk, since they do talk sense in this case:

"the risk that the Greek government cannot roll over its existing debt or finance its deficit over the next few years is not materially different from that faced by several other euro area member states".

So here's the first point, the Greek situation is a bad one, but it is not "materially different" from that of a number of other eurozone member states (I will return to this) even if the risk of its losing sovereign bond collateral eligibility is greater than that of any other member state, at this point. In the second place what Greece is inevitably facing is not a liquidity crisis (I'm sorry Maria, no financial crisis at this point), but a long term solvency one if it can't raise its trend growth rate in the context of the looming cost of maintaining an ever larger dependent population with a declining and ageing workforce. That is to say, the strategic problem for Greek public finance is not the quantity of debt accumulated to date, but rather the impending dead weight of future liabilities, and how these can be met. In this case, short term technical default to wipe the slate partially clean and start-up again would resolve nothing, since without a much higher underlying growth rate (without the aid of government deficit funding) the impending liabilites are not supportable, and decision takers at Ecofin and the ECB know this perfectly well, which is why they may well rattle the sabres, but in the short term at least we will see little in the way of exemplary action. For a sovereign default in Greece (a mature developed economy) would be a complete first, and would take us all into very new, and uncertain territory, since it could quite literally become a default from which there was no viable route for return.

So What Is The ECB Up To?

The FT's Frank Atkins has confessed to having been struck by the comments on Greece made by Jean-Claude Trichet, European Central Bank president, at the press conference which followed last weeks ECB rate setting meeting. I am sure he was not the only one who was listening, and given food for thought.

When asked about the country’s acute fiscal difficulties and the risk of a possible default, M Trichet simply stated he had every "confidence that the government of Greece will take the appropriate decisions”. This remark, as Frank Atkins says, was notable for its lack of forecfulness and could suggest he does not entirely rule out Greece facing sufficient problems servicing its debt that it might be forced into the hands of an external agency like the International Monetary Fund.

Indeed M Trichet's statement could be interpreted as meaning that an exasperated ECB would almost welcome such an eventuality, and might by withdrawing easy short term funding from Greek Banks even give things a hefty shove in the direction of just such an outcome. But an ECB which does not frown on the possibility of their most recalcitrant pupil being steered briskly towards the welcoming arms of the IMF is not the same thing as an ECB which envisaging, contemplating, or even in its wildest dreams vaguely imagining a Greek sovereign default. Any suchbdefault would surely follow, and not precede a (flawed and failed) IMF intervention, or would be the inevitable by prooduct of Greece being unceremoniously ejected from the Eurozone by sheer market forces, with the ECB relegated to meer spectator, unable despite its best efforts to contain the situation.

So my reading of the situation as it stands now, is that policymakers will do all that is in the power (which is a lot) to avoid the markets having so much say in the matter, but that what they do want to do is keep up the pressure on the new Socialist administration in Athens. Their aim is surely to try to turn back the “moral hazard” screw whereby European Union authorities, in giving the impression that they will always and ever ride to the rescue, no matter what the provocation (and Greek statistical authorities sure have been doing some provoking), simply encourage member state governments to continue to act recklessly. And this becomes all the more important given the fact, as I mentioned earlier, that Greece is only one among several problem pupils, and that more than the credibility of the Greek government (of which surely there is little left), what is being tested is the credibility of the European Union's institutional structure.

We might be forgiven for getting the impression that to date rather than acting as a stimulus to deep economic reform, Euro membership has rather acted to reward those countries who would get into more and more debt, with ever less sustainable economic models, by supplying them with funding at far cheaper rates of interest than the markets would otherwise make available. It is this particular clockhand that Europe's leaders would now dearly like to turn backwards, and this is why I have little doubt that it is in Greece that a stand will now be taken. If not, then that longest of long runs may arrive rather sooner than some of us, at least, are comfortable with.

The Almunia Syllogism

European Monetary Affairs Commissioner Joaquín Almunia recently, and possibly totally inadvertently, stumbled on a very interesting argument. Here it is:

"Who is crazy enough to leave the euro area? Nobody," Almunia said. "The number of candidates to join the euro area increases. The number of candidates to leave the euro area is zero."

Reductio Ad Absurdum

Now you don't need a PhD in economics to understand what follows, although a little bit of basic logic would help. What we have here could be construed as a kind of syllogism (and from now on let's christen this one "The Almunia Syllogism"). The Almunia Syllogism has the following form:

a) Anyone leaving (or aiding and abetting the departure of someone from) the Eurozone is crazy
b) The EU Commission, The ECB and The National Leaders are not crazy
c) Therefore no one will leave, or be allowed to leave, the eurozone (at least under current conditions)

Q.E.D. We Will Have A United States Of Europe.

Well, ok, I do need to add a lettle lemma here to the effect that the only way to enforce (c) is to build the necessary architecture, and there is room for debate about this, since this lemma is neither proven, nor is it self evident. You also need to accept that there is an excluded middle here, and we do not have a "now either the EU leaders are crazy ot they aren't" fork which we can get diverted down.

As I say, the lemma is not self evident, although my own opinion is that in the weeks and months to come its validity will become extraordinarily clear even to the most reticent among us, but this still needs to be established. The thing about the lemma is that it focuses the debate. Those who do not agree with it need to be able to show how we can have (c) within the present architecture (since here there is a middle to exclude, either we can or we can't). The results coming out from the "we can" camp are not entirely encouraging. For example, ECB Executive Board member Lorenzo Bini Smaghi's recent attempt to argue that Krugman has it wrong, and that (we can manage with what we have) fails stupendously to convince, in my opinion, and especially the extract I reproduce below (which exemplifies precisely the point those who want new achitecture are making).

For instance, for the period 2009-10, discretionary measures adopted in Germany total 3.5% of GDP, compared with 3.8%in the United States. In some European countries, such as Italy, the size of such stimulus measures is relatively limited owing to the high levels of debt, but in other countries the total fiscal stimulus is larger than in the United States.

The whole issue is that we need a mechanism to average out the stimulus, is that so hard to understand? Is this obscurantism, or simply stupidity?

A Literary Trope Not A Syllogism

On the other hand, the formal validity of the following "utterance" from Almunia is rather more questionable.

"Don't fear for this moment," he said. "We are equipped intellectually, politically and economically to face this crisis scenario. But by definition these kinds of things should not be explained in public."

The first phrase is an exhortation, one which I would agree with (but not for the same reasons), the second is an assertion whose truth content is, at least, questionable, while the third is an admission, one which would perhaps better not have been made, or a piece of advice, which the unfortunate Otto Bernhardt seems never to have received.

A senior German lawmaker said euro zone states stood ready to come to the aid of financially fragile members of the currency bloc, sparking furious denials from European leaders that a specific rescue plan existed. Otto Bernhardt, a leading lawmaker in Angela Merkel's Christian Democrats (CDU), told Reuters in an interview late on Thursday: "There is a plan."

and then Bloomberg let us know a bit more about the details of the plan.

The German Finance Ministry has no knowledge of a rescue fund organized by the European Central Bank for troubled euro-region members such as Ireland and Greece, spokeswoman Jeanette Schwamberger said.

Otto Bernhardt, finance spokesman for Chancellor Angela Merkel’s Christian Democratic Union, said in an interview with Reuters today that the ECB has a fund at its disposal to help troubled countries and can make money available at 24 hours’ notice.

Greece Introduces A Public Sector Wage Freeze

Ten Year Bond Spread Between Between Greek and German Benchmarks Post 1999

The Greek government announced this week that it is introducing a public sector wage freeze together with and a one-off tax for high-income earners in an attempt to prevent the budget deficit from spiralling yet further out of control. The measures, which were announced on Wednesday, constitute a significant change of discourse from a government which until now has claimed Greece’s service-based economy could avoid falling into recession. Speads on European government bonds widened again this morning The difference in yield between German and Irish 10-year government bonds, increasing five basis points (to 281 basis points), the most since February 1993. Portuguese, Spanish and Greek (see chart above) spreads also widened versus the German benchmark.

Basically what follows is a brief examination of the evidence we now have to hand for a sudden and sharp slowdown in Greek GDP, and of how this may influence future expectations on the spreads. This follows in the path of my two previous Greece related studies:

Why We All Need To Keep A Watchful Eye On What Is Happening In Greece

and

The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation



The Noose Tightens

Today's decision follows mounting concern about the future competitiveness of the Greek economy and the sustainability of its mounting soveregin debt. Moody's Investors Service cut its outlook on Greece's A1 government bond ratings to stable from positive on Wednesday, saying any upgrade over the next 12-18 months was now highly unlikely due to evolution path of the debt levels. The agency stated they expect the public debt situation to worsen, with debt to gross domestic product (GDP) rising towards 100 percent, though it did note in passing that the pace of the deterioration was in fact in line with what was happening in the case of most other European Union governments. The issue is not so much the rate at which Greece is now extending its debt, but that the indebtedness starts from such high levels, and that so little has been done in recent years to effectively bring the situation under control.

'The global synchronised downturn is taking its toll on the Greek economy as it is on other advanced economies, with growth coming to a halt and public debt ratios reversing their decline from previous years,' Moody's said in a statement.

Greece, which currently expects its borrowing needs to reach 43.7 billion euros this year, up frm an earlier projection of 42 billion. Public debt to GDP, which is expected to grow to about 96 percent this year, is the second highest in the euro zone.

The move followed a February decision by Standard & Poor's to cut Greek sovereign credit ratings by one notch to A-/A-2 with a stable outlook, citing eroding economic competitiveness and a rising fiscal deficit.

South East Europe Dependence?


In fact, on the face of it Greek GDP has held up pretty well in the present crisis.The outlook for 2009, however, looks progressively less healthy. The Greek economy is quite dependent on its services sector, mainly shipping and tourism. And while the shipping sector is suffering badly from the decline in freight charges, tourist bookings have slumped by an average of 10 per cent, according to hoteliers and tour operators associations. But there is one more element we should be considering, the South East Europe (SEE) factor. In fact Greece's commercial banks, who had been expanding very rapidly in southeastern Europe over the last decade, acquiring subsidiaries or established branch networks throughout the Balkans, Ukraine and Turkey, are now faced with the pain of handling what is now becoming a very sharp slowdown in those CEE countries where they have opened shop.

The big four Greek banks - National Bank of Greece, Alpha Bank, Eurobank EFG and Piraeus - have all gotten involved, and are estimated to have combined market shares of around 40% in Macedonia, 35% in Albania, 30% in Bulgaria and 20% in Romania. And then there is Turkey, Serbia, Ukraine and Russia to think about.

During the last few years the SEE countries have all seen gross domestic product growth rates in the 5% to 8% region, compared with 4% in Greece. However, private sector credit in these countries averaged only around 25% of GDP, compared with 81% in Greece itself. Only last month, Bank of Greece Governor George Provopoulos estimated that Greek commercial banks exposure in SEE countries alone stood at about 55 billion - about 22% of Greek GDP, and about 13% of total banking system assets. So now, aprt from the homegrown housing slowdown the commercial banks face the prospect of an accelerating SEE slowdown too. In mid 2008, before the financial crisis hit the SEE region, bank analysts were cheerfully predicting 2009 GDP growth of 6% and above in the region; they are now forecasting zero or even negative growth. There are no detailed NPL figures as yet, but last month George Provopoulos estimated that loans in arrears to Greek commercial banks operating in SEE had already reached 10% of their regional loan books. The Greek government is already preparing itself for the shock, and has introduced a 28 billion euro liquidity stimulus package - again, a little over 10% of GDP and with as yet unkown impacts on the gross debt to GDP ratio.

Greek GDP Has Surprised On The Upside


So as SEE creaks, evidence of the impact of the slowdown on Greece itself is steadily building up. During the fourth-quarter GDP growth did slow to a revised 2.4% ratyear on year rate - down from the 2.7% rate regiseterd in the third quarter, but still a far cry from the substantial contractions in other countries . According to the statistics office the slowdown was a result of the falling rate of household spending combined with a contining drop in investments and exports. So the effects of the economic crisis are begining its seems to have an impact on the Greek economy.

Since mid-2004, Greece has been buoyed by an explosion in consumer spending and a booming property market that has helped fuel an average growth rate of over 4% in recent years. A strong tourist industry, and several record years of growth in the shipping industry have also helped. But over the wholeof 2008 the economy grew at a revised 2.9% rate, significantly down on that 4% average (see the obvious downward drift inheadline growth in the chart below), and with evidently worse to come in 2009.



The main reason for the downward revision was a lower rate of investment spending, produced by a continued decline in construction, a drop in purchases of transport machinery like trucks, and a decline in industrial machinery imports. According to the data, consumption spending was up only 1% on a year earlier. Fixed capital investment fell on the other hand by 5.3%, with a 30.3% decline in purchases of transport equipment and a 19.9% drop in residential housing. Exports were down 1.5% on the year, while imports were also lower, down by 5.3%. Thus the impact of external trade was actually positive for overall growth.

The Greek government now estimates the Greek economy will grow at a 1.1% rate this year. The European commission, on the other hand forecasts a 0.2% expansion rate, while the Bank of Greece expects the Greek economy to grow by 0.5%.

Industrial Decline


Industrial output in Greece fell at a an 8.7% rate in December, following several months of contraction.


In fact, as can be seen from the index in the chart below, output remained pretty flat in 2007, and has then fallen all through 2008.

And the situation lloks set to get worse, since the February manufacturing PMI showed the strongest contraction to date.



Construction industry activity was down by 12.9% year on year inDecember, and retail sales, after quite strong growth in 2007, were also pretty weak all through 2008.




Whopping Current Account Deficit


Basically Greece's problems can be summed up in two pices of data, the huge current account deficit, and the loss of international competitiveness which is reflected in those deteriorating industrial output numbers. In fact Greece's current account deficit reached a record 14.5% of gross domestic product in 2008, although, as the financing necessary to maintain such deficits dries up there are now signs that the gap is narrowing rapidly.





As compared with a year earlier December's current account deficit declined by EUR1.81 billion to EUR3.127 billion, according to Bank of Greece data, following a much smaller decline in November. The weight of the correction is being borne by a drop in imports, with good imports falling to EUR4.51 billion which compares with September's total EUR5.93 billion. Analysts in Greece seem to be expecting a fairly benign slowdown and correction - there is talk of the imbalance narrowing to around 12% to 12.5% of GDP this year - but in present conditions, and far less tolerance of such huge CA deficits, thereis the danger of amuch stronger correction.

Strong Loss Of Competitiveness

The weight of the correction will obviously have to be supported by import (and living standard) declines, since apart from the difficulty of increasing exports under current conditions, the Greek economy has obviously lost considerable competiveness in recent years (after recovering ground between 1991 and 2001.

One of the worrying features of of the Greek situation at present is the general lack of realism that is being demonstrated. Perhaps the most recent example ofthis was last weeks rejection by Finance Minister George Papathanassiou of the EU Commission’s forecast of flat growth for this year - he argues the economy could expand by up to 1.5 per cent - since this means that the budget estimates are bound to prove far too generous, with the consequent danger of deficit overshoot and subsequent credit downgrades.

Too Little Too Late?

The wage measures currently being enacted are far from Draconian , since the freeze will only affect public sector workers earning over €1,700 a month, while lower paid workers are to receive a one-off payment of €500, and the original budget proposals seemto have been ridiculous under the circumstances since they provided for increases of 8 per cent for public sector employees while the year-end inflation rate was projected at 2.5 per cent. The one-off tax is only going to affect the more than 100,000 Greeks who had declared incomes above €60,000 in 2008, and is expected to raise an additional €250m in revenues.

The government's forecast, revised at the end of January, is for 1.1% economic expansion this year; the European Commission says it will be just 0.2%; the central bank, 0.5%. All of these look rather optimistic under the circumstances, and a contraction in the region of 2% of GDP looks much more realistic, especially with wage tightening, and government cuts in the pipeline. Credit expansion, is also slowing internally as a result of the deteriorating economic climate, and this coupled with the more cautious approach to loan approvals will make it difficult for the government to maintain its 10 year on year new loan creation target, especially with joint public and private gross debt to GDP levels nearing the 200% mark, and the heavy external financing requirement making an over-rapid closing of the CA deficit now a distinct risk. In October, the rate of new loan growth was 18% year-on-year; by January it had decelerated to 15% - a rate last seen in 2005, and there is no end to the process in sight.