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.

Eurozone Inflation Expectations Fall As The Output Gap Rises

It’s a depressing spectacle: on both sides of the Atlantic, policy-makers just keep falling short — and the odds that this slump really will turn into Great Depression II keep rising.

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.

Oh, and Jean-Claude Trichet says that there is no deflation threat in Europe. What’s the weather like on his planet?
Paul Krugman, yesterday

What follows here are simply a few charts to illustrate further the argument I developed yesterday as regards the significance of the deflation threat which now exists in the eurozone. The argument is that the ECB is once again being far too cautious, and risks allowing the entire eurozone to entire a deflationary cycle which may prove to be a lot harder to get out of than it was to get into. In my view the ECB should bring the refinancing rate close to zero % at next Thursday's rate setting meeting, and then explore what measures can be taken to introduce a zonewide version of US/Japan style Quantitative Easing as quickly as possible.

The key argument I am presenting is that it is a mistake to focus at this point on what is happening to energy, food and other commodity prices. The key issue is what is happening to core prices, and what will continue to happen to them as output contracts further. The other side of the coin are inflation expectations, and as we will see below these are now falling rapidly across Europe. It is very important at this point that these expectations do not get "locked in" to price fall expectations.

It is evident that the degree of economic slack in the OECD is now widening rapdily as unemployment rises and capacity utilization falls. The OECD output gap (the difference between current levels of output and some estimate of what "capacity" output could be at this point) continues to widen and is now only second in importance to the output gap seen in the early 1980s. In fact, the output gap is likely to have widened further since the OECD last made its forecasts in November 2008 (the OECD leading indicator has, for example, continued to decline since that point) but the output gaps shown for the US, the UK and eurozone in the chart below are already sufficiently pronounced to make the point quite clearly I think.

In fact, spare capacity is a phenomenon which extends way beyond the OECD, and economies throughout the world are operating at below their potential and look set to do so for both the remainder of this year and most of 2010. Global manufacturing has been contracting and global trade has collapsed. Here is the latest JP Morgan Global Manufacturing PMI.




The IMF currently estimates that the cumulative global output loss relative to potential over the period 2008-2010 will be as much as 5% (see chart below).


And inflation expectations are falling rapidly. The latest findings in the European Commission’s own consumer questionnaire show that the net balance of respondents in the UK and the Euro zone expecting prices to be higher this time next year is now at the lowest recorded level - just 2.7% and 4.1% respectively ( see chart below).

"There Is No Deflation Threat In Europe" - Jean Claude Trichet - Oh Really!

He's at it again. Last year he was busily trying to worry us all that inflation was set to get completely out of hand among the 16 countries who make up the eurozone. Now the President of the European Central Bank, Jean-Claude Trichet, is hard at it on another tack and is busying himself trying to convince us that there is no credible deflation threat facing these countries. Apart from getting it wrong on both occasions, the common point here would be a certain inbuilt "inflation bias", a bias which was earlier called "the original sin of the Bundesbank" by nobel prize winning Italian economist Franco Modigliani.

"There is presently no threat of deflation," Trichet told a committee of the European Parliament on Wednesday 14 February. "We are currently witnessing is a process of disinflation, driven in particular by a sharp decline in commodity prices." ..."It is a welcome development," he said, adding that the fall in energy, and other prices should help boost struggling economies.

Apart from manifesting a spectacular lack of economic judgement, the Financial Times's Banker of the Year 2007 is now forcing us to ask the embarassing question as to just how far "out of touch" you can get with the material you are supposed to be handling and continue to hold down your job. It seems we are forced to come up with the rather worrying response, that, in the case of the principal EU institutions (remember the sad case of Economy and Finance Commissioner Joaquin Almunia), the answer is "bastante" (consideably), since a quick look at the data we have to hand shows us that Eurozone inflation is already significantly undershooting the European Central Bank’s own target (and principle policy objective) of maintaining the annual rate “below but close” to 2%. Worse, by all appearances the rate of consumer price inflation in the eurozone is now set to head straight off into negative territory.

If we look at headline HICP inflation on an annualised basis, we will find that it fell more than expected in January - to 1.1 per cent, according to Eurostat data - down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The "core" inflation rate - that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco - we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).



Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.



Why Should Prices Continue to Fall?

So what are the grounds for thinking that inflation may be now heading into negative territory (ie that we are entering deflation right now), despite the fact that the ECB revised forecast is likely to come out at about 0.7 per cent this year and 1.5 per cent in 2010, according to estimates from Julian Callow, European economist at Barclays Capital. Well let's look at a chart produced by Paul Krugman showing the relation between the US output gap and the inflation rate.



Now as Krugman explains the figure plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. (Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007).

The fit, as he says, is not perfect, but the correlation is evident, and there is an implied slope of about 0.5 — that is, every percentage point by which real US GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year. Now I am not going to advance here estimates of the present output gap in the eurozone, but we do have clear indications of a sharp and ongoing contraction in demand in the GDP numbers. Eurozone GDP contracted by 0.2% between the second and the third quarters of last year, and by 1.5% between the third and fourth quarters.

What's more the key indicators suggest that the contraction is accelerating at this point. The February Markit euro-zone composite PMI reading dropped to a record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one, and considering (as mentioned previously) that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). For those of you who simply don't believe that PMIs can tell you so much, take a look at Markit's own chart (below), showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. The results they achieve are pretty impressive I would say.

and if we look at an additional indicator (the EU's own Economic Sentiment Indicator for the eurozone) we will see that it hit yet another low in February (see below) which again suggests that the contraction is accelerating at this point, and substantially so.



So the core HICP index is on the point of turning negative on a six monthly basis, and the situation appears set to get even worse, and our Central Bank President assures us that "there is presently no threat of deflation". So which world am I living in, or which is he?

There are further reasons to anticipate a sharp downward pull on prices from some countries in the zone (like Spain and Ireland), since they have housing and construction booms which are in the process of unwinding, and the only way they can recover the competitiveness they have lost is by conducting a sharp and significant downward revision in prices and wages (since in a currency union there is effectively no currency to devalue). The two charts below show the loss of competitiveness experienced by the Irish and the Spanish economies (respectively) with regards to the German economy since 1999 as measured by real effective exchange rates (REERs).



REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators are deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness.



Now the eurozone being a common currency area presents us with specific problems in the context of deflation since, as the Irish economist Philip Lane argues a member of a currency union comes up against a natural limit in national-level deflation. Thus, he argues, while a country like Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a greater or lesser period of time), the situation should tend to be self-correcting since the deflation implies an improvement in competitiveness, which should generate a boost in export driven economic activity and, over time, a return to an inflation rate at around the euro area average. I'm not sure that this argument is 100% valid, since sufficient internal demand lead deflation can so effect household and corporate solvency that debt deflation can at the very least send a country off into a sizeable and significant correction (say a decade long one) before the price level falls sufficiently to generate sufficient export activity to offset the decline in domestic demand and enable balance sheets to recover. But going into all this would get pretty wonkish, so, leaving that rather theoretical point aside, lets think about a more rather concrete and immediate reason for worrying about what is happening at the present time in the eurozone, and that is the possibility that the inflation and competitiveness benchmark country, in this case Germany, may itself be about to experience an internal price deflation process which is every bit as sharp as the fall in prices which is taking place in those economies which are supposed to be correcting vis-a-vis Germany itself. That is, let's consider the possibility that through this mechanism the deflation may become eurozone wide, and relatively self perpetuating, if something is not done to break the cycle.

So, if we now go on to look at the two relevant charts below (for Spain and Ireland) we will find that in each case core indexes are falling more or less in line with the German one. In fact, both the Spanish and the German indexes are unchanged over the last six months, the Irish one is down 0.5%. At this pace (a 1% a year differential with Germany) Ireland would recover its 1999 comparative position vis-a-vis Germany in around 30 years, a rather lengthy process to say the least.

But the point here is not that prices are falling in Ireland and Spain (they have to do this) but that prices are also set to fall in Germany, and this is where monetary policy from the ECB becomes vital, since if Germany is allowed to fall into deflation then it will be extremely difficult for Spain and Ireland to "correct" (the drop in wages and prices would have to be sharp indeed) but also monetary policy from the ECB would be in danger of becoming a complete mess.





Of course not everyone on the ECB governing council shares Trichet's rosier-than-rosy view, and in a comment that offered an insight into how at least some ECB council members are thinking, Mario Draghi, Italy’s Central Bank Governor said recently that “the governing council is keeping a close watch on the real cost of money”. What he means is that, if Spain's 1.5% drop in core prices over the last three months turned into a 6% annual drop, then the real rate of interest currently being applied would be around 8%, which would constitute a very tight monetary policy in the context of Spain's worst recession in living memory.

Perhaps some readers may feel I have been unduly hard on Jean Claude Trichet in this post, but I would simply close by reminding everyone of the conclusions reached in a once widely quoted paper - Preventing deflation: lessons from Japan's experience in the 1990s, by Alan Ahearne, Joseph Gagnon, Jane Haltmaier and Steve Kamin (2002) - where the authors argued:

We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

As some economist or other I read is in the habit of saying "history has a nasty habit of repeating itself, the first time as tragedy and the second time as tragedy". Or put another way, here we go again. Hello, is there anyone out there?

Europe's Economic Contraction Intensifies In February

Hopes that Europe's battered economies might be about to turn themselves around took another sharp knock today (Friday), as the preliminary flash reading on the purchasing manager survey signaled that activity in both the manufacturing and the services sectors are contracting at a new record pace in February.

The preliminary Markit euro-zone manufacturing purchasing managers index, or PMI, fell to a record low of 33.6 in February from 34.4 in January, while the services PMI also fell to a record low, dropping to 38.9 from 42.2 in January. As a consequence the euro-zone composite PMI reading dropped to its own record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one. If we consider that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). Not quite Japan territory yet, but not far behind. And for those who simply don't believe the PMIs can tell you so much, here is Markit's own chart, showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. Pretty impressive I would say.




Germany's Contraction Intensifies


The German service PMI came in at at 41.6, showing the fifth consecutive month of contraction. This was a sharp drop from last months 45.2 reading, and means that the recession is now feeding through from manufacturing to services. The difficult conditions have lead service business owners to hold to the grimmest outlook in the last decade, that is since the index was started. More ominously, the recent data points to a strong reduction in the employment level.



On the other hand February saw the tiniest of upticks in the manufacturing sector, since the PMI came in at 32.2, from January's 32 , the best that can be said here is that the rate of contraction may have stabilised.



France Holds Up Slightly Better Than Most

In France, the manufacturing sector (see chart below) gave up on most of January's rebound, and the PMI fell to 35.4 from 37.9 in January, while services (see chart above) slipped to a record low of 40.1 from 42.6 in January. Nonetheless France is visibly performing rather better than Germany, and when all this is over we will have plenty of time to hold the debate as to why that has been.

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

In view of Greece's EMU membership, the availability of external financing is not a concern, but the correction of cumulating indebtedness could weigh appreciably on growth going forward. While the risk of transmitting vulnerabilities to the euro area is very small reflecting Greece’s small relative size, large persistent current account deficits would increase the vulnerabilities to a reversal in market sentiment, leading to a corrective retrenchment of private sector balance-sheets in the face of rising indebtedness, and a possible appreciable rise in the cost of funding over time. These developments would have significant negative implications for growth.
Greece: 2007 Article IV Consultation - IMF Staff Report

The above quited paragraph from the IMF is a very good example of what used to be the orthodox wisdom about Greece's economic imbalances - that given EMU membership the availability of external financing should not be a concern, and that the Greek economy is effectively too small for it to constitute a menace to the stability of the eurozone itself, even on a worst case scenario. Well, if we look at the growing yield spreads you can see in the chart above (please click for better viewing) the first premiss seems to be in real danger of falling, EMU membership no longer gives an automatic guarantee of oncost-free external financing, and if you look at the names of the other countries lining up in the queue behind Greece - Italy, Spain and Portugal in particular - you can begin to see the outline of a contagion mechanism whereby the coming to reality of the worst case Greek scenario might just extend itself into a problem of sufficient magnitude to transmit Greek vulnerabilities across and into the entire euro area. No one is too small to be a problem when it comes to financial crises, and if you think I am exaggerating just look at how the "pipsqueak" Baltic economies have paved the way and opened the door to much bigger problems right across Central and Eastern Europe even as I write.

But just what are the problems Greece faces, and just what are the risks of transmission of these elsewhere?

Bank Credit Downgrades

The first of the things which has changed since the IMF wrote the staff report I cite above (back in 2007) is the soundness and stability of what was then seen as being a very well funded and liquid banking system. Only last Friday Moody's Investors Service announced they had changed the outlook on the bank financial strength ratings (BFSRs) and long-term deposit and debt ratings of four Greek banks - to negative from stable. The banks in question are National Bank of Greece, EFG Eurobank, Alpha Bank and Piraeus Bank. This move follows decisions earlier in the week by EFG Eurobank and Piraeus Bank to participate in the Greek government's 28 billion euro (about 12% of GDP) bank bailout scheme the aim of which is to provide capital injections to the participating banks via the sale of preferred shares to the state, guarantees on debt issuance, and liquidity support. The decision by these two banks now brings to six the number of Greek banks who have decided to seek refuge in the government scheme, with the other banks being National Bank, Alpha Bank and the smaller ATEbank and Proton Bank.

Piraeus Bank has said it will hold a shareholders' meeting on January 23 to seek approval for a 370 million euro issue of preferred shares to be sold to the state. Under the terms of the bailout plan, the Greek government may spend up to 5.0 billion euros (of the 28 billion euros total, or a little over 2% of GDP) on boosting bank capital ratios via the purchase of preferred shares. These shares will pay the government a 10 percent dividend, and banks using the facility will need to accept a state representative with a right to veto dividend policy and executive pay on their boards. Banks will also have the right to buy back the preferred shares no sooner than July 1, 2009.

In addition to the evident weaknesses which have now come to light in the Greek financial system, the other worrying development we are seeing in Greece at the present time - apart that is from the largescale social conflict that has been hitting the headlines in recent weeks - is the movement in what is know as the yield spreads. These spreads are the interest rate difference a national government has to pay for borrowing money (over ten years say) when compared with that paid by the (benchmark) German government. What this means is Greek government bonds are sold cheaper (ie the government receives less for them) than their German counterparts, but their yields are higher and this is because external investors increasingly see Greece as a less creditworthy country. If Greece itself was fully self sufficient in finance (like say Japan is) then this wouldn't present a problem for bond yields (as we can see in the case of an equally indebted Japanese govenment) since domestic investors could be relied on to buy up the bonds (in a process known as "home bias"), but Greece is not self sufficient, and has to depend on external finance to fund a current account deficit of around 15% of GDP. Thus the opening up in these spreads over the last two months most now constitute the biggest headache those responsible for managing European Monetary Union have had to face since the creation of the eurozone, since according to the well know neo-classical theory of contingent convergence they should be disappearing, and not increasing.

But increasing they are, in what is only the latest example of reality defying received theory, and the Greek 10-year bond, for example, was yielding 4.89% at the close of European trading last Tuesday, while the 10-year German issue returned just 3.23%. The spread between Greek and German bonds has now more than doubled since October and indeed hit its highest level ever since the launch of the euro last Thursday - reaching 190 basis points, up from 168 before the rioting began.

These widening spreads mean more expensive bond auctions for the Greek government, and this is just where the trouble comes, since Greece has a very hefty accumulated debt to continually refinance (around 90% GDP), and it is partly because investors don't see how a government with a damaged banking system and an economy which may soon start shrinking as the recession bites can shoulder the weight of this debt, especially given the evident difficulty faced by the Greek government in enforcing measures to reduce it, that the widening is occuring.

Twin Deficit To Beat All Twin Deficits?


Basically, if I could sum all this up in a nutshell I would ask, just why are we seeing rioting out on the streets of Greece, and calm placidity down there on the Spanish highway. Well, apart from the evident differences in national cultures (which I am certainly not in any way equipped to get into) I would say there is one single fact that marks out the difference: Spanish Prime Minister Jose Luis Rodriguez Zapatero can still sign any cheque he wants to to try to fend off the worst of the Spanish crisis, while Greek Prime Minister Kostas Karamanlis no longer can. Words of warnings left unheard are now coming home to roost and the Greek government's room for fiscal manoeuvre is very very limited indeed at this point. Undoubtedly time will also run out on the Spanish Prime Minister too if we continue on the present course (as I argue in this post) but my point here is that we should be aware that events in Greece, depending on how badly things go, or how quickly they go bad, could end up cutting the available time for Spain even further, via a nasty little process which is ferquently known to go to work during financial crises: regional contagion.

We have already seen just a process at work in Eastern Europe, following the ill-advised excursion of Russia's tanks through the Roki tunnel in early August, are we now about to see something similar happen in Southern Europe following the course of the ill-gotten police bullet which ripped life and lung out of a poor young 15 year old schoolboy in Athen's Exarcheia district this week? Actually I doubt it, that is I doubt we are likely to see a similar chain reaction process just yet, but the severity of the social backdraft we have scene following the incident should serve as a warning to us all of just how delicate this situation now is, and just how easily things could be knocked off balance.

The core of the problem we have before us lies in the Greek twin defict - Greece has a very large and continuing current account defcit (around 15% of GDP, see chart below) and a very large accumulated government debt (around 90% of GDP, see second chart below).



Part of the reason for the recent surge in Greek external debt has been a rapid rise in domestic investment which was not matched by a similar increase in national saving - in fact household savings have been more or less stagnant - and this has meant that the gap between national saving and investment has been steadily growing since 2001 - increasing from 10.5% of GDP in 2001 to nearly 15% in 2006. Most of the additional gap has been due to a rise in net indebtedness by the household sector. To a large extent the decline in household saving and the increased demand for housing as a private investment vehicle can be explained by the increased access to and demand for credit in the context of financial liberalization and the lower interest rates which have followed from Greece's euro participation. Undoubtedly during the years in which Greece "enjoyed" negative real interest rates, it seem a much more attractive proposition to buy a piece of property whose price it was imagined would "never fall" rather then watch savings steadily lose their value in time deposits which were effectively being ravaged by infaltion attrition. On the other hand it is worth bearing in mind that gross Greek household debt - at a little over 40% of GDP - never reached the heady levels attained in Spain of around 90% of GDP.

In contrast, the Greek corporate sector has been running a net savings surplus throughout the entire period (and this of course is another big difference from Spain), with rising saving repeatedly exceeding investment. This notable increase in corporate saving has largely been the result of the strong profitability in the shipping and financial sectors, and it is this profitability which is now, suddenly, under threat in the current downturn.

Greek government debt, on the other hand is somewhere in the region of 90% of GDP, while the deficit is currently somewhere around 3% of GDP, but none of us (including the European statistics agency Eurostat or the EU Commission) can really be too sure of all this, since the goalposts seem to be being constantly moved in more than the football stadia down in Greece, and while it would be an exaggeration to say the data changes on a weekly basis, sometimes it seems we are not so far away from that point. Such shortcomings in Greek public finance statistics (and economic data from Greece generally I would say, if you look at all the regular omissions in the Eurostat short term data relases) are by now a reasonably well-known problem - the general government deficit for 2007 has only in the last month been revised upwards yet one more time - from 2.8% to 3.5% of GDP (much to the furor and chagrin of the EU Commission, since this put Greece in technical breach of its committments to the Commission, yet one more time), while for 2008, the official public deficit target has already been revised up by 0.75% of GDP, compared with the initial budgetary target of 1.6% of GDP, and of course with the historic record to go by and bank bailouts and the economic slowdown to think about, it hardly seems to be credible that this year will be the year, the year we finally make it back under the 3% deficit limit on a consolidated basis. The latest upward adjustment in the forecast reflects expenditure overruns of 1% of GDP and revenue shortfalls of 0.5% of GDP, although at the present time these are supposedly being partially compensated for by a series of measures implemented in September (with unknown outcome at the time of writing, but with an evident adverse impact on Greek public opinion if the images on our TV screens are anything to go by).

The September package consisted of both revenue enhancing and public consumption cutting measures with a projected budgetary impact of some 0.75% of GDP - and hence in part of course the recent furor on the Greek street. If the intended outcome were to be achieved - something which is, as I say, very unlikely under the present economic circumstances and given the government's track record - then the Greek government deficit for 2009 would be somehwere in the region of 2.5% of GDP. But the point about all this rigmorole, is that the end result of all this coming and going, and too-ing and frowing down the years is that Greece is still not completely out of its EU excess deficit procedure, and this at the end of what has been one hell of a "good times" boom, so what can we seriously expect now that the bad time have most definitely come?

Greek consolidated debt has been steadily coming down, as can be seen in the above chart (the brown line, right hand scale, please click on image for better viewing) but the problem that is facing decision makers is, will getting to grips with the heart of the financial problem imply measures which once more reverse this trend, and if it does, just how will the ratings agencies respond, and assuming we already know the answer to the last question, what will this mean for the yield spread?

Greek Economic Performance

The Greek economy has been buoyant for several years, and the gap in real per capita income between Greece and the EU–15 has narrowed significantly. Real GDP growth averaged 4.25 percent during 2000–06, and is estimated at 4 percent in 2007. Solid gains in employment and handsome real wage increases have underpinned strong consumption growth. Rapid credit expansion that followed financial sector liberalization and the drop in interest rates associated with euro adoption have fostered rising residential investment by households, while strong profitability has fueled corporate sector investment. However, the external sector has been a drag on growth; external imbalances have remained large throughout and widened.
Greece: 2007 Article IV Consultation - IMF Staff Report

Recent Greece economic performance, as measured in terms of growth in per capita income and GDP (see chart below) has been - as the IMF indicate - strong, with average annual growth running at a little over 4%, but looking at the macro imbalances which have been accumulating, we need to ask ourselves, as in the case of Spain, will there be a payback to be made for all of this good news?

If we examine the inflation chart (see below), we will find that Greek annual inflation has also been hovering around the 4% mark since the start of the century, a clear two percentage points above the ECB inflation target, and also two percentage points over the ECB policy rate during the key period from June 2003 and December 2005 (when the rate was held at 2% offering monetary conditions which were far too loose for several key members of the eurozone and in the process fuelling housing bubbles in a number of zone member states). Thus with GDP running way above what might be considered a reasonable trend level, interest rates were being adminstered at what was a real rate of minus 2%, despite the evident inflationary symptoms that there was significant "overheating" going on. Thus the Greek economy was given a pretty significant monetary stimulus during what could only have been perceived as the height boom, and at a time when the fiscal stance was also very expansionary. If any of this could work, then we would have to admit that most of what we claim to know in terms of economic theory was simply wrong - although the ECB at the point may simply have taken the IMF view that "the risk of transmitting vulnerabilities to the euro area is very small reflecting Greece’s small relative size". However since I certainly do not think that Greece is "too small to matter" and since I also think the part of our current body of economic knowledge about what you should and shouldn't do during overheating episodes is among the most tried and tested portions of our theoretical heritage,the Greek economy now seems likely to suffer from some rather severe macro problems in the course of the unwind of this particular binge, and I doubt the knock-on effects from the unwind for the rest of the eurozone will simply be too benign to notice.

We might, of course like to ask ourselves whether it wasn't a pragmatic case of "simply nothing to be done"? I would argue that there most certainly was something to be done, and it was on the fiscal side, since interest rate policy was effectively under ECB control. The Greek government, on noting the signs of overheating should have moved to a restrictive fiscal stance - in other words it should have been running a surplus, and a big one, of possibly 2% or 3% of GDP - but as we have seen, just the opposite was the case, and at the same time as monetary policy was excessively accommodative fiscal policy was busy pumping in even more juice.

And so it went on, until it simply couldn't go on any more, which is where we are now, and why Prime Minister Karamanlis cannot simply keep signing the cheques to buy social peace and satve off the downturn, although it is quite clear that this evident reality still hasn't been gotten across to Greece's two largest union federations who last week held a nationwide general strike to protest a set of government's remedial policies which, if they are anything, are already too little and too late. To give you a flavour of what is involved, here is a selection of some of the reforms that are currently causing so many problems.

The Much Needed Pension Reform

Unless the social security system is fundamentally reformed, the long-term costs of population aging are expected to threaten the sustainability of the public finances. The completion of the actuarial studies of the major pension funds has been further delayed, and the authorities are proceeding with a narrowly focused reform agenda which is nonetheless already drawing considerable protest. They have ruled out reduction of the replacement rate and increases in the contribution rates. Instead, the focus is on obtaining efficiency gains through the merger of pension funds, tightening provisions for early retirement (the list of “heavy and unhealthy” occupations and the disability pension code would be reformed toward this end), increasing the incentives for people to stay employed longer, and tackling contribution evasion. In the absence of an assessment of the cost savings, it was not clear to what extent the current reform proposals would suffice to restore the pension fund to financial viability.
Greece: 2007 Article IV Consultation - IMF Staff Report

Despite strong opposition from the main trade organisation unions, the Greek parliament last March approved a law which aimed at a long overdue overhaul of the country's ailing social security system whose longer run actuarial deficits are now estimated to be running at more than twice Greece's 240 billion euro GDP. Experts predict a collapse of the system in 15 years unless something is done to prevent this and have warned that even the current reforms may not be enough to guarantee the system. We should remember that Greece has long running low fertility (around 1.3tfr) and has a rapidly rising population median age. The working age population is soon set to start declining as a proportion of the total population. Many of Greec's working population, however, simply do not understand this rather harsh and complex reality, and are angry about being asked to increase pension contributions for what they feel may well be reduced pension entitlements later, especially at the present time as they are already feeling the pinch of the global economic downturn. The changes included merging the country's myriad 133 pension funds to form a mere 13, raising retirement ages, eliminating special and supplementary pensions, and introducing incentives to encourage people to work additional years.

Privatisations To Pay Down Some Of The Debt

Greece's New Democracy government has already auctioned stakes in Greece's largest ports in Piraeus and Thessaloniki, and sold a stake in telecoms company OTE. It has also pledged to push ahead with the privatization of several state-owned companies, such as Olympic Airways and Postal Savings Bank. Other assets to go on the auction block may include Athens International Airport. These sales have been pushed forward despite strong opposition by unions who fear job losses and wage reductions, but really - apart from the competitiveness arguments which underpin such moves - the government really have little alternative since something or other has to be sold here.

Wages and Salaries

Wage moderation and enhancing wage flexibility are important challenges. The authorities will continue with the policy of containing increases in basic wages of government employees and are hoping for a favorable signaling effect on private sector wage settlements. However, in recent years, wage increases in the private sector have been relatively large and often exceeded productivity growth.
Greece: 2007 Article IV Consultation - IMF Staff Report

One of the key areas of controversy in recent weeks has been a law which effectively ends the employees' right to collective wage contracts (Spain, be warned) and which won approval in the Greek parliament last August. The government said it wanted to clean-up debt-ridden state companies and overhaul protective employment laws in an attempt to attract more foreign investment. The Finance Minister Alogoskoufis recently told parliament the reform should be pushed ahead "for the sake of the Greek economy and society," since higher wages have added to state companies' debts, which ordinary Greeks had to cover with their taxes.

Are We A Bunch Of Hypocrites In Southern Europe?



One question I often ask myself when speaking with Spanish government employees who timidly ask me the predictable "crisis, what crisis? Can't you see, all the bars are still full!" question is just what is meant by that much used and little understood word "solidarity". We are proud to note down here in Southern Europe that we have a complex set of collective institutions which are driven by objectives of "social solidarity", not like those nasty little anglo saxon types (you know, the "neo-liberals") who live up north. But why is it, I ask myself, that I don't here this "crisis, what crisis" stuff from those working in the private sector, who spend the best part of the day at the present time looking across the factory or office floor at their colleagues and asking themselves who it is who will find themself going out of the door this week?

Solidarity means, if it means anything, that everyone shoulders some part of the burden in difficult times, and that people behave responsibily with their national resources and heritage, and accepting that when there is no money to pay for something, then there simply is no money to pay for it. If you find yourself having to depend on the stringent demands of others from outside your country, then the best thing you can do is to get your country out of the debt which is the cause of the problem, and then you can freely decide your own future for yourself. But while I can well understand how a relatively poor country like Ecuador gets itself into such a dependence-based mess, I am at a loss to understand how comparatively rich countries like Spain, Greece and Portugal have allowed things to come to the pass they have now come to, or how their citizens have let them get to the point they are at now.

One good example of the ways you get into such difficulty comes from Spain where the government now wants power companies to pay off one third of the latest tranche of a multi-billion euro deficit which has been created by utilities charging small consumers less than the cost of generation. At the present time, and following the partial deregulation of Spain's electricity sector, the government continues to set tariffs for small consumers. This deficit is estimated by the Spanish energy regulator CNE to be running at 5 billion euros for 2008 alone.
The government has no immediate plans to oblige utilities to pay for a further third of the 11.2 billion euros of tariff deficit accumulated pre 2008, since this deficit is provided for in Spansih law and appears on the companies' books as a long term credit which they are expected to eventually claw back gradually through their customers. The government has been trying to finance this deficit through quarterly debt auctions, but these have met with mixed results, and the government had to declare null and void an attempted sale of 3.85 billion euros of debt amid market turbulence in back in September. The scandalous part about all this isn't that the government could use any funds it could raise at auction for other and better purposes right now, rather it is the fact that this 5 billion euro debt which has been incurred in 2008 by selling energy to customers below cost has only been adding to the hole in the current account deficit, since the energy it pays for effectively needs to be imported.

One key feature in all this woe has to be a political process that is extremely ineffective, and driven by the fact that no one likes to hear bad news, and that the last thing a politician is able to say is tighten-up your belts now lads and lasses, we are in for a rough ride. But isn't this just how the IMF gets such a bad name for itself, since the IMF doctors get called in just where the domestic political process breaks down, and where local politicians haven't the ability to stand up in front of their citizens and say, it's going to have to be like this, I'm afraid. Isn't this what just happened in Ukraine, Hungary and Latvia? And then people say, those "nasty folk" at the IMF, they cut pensions everywhere they go, and wages are down 8% in Hungary, and 15% in Latvia once the IMF get to run the show. That is the IMF make for a convenient scapegoat, but people seldom ask themselves why wages needed reducing, or why there is no money to pay the pensions. Oh, I know.................

The Greek Economy Is Slowing Rapidly

Greek economic growth is now slowing rapidly. Quarter on quarter growth in Q3 2008 was 0.4%, and almost all the growth the economy has been getting this year (including that sharp spike you can see in Q2 in the chart below) comes from earnings from shipping services, earnings which are now falling dramatically as global trade starts to contract. The economy is expected to decelerate further in Q4, and may even contract slightly, with a best case scenario of remaining around the stationary level. Thus the Greek economy should start contracting - and thus formally enter recession in Q1 2009, at the latest.

Given the difficulties Greek banks are having in raising finance in the global financial and capital markets, the ensuing tightening credit conditions are bound to lead to a further slowdown in private consumption. Government consumption is expected to move more or less in line with GDP, while public investment is expected to rebound in 2009, largely reflecting an accelerating pace in the implementation of EU Structural Funds. Household borrowing has - as we have noted - increased at a rapid rate between 2003 and 2007, but during 2008 the rate of increase has been slowing steadily (see chart below).

This reality is reflected in the recent statement by central bank govenor George Provopoulos that he hoped the bank bailout plan would be able to keep the country's credit expansion pace at 10 percent next year (down from around 18.1 percent currently). Even were this to be achieved (which is far from clear), as we have seen in Spain it will lead to a sharp contraction in an economy which had grown accustomed to new credit generation at twice that rate, and especially given the governments inability to step in and offer any fiscal support.



In addition, the Greek construction sector - which, it should be noted, never became so bloated as a share of GDP as it did in Spain and Ireland (where it hit around 11%) - has now been slowing since Q3 2007, when it hit around 7.5% of GDP, and was down to 5.4% in Q3 2008, and was dropping year on year at an annual 6.7% rate in September 2008 according to the latest data from the national statistics office.

Industrial output is also now falling, by 4.5% in October, and the November manufacturing PMI registered a series low of 42.3 indicating even faster contractions in the pipeline. Greek industry has been getting some uplift from the economic boom in South Eastern Europe, and since that is now well and truly over, we should expect the manufacturing downturn to be sharp and sustained.

In the shipping sector, a significant jump in world freight rates and a rise in shipping volumes on the back of a hefty increase in world demand for oil and other minerals both boosted the sector’s profitability, and increased it's importance in GDP growth (indeed growth in the last couple of quarters has been virtually all about shipping). This favourable position has now very much turned. George Economou, Greek shipping billionaire and Chairman and CEO of DryShips recently characterized the current collpase in the Baltic Dry Index (of bulk charter cargo rates) as something like "a nuclear explosion" for those in the shipping industry. The index, which measures world shipping charges for raw materials, has plummeted from a high of 11,793 in May to 672 (see chart below), its lowest level since soon after the index was established, back in 1985. Daily-rental rates for the largest Capesize category of carrier have plunged from $234,000 just two months ago to $2,320, a fall of a staggering 99%.



Even more worrying for the mid-term outlook is the rush to cancel orders of new ships. In November, New York–based Genco Shipping and Trading willingly agreed to say adios to a $53 million deposit simply to get out of a half-a-billion-dollar deal to buy six new vessels. Clarkson Plc, the world's largest shipbroker, announced that while 378 ships were ordered during October 2007, only 37 were ordered in October 2008. And back in Greece Kriton Lendoudis, managing director of Athens-based Evalend Shipping Co., estiamets that in Greece there are currently some 100 applications by shipowners to lay up their vessels. Lendoudis concludes, "The next 24 months do not look very optimistic." It's hard to disagree.

So my feeling is that - taking all the above elements into account - we should expect Greek economic performance to deteriorate at a rate and to an extent which may surprise the casual observer of economic events. Those who have already been following closely what has happened in countries like Spain, Latvia and Romania should, however, be fully prepared for what is now to come. The first signs are there, in the EU confidence chart I close with (below). As can be observed, a slow and steady deterioration has suddenly, after the summer, changed course, and become a sharp downturn. I fully expect that we will now see this general shift in confidence find its reflection in the real economy data that comes rolling in over the next three or four months.