The Debt Snowball Problem

OK, just for a change let's start with some math. The increase in a country’s sovereign debt stock to GDP ratio is given by the following formula:



where D is the total debt level, Y is nominal GDP, PD is the primary deficit, i is the average (nominal) interest paid on government debt, y is the nominal GDP growth rate and SF is the stock-flow adjustment.

Now, if like me, you don't especially love maths, you may want to ask "what the hell does this rigmarole mean?".

Well, in simple plain English the above equation - which in fact comes from the recent Danske Bank report on EU Sovereign Debt- means that movements in the critical debt to GDP level depend both on the level of the annual fiscal deficit (the primary deficit, on which so much attention is currently focused in the Greek case) and on changes in the ratio between the value of the stock of debt and the value GDP. The key term is the one in brackets, and it is often referred to as the “snow-ball” effect on debt - the self-reinforcing effect of debt accumulation (or de-cumulation) arising from the difference between the interest rate paid on public debt and the nominal growth rate of the national economy.

Nominal here means GDP values before adjustment for inflation (what is known as current price GDP). So what we can say is that the trajectory of (for example) Greek debt to GDP going forward (and thus the effectiveness of the adjustment programme) depends critically on only three main variables - the rate of deflation/inflation, the rate of GDP growth, and the interest spread charged on Greek bonds. Ideally, Greece needs solid GDP growth, inflation, and a low spread on Greek bonds vis-a-vis German ones. The problem is the Greek Stability Programme may achieve none of these.

In the first place, the attempt to reduce the primary deficit will involve withdrawing some 10% of GDP in government demand from the economy in the space of three years (to go from an annual fiscal deficit of 12.7% a year in 2009 to one of 2.8% in 2012). The Greek government plan projects the economy to shrink by 0.3 per cent this year before rebounding with growth of 1.5 per cent in 2011 and 1.9 per cent in 2012. Most analysts are very sceptical about this forecast, since sustaining any kind of GDP growth under the present circumstances will be hard, and I think the most realistic expectation is that the Greek economy will see some sort of annual contraction during each of the three relevant programme years.

Secondly, to keep the debt GDP level from snowballing Greece needs inflation. But to get GDP growth Greeec needs to restore competitiveness, and this means (given they have no currency of their own) price and wage reductions (ie the so called internal devaluation) so they will have deflation not inflation, or they will not "correct" and move towards GDP growth.

Thirdly, and this one is easier: Greece needs to reduce the bond spread to keep interest rates on the debt as low as possible. This is doable, should Greece be able to convince market participants a viable correction plan is being operated. The ECB could also play a role here. But Monsieur Trichet, in his wisdom, said two things which were relevant in the post-monthly-meeting press conference yesterday. In the first place he said, quite correctly "we are here to help" - which I read as meaning that he is saying to the Greek government that "you take the steps you need to take, and we will help with liquidity", but on the other hand he also said "we will make no exception for individual countries" in setting our collateral rule, which effectively means that (from 1 January 2011) should Greece lose it's A2 status from Moodys (by two notches), the ECB will not be able to accept Greek bonds.

The first statement clearly offers support to the Greek spread, but the second (which might lead people to think they should start to steadily remove Greek sovereign debt from their portfolio) obviously wasn't.

It was hardly surprising then that the yield on the 10-year Greek government bond remained above 6.1% this (Friday) morning, up around 0.2 percentage point from early Thursday. The yield stood some 2.79 percentage points above the yield on the comparable 10-year German bund, the euro-zone benchmark, up about 0.25 percentage point from early Thursday. The spread even widened as far as 2.9 percentage points at one point yesterday, following the ECB meeting, and details of the Greek government's budget plan.



So basically, to make Greek debt to GDP dynamics sustainable, and avoid the snowball effect, my guess is you need two things:

a) to convince investors that Moody's will not downgrade, or some that some other form of support will be offered to the country.

b) some solution to the restoration of competitiveness dilemma. Basically, at the moment the Greek government has no interest in carrying out an internal devaluation, since the deflation impact on the debt formula would simply precipitate the snowball. But if they don't carry it out the economy will not return to growth, and investors will lose confidence and the bond spreads widen again, effectively setting off the snowball via another route.

So there needs to be a quid-pro-quo here, where the EU authorities undertake to restructure Greek debt in some way via the use of (eg) EU bonds (the famous bail-out) should Greece comply with a certain number of specified conditions first. Now many will scream at this point, "well they got themselves into this mess, now let them get themselves out of it". But matters are never that simple. Greek sovereign debt is in part a by-product of the eurosystem experiment, which made the accumulation of such debts at apparently cheap rates of interest possible (although none of those responsible for overseeing the system seem willing to recognise this). The Greek people have to accept their share of responsibility for the mess, and for the behaviour of their elected representatives. But there should be a limit to the "financial penalty" imposed. As Martin Wolf says in the Iceland context:

The final and, in truth, most important question is whether these demands are reasonable. After all, in every civilised country it has long been accepted that there is a limit to the pursuit of any debts. That is why we have introduced limited liability and abolished debtors’ prisons. Asking a people to transfer as much as 50 per cent of GDP, plus interest, via a sustained current account surplus is extraordinarily onerous.

In fact, asked in a Reuters poll carried out between January 11-14 what they felt was the the probability of Greece actually seeking a bailout this year, the median response from around 30 analysts that they would was 20 percent, with the same likelihood being expressed that it would be necessary at some point in the next five years.

This is not a very high probability at this point, but then when the same sample of analysts was asked about future ratings decisions, some 16 of the 27 analysts involved said they thought Moody's Ratings Service would downgrade its rating from A2 to a below-A rating by the end of the year. This is a much more significant result.

As it happens, I personally don't agree with either verdict, since in the first place Moody's are concerned with long term sustainability, so I doubt they will change their view on that one this year if the Greek government follow an agreed EU programme, while I do think (for the reasons expressed above) that some sort of Greek "bail-out" will be necessary over the next five years (to stop the snowball) if the government does what it has to do.

But all of this only serves to highlight juest how precarious the Greek situation actually is, in particular since the government still haven't accepted the need for internal devaluation, which is the only policy which will really restore growth. With a majority of analysts thinking Moody's will move to a below-A rating by the end of the year, and Monsieur Trichet saying that as of 1 January 2011 the ECB will not accept such bonds as collateral for lending, something, somewhere is likely to give, which is why I think the Greek government should at this very moment be throwing itself into the welcoming arms of the IMF before matters reach the point of no return on the spreads and the debt snowball. To do otherwise would be to risk far greater problems in a future which will not be that far away.

Will She....Won't She? The Greek Government's "Latin Tango" With The IMF

Well the wires are really alive this morning. Greece is receiving a visit from the IMF today. The meeting was scheduled well in advance, but that doesn't mean the agenda was.

A team of International Monetary Fund officials arrive in Greece today to aid the government in its efforts to tame Europe’s biggest budget deficit. The mission, “within the context of the regular surveillance that the IMF provides to its membership,” will help the government with “pension reform, tax policy, tax administration and budget management,” a spokeswoman for the Washington-based lender said in an e-mailed statement yesterday.

Really we have what is know as a "fluid" situation right now, and no one seems to be very clear about what happens next. The IMF arrive in the wake of an Athens visit by EU and European Central Bank officials last week (to discuss the government’s plan to be submitted to the EU before the end of the month), and EU President Herman van Rompuy is also scheduled to visit today. It is hard to know what the outcome of last week's visit was, but press reports speak of the delegation pushing Greece to adopt tougher measures to cut the fiscal deficit.

It is however very important to understand that the issue in Greece is not simply one of reducing public spending to rein-in the deficit. The underlying problem is the external deficit (15% of GDP current account deficit) and the distortions in the economy and loss of competitiveness that this reflects. Simply cutting the fiscal deficit without addressing these issues will not reduce the government debt to GDP ratio, and may well actually increase it. It is the sustainability of Greek finances in the longer term that is the issue, and the only way of putting government finances back on a sustainable path is to return growth to the economy, and the only way to do that is to carry out an internal devaluation.

This is one of the principle reasons that I personally am arguing of the the IMF to take Greece into its arms now. Basically, I fear the Greek government itself is far from convinced of the necessity for the measures it needs to take, and a government which is itself not convinced will prove incapable of convincing a citizenry who still remain substantially in the dark about why what is about to happen needs to happen. The IMF is the only institution which I can see available at this point to oversee the process with the firmness which will be needed.

Olli Rehn Fails To Convince

What is required of Europe's leaders at this point in time is some clear speaking, and this is exactly what we are not receiving. Asked by the Catalan MEP Ramon Tremosa (CDC) during his confirmation hearing yesterday whether he intended to put in place the kind of mechanism which IMF European Director Marek Belka has been calling for Rehn fought shy of an outright commitment to direct means of compulsion, and suggested that the desired result could be achieved by using “incentives” to encourage states which found themselves in difficulty to move toward compliance adding that there was a need for “broader surveillance”. But he did pledge to use “all instruments” to help member states restore their finances and come into compliance with the terms of the stability and growth pact, so I imagine that we are still talking about a "fluid situation" whose actual significance will only become clearer at the February EU summit. It could simply be that in order to get the 2020 plan consensually agreed Olli Rehn is putting the emphasis on incentives rather than coercion, but it must be evident that the means of coercion must be there if needed, and this must be clear to all, and in particular to the electors who vote-in those otherwise wavering politicians.

Certainly Spain's leader José Luis Zapatero hasn't made things easy for Rehn, as he seems to have bungled matters yet one more time in the present case, and his proposal that the EU should adopt "biting economic safeguards" only met with a full frontal rebuttal from German Economy Minister Rainer Brüderle, who on being interviewed stated he was opposed to what he described as plans by the Spanish EU Presidency to "sanction" member states who do not comply with the European Union's "growth objectives".

Basically this confusion is all Zapatero's fault, since he presented the proposals as a move to set binding economic goals for member states under the coming 10-year plan to boost growth and competiveness, and called for corrective measures for those that do not comply. The 2020 strategy is intended to replace an earlier plan (the Lisbon aganda) that has manifestly failed in its goal of making the EU the world's most competitive economy by 2010.

"It's absolutely necessary for the 2020 strategy [...] to take on a new nature, a binding nature," Zapatero told reporters in Madrid one week after Spain began its six-month EU presidency, a mainly organisational role in which it can influence policy. He made clear he had not secured the agreement of other member states to make the economic goals binding under the 2020 strategy, but called for such proposals to be discussed at an economic summit in Brussels next month. "The informal summit on 11 February must bring up, in my opinion, measures including incentives and corrective measures for objectives set out in our economic policy," he said. "European competitiveness depends on two words - unity and competitiveness. European unity and a competitive economy."

All of this is really a complete confusion. The "binding measures" are need to reinforce the Excess Deficit Procedure which is applied under the Stability and Growth pact, and to give the right to the Commission to oversee the necessary structural reforms and internal devaluations. They are not needed to police growth targets which may or may not be realistic. No wonder the German economy minister got irritated. These measures are likely to be used against Spain, not Germany, and the growth issue only arises in the context of enforcing the SGP, since for those countries who enter a negative debt dynamic, a return to growth is essential, if default is not to be come inevitable.

Greece Is Not Argentina, Yet

Moving now from the ridiculous to the even more ridiculous, Desmond Lachman has an article in the Financial Times this morning entitled Greece looks set to go the way of Argentina.

"....much like Argentina a decade ago, Greece is approaching the final stages of its currency arrangement. There is every prospect that within two to three years, after much official money is thrown its way, Greece's euro membership will end with a bang."

This is nonsense, at least at this point. At this moment in time no country is either near, or even remotely near leaving the Eurozone, and I'll tell you why. If Greece's Eurozone membership ends with a pop (or even a whimper) that wouldn't be anywhere near the end of the matter, since Spain would come hurtling right along behind, producing in the process the largest external debt default in recorded history, and the most likely aftermath would be that the whole Eurozone would end with a bang (with totally unknown consequences for the global financial system). So, quite simply, we cannot let that happen. Greece would not be Argentina (which was, after all the shouting, a mere financial pinprick). Greece could potentially be a much more serious matter than Argentina ever was.

I repeat, the issue is internal devaluation, and enforcing it. And if we can't do it in the Greek case the markets would be quite entitled to draw the conclusion that we won't be able to do it in the Spanish one.

The basic problem is returning the key countries to a sustainable growth path. As Standard & Poor's stated when they took their recent decision to lower their ratings outlook on Spain, the reason for the change was the probability that the country will see "significantly lower" gross domestic product growth and "persistently high fiscal deficits relative to peers over the medium term".

Personally I find nothing especially exaggerated in this judgement. S&P's preoccupations seem valid, and widely shared, among others by the technical staff who prepare forecasts for the European Commission. The issue is not that Greece and Spain are on the verge of default, but that it would be dangerous to allow the situation in these two countries to deteriorate further. Reducing the level of external debt has to be one of the top priorities for both the Greek and the Spanish administrations, and it is clear that the only way to do this is by exporting more, importing less, and running a trade surplus. This is what the whole issue of restoring price competitiveness is all about, and since Spain no longer has the means to carry out a conventional devaluation the technique known as internal devaluation is the only one presently on the table and able to do the work in the time available.


So the immediate issue is not the inability of Greece and Spain to repay their external debt, but the fact that anti-crisis measures that simply have the effect of pushing up both the external debt to GDP ratio and the government debt to GDP one are hardly a helpful contribution. Both countries need to correct their external imbalances, not increase them further. What the Greek and Spanish governments need to apply are not policies which simply allow their countries to limp along from one year to the next, but reform measures which help them straighten out all the distortions which have accumulated during the course of the property bubble.


Obviously it would be proposterous to compare Spain's fiscal situation with that of Greece, and indeed I know no one who has actually suggested that this is the situation. The concern being expressed is not that Spanish finances are on the verge of bankruptcy, but rather that the level of government debt to GDP is rising very rapidly, and that unless growth is restored to the economy the sustainability of public finances will become a problem in the longer term. According to the most recent EU Commission forecast Spanish gross government debt to GDP is set to rise from 39.7% in 2008 to 74% in 2011.

The situation with unemployment and job creation is similar. José Luis Zapatero has at long last publicly recognised that Spanish unemployment will only start to fall in 2010 (and not 2009 as previously forecast). The only problem with this is that outside Spain no one seems to recognise this seemingly good news, since the EU Commission and the IMF both maintain their forecasts for no improvement in unemployment in 2010 or 2011. In fact the forecasts for growth in GDP are still so low for 2011 (1% in the best of circumstances) that it will obviously be impossible to create increased aggregate employment if there is even a minimum level of productivity improvement.

Let us be clear then: the number one topic facing the Spanish government is how to restore growth to the economy. All the policy measures applied up to now have evidently failed to achieve this end. And now, following pressure the European Union to change course, Spain is going to have to increase taxes and reducing spending, while interest rates are likely to start to rise slowly. Far from adding momentum to the economy, all of these developments will simply serve to reinforce the recession, driving the level of GDP further and further downwards, and of course debt to GDP levels further and further upwards.

Evidently the Spanish situation is not yet as severe as the Greek one is. But risks abound. In the first place, and as Olli Rehn says, what happens to Greece is vital importance to Spain.

“The problem in Greece concerning the excessive deficit and rapidly rising debt is a very serious one,” Rehn said. “It has also potential spill-over effects for the whole euro zone.”

But risks to Spain are also accumulating inside the country itself, in particular in the form of the large stock of unsold houses the banks effectively are taking onto their balance sheets, houses whose value are effectively an unknown quantity. There are an estimated one and a half million new properties in Spain awaiting a buyer. Some of them are on bank balance sheets after being accepted in debt for property swaps. But far, far more are indirectly on their balance sheet via loans to property developers which will eventually be defaulted on. Many of these loans are continuing to be restructured, with developers generally now unable to afford even the interest payments, which are tending to get "rolled over".

And now a new threat is looming: the rising rate of repossesions that the banks will need to accept in 2010. According to a recent article in the Spanish daily Publico - as reported by Spain Property Insight's Mark Stucklin - Spain's banks will have to cope with between a further 100,000 and 150,000 repossessions which are likely to come to a head in 2010. Many of these foreclosures started as far back as 2008, but have been delayed by overloaded courts unable to process the avalanche of repossession demands. From now on these foreclosures will be the “biggest problem for the banks” according to one real estate professional quoted in the article.

And the situation has become even more complicated, since the banks now find it very difficult to take such properties to auction, for the simple reason that the people who are normally there to buy them - the subasteros - are unable to get the credit from the banks that they normally use to buy with.

As Mark points out:

The big question is what impact this new batch of repossession – the equivalent of 15% to 20% of the current inventory of property for sale – will have on the market. Unable to sell at auction, the banks might end up offering them for sale at their write-off values. The danger is that an avalanche of these properties dumped on the market at write off values will send the market into a spin, with prices falling another 20% to 30%.

So, my final point is, we should not take the idea that the Eurozone is not about to fall apart as a reason for being complacent. Risks abound, and are painfully evident. And what we now need from Europe's leaders is action, more action, and yet more action to establish clearly in everyone's mind that they are aware of the task in hand, and are up to the job of carrying it through.

Stark Raving Mad?

Not necessarily, but he is causing one hell of a fuss today. The Stark in question here is, of course, ECB Executive Board member Juergen Stark, who stated in an interview with the Italian Newspaper Il Sole 24 Ore that, in his opionion, the European Union would not help bail out Greece if the need were to arise. Certainly the initial reports of his statements sent shock waves round the globe. The euro dropped as much as 0.5 percent to $1.4282 after the remarks before laterrecouping its losses, and the yield on Greece’s 10-year government bond rose 4 basis points to 5.672 percent. Essentially it is hardly surprising that this should be the case, since following what happened in Dubai, two questions seem to have been in the forefront of investors' minds: i) who is going to pay for all that surplus second residence property that has been built all along Europe's periphery (from Ireland, to the Baltics, to Hungary, to Bulgaria, to Greece, to Sovenia, to Spain, and to Portugal); and ii) are the core European states really going to prop up the peripheral ones (in extremis) or will they follow the example of Abu Dhabi, and pick and chose what they will support and what they won't. More than anything else it is uncertainty on these two points which lies behind all the earth tremors currently shaking the monetary union.

In the interests of clarity, and before commenting further, I am reproducing the relevant extract in its entirely below, first in Italian, and then as a rough and ready English translation.

Il Sole 24 Ore: Il caso Grecia continua a tenere banco, nonostante le assicurazioni di Atene su una rapida riduzione del deficit. Non crede che un salvataggio debba considerarsi necessario o forse anche inevitabile?

Juergen Stark: La Grecia è in una situazione molto difficile: non solo il deficit è a livelli molto elevati, ma il paese ha anche sofferto una grave perdita di competitività. Questi problemi non sono legati alla crisi globale, ma sono stati creati in casa. E devono essere affrontati con le dovute misure economiche nell'interesse dei cittadini greci e nel rispetto delle responsabilità che il governo ha nei confronti della moneta unica e dei paesi partner. Le regole, ribadite in una dichiarazione dell'Ecofin a Cardiff nel 1998, sono chiare: la partecipazione all'Unione monetaria non consente alcun diritto a rivendicare sostegno finanziario da parte di uno Stato membro.

Il Sole 24 Ore: Ma appartenere all'Unione monetaria non significa anche solidarietà, oltre che responsabilità? Gli stessi Trattati permettono «un'assistenza finanziaria» nel caso di «gravi difficoltà» e in «circostanze eccezionali».

Juergen Stark: È vero, ma i Trattati dicono anche che queste circostanze devono «sfuggire al controllo» del paese in questione. Non è il nostro caso. Come ho appena detto, i problemi della Grecia sono prettamente greci, come ha ammesso lo stesso premier George Papandreou. In questi anni, il paese non ha tenuto sotto controllo i conti pubblici, né ha lavorato per migliorare la competitività. I Trattati prevedono la clausola di non salvataggio e le regole vanno rispettate. È un aspetto cruciale per garantire il futuro di un'Unione monetaria tra paesi sovrani con bilanci nazionali. I mercati si illudono quando pensano che a un certo punto gli altri Stati membri metteranno mano al portafoglio per salvare la Grecia.

Il Sole 24 Ore: The Greece situation continues to be a focus of attention, despite assurances from Athens on a rapid reduction in the deficit. Do you not believe that a rescue might be considered necessary or perhaps even inevitable?

Juergen Stark: Greece is a very difficult situation: not only is the deficit very high, but the country has also suffered a serious loss of competitiveness. These problems are not related to the global crisis, but were created in-house. And they must be addressed with appropriate economic measures in the interests of both Greek citizens, and with respect to the responsibilities that the Greek government has with both the euro and its EU partners. The rules, as set out in an Econfin statement in Cardiff in 1998, are clear: the monetary union does not allow any right of any Member State to claim financial support.

Il Sole 24 Ore: But doesn't belonging to a monetary union also imply solidarity, as well as responsibility? The very same treaties allow "financial assistance" in case of 'serious difficulties' and 'exceptional circumstances'.

Juergen Stark: True, but the treaties also say that these circumstancesmust be "out of control" of the country in question. Is not the present case. As I just said, the problems in Greece are purely Greek, as was admitted by the Prime Minister George Papandreou. In recent years, the country has not kept public accounts under control, nor has it worked to improve competitiveness. The treaties provide for a "no bail out clause" and these rules must be respected. This is crucial to ensure the future of a monetary union between sovereign countries with separate national budgets. The markets are deluded if they think that at some point the other States will put their hand in their wallets to save Greece

Well, a lot of points arise here. In the first place the ECB simply is not the competent authority to take decisions on whether or not to bail out a country. Decisions of this order would need to be taken by the EU Council (which essentially means the collectivity of individual States) and would involve financial intermediation in which the ECB may or may not participate. Secondly, Juergen Stark is an elected politician, and his view do NOT necessarily represent those of the present German government

As Laurent Bilke, economist with Nomura International says:

"ECB officials tend to consider themselves as the guardian of the temple of fiscal discipline, but Juergen Stark pushed maybe the argument a bit far this time. The ECB is just not in the business of bailing out countries. It is not competent to dispose (or not) of EU states, European Commission or IMF funds. Juergen Stark also sounded more alarmist than his fellow ECB colleagues have recently and this may not be very opportune in the current context. That is hitting where it hurts. The ECB President, in contrast, stressed that he was confident that the Greek government would do what is required, a more positive message."

But there is another detail which most of the press corps who jumped on the story seem to have missed, and that is that a bail out is not in question at the present time, and even if it was, EU institutions would find solutions to go round the problem, like a joint Eurobond issuance or some appropriate funding from the European Commission. Further, it is very important to note that Juergen Stark does not rule out common support in a country where the situation had gotten "out of control". This may, or may not, happen at some point with Greece, the only real reading you can put on Stark's statement is that we haven't gotten there yet. He could also be seen as giving a warning shot to the Greek authorities in the current situation - "sort the problems out yourselves".

Certainly Greek Finance Minister George Papaconstantinou seems to have got that part of the message, since he was very quick to jump in and point out that his government doesn’t need outside help to cut its budget deficit. “Frankly we don’t need that clarification,” Papaconstantinou told Bloomberg Television. “We don’t expect to be bailed out by anybody as, I think, is perfectly clear we’re doing what needs to be done to bring the deficit down and control the public debt.”

But doubts still remain, since while Papaconstantinou talks about correcting the budget deficit, everyone else is talking about deep structural reform and restoring competitiveness, and it isn't clear that the Greek government is single-handedly able to assume responsibility for this inside the country. As Jonathan Tepper of Variant Perception puts it:

The problems Greece faces are not problems the ECB can solve. Greece's problems are problems relating to competitiveness, real effective exchange rates, and fiscal budgets. The Greeks must address these structural problems themselves. If they were to seek outside help, the IMF would be the logical organization charged with helping countries in fiscal binds that are making structural adjustments. The ECB simply doesn't have the power or ability to do that. I'm afraid we'll likely see more internal civil unrest, as the necessary adjustments for Greece will be painful.

Mark Pittaway, Senior Lecturer in European Studies at the UK Open University goes even further, by adding a CEE dimension:

"If the zone does lock weaker economies into 'competitive disinflation' vis-a-vis an export-oriented Germany, why is it in the interests of 'peripheral countries' to say in the Eurozone at all? Why is it in the interests of CEE countries to attempt to join in the first place, since if Martin Woolf is right, it would mean Hungary and other states abandoning their long-term goal of having living standards like those in western Europe?"

"Given that political legitimacy in many European states is all about welfare, and 'European' legitimacy is about the alleged social superiority of a 'European model' over its Anglo-Saxon equivalents (whether this is actually true is irrelevant, the point is that many European believe it to be true), then the potential size of this crisis is quite big. And one thing is clear, that Brussels and others will have to do some fairly serious re-thinking if they want to go forward."

Basically, personally, I haven't that much to add at this stage to what I said yesterday, the big difficulty we have right now is making it clear who is authorised to do what, and then doing it.

Basically, what seems to be going on here is a huge poker-style game of brinksmanship, with none of the various parties (the Greek government, the EU Commission, the IMF, and the Credit Ratings Agencies - to name but a few - really absolutely clear about what the others are up to, or what they really want. You could even add-in more “stakeholders” (in terms of parties who will have to assume ownership of any final agreement) if you want, the French and German governments, for example, the EU Finance Ministers, the Greek Socialist Party, the Greek Trade Unions, the list, in fact, is well nigh endless.

This is really far from a desireable state of affairs for a team of people who collectively are going to have to try and solve one of the most complex problems to have emerged from the recent economic and financial crisis, and do it quickly, since there is a clock ticking away in the background. Evidently the Greek government should be having to negotiate with everyone else, but the others should have one common voice, and this is far from being the case, which is what leads to all the confusion, and is why Belka says the EU needs to put a mechanism in place to handle this kind of situation - a uniform mechanism which treats all EU members - whether inside or outside the Eurozone - fairly, and where the rules and procedures are clear to all. This mechanism, should, as I have suggested, include powers for the EU Commission to intervene over the heads of national parliaments (a need which is already evident in the Latvian case), and implement hard and unpopular solutions when they are in the interest of the entire community of Europeans. We cannot have one minority interest after another playing themselves off against the rest, it makes the Union harder to manage than a “hung” parliament.

Actually the FT's Ralph Atkins turns this amibguity into a virtue:

"Mr Stark’s comments fit with Europe’s policy of “constructive ambiguity” towards Athens - by which policymakers are deliberately being vague about what would actually happen if the worst came to pass. Pressure is thus being maintained on Greece to make good its pledges of fiscal discipline."

I am not convinced, I think all this ambiguity is more disconcerting than it is constructive, it isn't like keeping markets guessing before a rate-setting meeting. I think what everyone needs is some assurance that EU authorities are aware of the depth of the problem, have solutions ready, and are hell bent on implementing them. That is the message the financial markets need to hear, and they need to know who is going to be leading this operation.

Finally, I want to emphasise that my argument here shouldn't be read as saying that I don’t wish the EU was equipped to do the necessary and start to shoulder responsibility for Greece. My view is a more practical one: I simply think the EU is not yet sufficiently prepared to go in and tell Greece what to do, in part because Greece are one of the old EU15 and this makes everything more difficult. I simply think it is more practical to get the IMF go in and do the job. You don’t want “good boys” here, you need “nasty people”, with smoothly polished teeth, and indirectly this could give a weak Greek government the strength it needs to sell the changes to a reluctant citizenry.

It’s like taking a child to the dentist. Maybe they scream when the drill comes out, but ultimately they need the filling. But I also accept that the IMF has no magic bullet. I do however hope that the IMF is capable of learning from its recent experiences in the East.

One of the key issues which clinches it for me is the collateral rating issue. Do the ECB say no Greek bonds after the next downgrade (this certainly will cause some chaos, since half Greek bonds are held out of Greece)? It would be chaos, but it would be manageable. Or should the ECB keep the lower level criteria - then what happens to Italy, since this rule was made for Italy, and never forget, Italy is also slippin-and-a-slidin steadily into the default danger zone?

The thing is, my view is that the problem of not having the ECB take your bonds does become a serious one, since it will make it much more difficult to sell debt, interest rates rise, GDP falls, nominal GDP falls further, and debt to GDP keeps rising, as a result of which interest rates rise further, and eventually there is no alternative to default. On the other hand, if the ECB say don’t worry, we will take the bonds anyway, then there is little incentive to do anything, as we have seen over the last decade.

In essence, were the IMF managing a programme in Greece, then the ECB could make an exception, and then say to Italy - “you want to be an exception, then go to the IMF first, or better, put your house in order before you are forced to do so".

Danske on Eurozone Debt - The Peril of Internal Devaluations

Guest Post by Claus Vistesen (Alpha Sources Blog)


This is really a follow-up to the earlier piece I wrote on my own blog today and my last piece on Eurozone imbalances and internal devaluation. In particular, I want to point you towards two things. Firstly, Edward has, no doubt after a long hard thought, come to the conclusion that Greece should be sent to the IMF or rather that it is ok to ask the fund for help in order credibly sort out the mess in Greece (and possibly Spain). This is not news as such since the proposition of sending ailing Eurozone countries to the IMF has been on the table for a while now. The main question basically is, as it has always been, whether the program proposed by Greece in conjunction with the EU and set in relation to what ever we might have left of the stability and growth pact (SGP) is really credible as a working solution.

Meanwhile, Danske Bank had a very interesting research note out today on the sovereign situation in the Eurozone and the potential for correcting not only in the immediate short term (i.e. preventing a collapse), but more importantly how to get debt to GDP ratios back on a solid footing within, let us say, a decade or so. As it turns out this is very difficult.

These are challenging times for public finances across Europe. Reducing debt to the Stability and Growth pact’s upper limit of 60% of GDP will not happen any time soon for most euro area member states. Indeed, even 100% of GDP appears an immense task for several countries. The situation is most dire in Greece and Ireland, which are to be found in the fast track lane for default in our mechanical “no change scenario”. However, it is still not too late to avoid default. If the plans put forward by Greece and Ireland are strictly adhered to, it would stop the debt-to-GDP ratio from sky-rocketing.

Now, Danske Bank's argument is based on some simple algebra of the government's budget constraint and some equally simple, one would presume, arithmetic. Basically, the gist is as follows and for all the attacks on Neo-Classical economics accounting, this argument is actually pretty solid.

Therefore, high nominal GDP growth and low interest rates on sovereign debt allow a country a larger deficit-to-debt multiple without increasing the debt-to-GDP ratio. A country with nominal growth lower than the interest rate level will on the other hand have to run primary surpluses in order to keep the debt-to-GDP ratio steady.

This is an important point to take away. Basically, it means that if you can maintain a high level of nominal growth (and what ever amount of primary deficit you run (in principle!)) the debt-to-GDP ratio can be kept in check. Well, we need to entertain this possibility a lot here I think and simply note that this is not likely to be relevant for many of the Eurozone economies going forward. This goes especially for those who are in the biggest trouble right these very days. In fact, the whole rigamole begins by taking to heart chart 4 and 5 in Danske's research note which shows that while Eurozone economies, in a pre crisis context, enjoyed high GDP growth (nominal) and low funding costs it is expected to be the exact opposite going forward.

This represents a gordian knot since it means that not withstanding the extremely tough austerity that Greece, Ireland and Spain (etc) now need to take in order to get the ship back into the wind through forced primary deficits, they cannot be sure that this in itself will bring the debt to GDP back on track. Much will of course depend on global yields here and the general discourse on fiscal adjustment and how sovereign risk (rising across the board) will quantitatively be reflected in bond yields.

Yet, I don't want to focus so much on bond yields here (although I do think they are important); rather I would like to focus on the other part of the equation as it were, namely that of nominal GDP. You see, this is where it not only gets complicated but also outright problematic. Consequently and since Greece, Spain, and Ireland are members of the Eurozone, the have no independent currency and thus the nominal exchange correction that would almost certainly had occured had these economies had a floating exhange rates now must occur through internal devaluation or outright price deflation.

So this is not only about public debt but also about net external borrowing which these economies now have to shed in order to become competitive and essentially in order to achieve growth in nominal GDP. However, in order to reach this point they need a large and severe bout of deflation exactly, one would imagine, brought about in part by running primary surpluses to simply shock-force the economy onto a more sustainable path. Notwithstanding the obvious cost on the employment from this process it has another very tangible costs. Price deflation thus, through its effect on nominal GDP, increases the real value of the debt and it is exactly this mechanism and how it intersects with the perspective offered by Danske Bank which is so damn important to understand here. And incidentally, as an aside, it is this point which Edward has been desperately trying to pass on during the past two month's worth of writing (see overview from link above).

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PS1: I am lining up a paper on Eurozone imbalances (quantifying them essentially) which will also tackle the issues mentioned above in some detail.

PS2: Danske Bank's piece is worth reading in its entirety.

The IMF Is Ready To Help Greece If Asked - So Why Not Ask Them?

"The EU should create a mechanism to help out countries which found themselves in Greece's shoes. But one has to believe Greece will solve its problems by itself." This is the view expressed by Marek Belka Director of the IMF's European Officein an interview with Reuters last week. Asked whether the IMF would be ready to help bail out Greece, Belka said: "Yes, we are ready. But it depends on whether the EU or Greece will request it."

In a separate interiew with IMF Survey Magazine (worth reading in its entirety) Belka cites Ireland and Spain as “good examples” of countries with “homemade imbalances” based primarily on “real estate and asset price bubbles”. As he points out, Ireland and Spain (unlike Greece) entered the financial crisis with “relatively low levels of public debt”, something which has enabled them “to react to the crisis by using the fiscal space that they had accumulated in good times”. “Now of course, both countries have been forced to start fiscal consolidation". And since, “In a monetary union, depreciating your economy out of the crisis is not an option...countries must rebuild their competitiveness through factory-price adjustment, which often means unfortunately, cutting wages.” He thus essentially reiterates the central point that Paul Krugman, I and numerous others have been making about this situation.

No Clear Decision Taker

So, as members of the ECB and EU delegations board their plane on the way to Athens tomorrow, they will have plenty of things to be thinking (and worrying) about. Basically, what seems to be going on here is a huge poker-style game of brinksmanship, with none of the various parties (the Greek government, the EU Commission, the IMF, and the Credit Ratings Agencies - to name but a few - really absolutely clear about what the others are up to, or what they really want. You could even add-in more "stakeholders" (in terms of parties who will have to assume ownership of any final agreement) if you want, the French and German governments, for example, the EU Finance Ministers, the Greek Socialist Party, the Greek Trade Unions, the list, in fact, is well nigh endless.

This is really far from a desireable state of affairs for a team of people who collectively are going to have to try and solve one of the most complex problems to have emerged from the recent economic and financial crisis, and do it quickly, since there is a clock ticking away in the background. Evidently the Greek government should be having to negotiate with everyone else, but the others should have one common voice, and this is far from being the case, which is what leads to all the confusion, and is why Belka says the EU needs to put a mechanism in place to handle this kind of situation - a uniform mechanism which treats all EU members - whether inside or outside the Eurozone - fairly, and where the rules and procedures are clear to all. This mechanism, should, as I have suggested, include powers for the EU Commission to intervene over the heads of national parliaments (a need which is already evident in the Latvian case), and implement hard and unpopular solutions when they are in the interest of the entire community of Europeans. We cannot have one minority interest after another playing themselves off against the rest, it makes the Union harder to manage than a "hung" parliament.

Timing As Well As Content Will Be Important

Problems and confusion at this point abound. In the first place, we still have no clear indication of what the final 2009 fiscal deficit number is going to look like. There has been a lot of speculation in the press, and little in the way of denial, so it seems to be the case that it will be above 12.7%, but exactly how much above may be just what those EU representatives are on their way to discuss.

In principle Athens submitted the first version of its budget report - known as its Stability Programme - to the European Commission yesterday (4 January), and it will be the content of this report that the ECB and EU Commission representatives will be travelling tomorrow to discuss. At this stage what the Commission have is a draft version for negotiation (there seems to be some doubt that this draft was even sent, but then some documentation must have gone to Brussels for them to talk about on Wednesday) and ammendment. The final plan will more than likely be submitted at the end of the month, after being discussed by the Greek cabinet on January 15 and put to the Greek Parliament on January 20.

According to the web portal Capital.gr there are three measures that both the European Commission and the European Central Bank seem to be insisting on: increasing VAT by one or two points, increasing the age limits for retirement and a continuing wage freeze until the deficit is brought below 3%. But according to the website, none of these is included in the Greek Stability Programme that was sent to Brussels. According to their report, "Greek officials will meet in Athens with EU executives to agree on the starting point, that is on the deficit level for 2009... Eurostat in January will also decide on the height of the deficit", which seems to suggest that the report I cited yesterday that even the 2009 deficit level (we are now in 2010 remember) forms part of the negotiations, a hypothesis which the ongoing silence from the Greek authorities only add credibility to.

In principle the eurozone finance ministers will discuss the outcome of the negotiations at their regular monthly meeting on 15-16 February, but apparently EU President Herman Van Rompuy has just "upped-the-ante" by calling an extraordinary meeting of Europes leaders for 11th February with the only topic - Europe's economy - on the agenda. This evidently on adds to the pressure on Greek Prime Minister Papandreou, since the purpose of the meeting is to allow the various countries to present their exit strategies from the crisis.

The Greek government is increasingly under siege, and the latest indication of this is their decision today to cut the adjustment period from four to three years, and reduce the country's deficit below 3% by the end of 2012. Obviously such decisions are not trivial, and not taken lightly, since the correction involved is rather large - basically the decision means that the Greek Finance Ministry will now need to “pull” between 24 and 25.5 billion euros out of the economy in three years. No mean feat this, even for a Herculean politicians like Papandreou. But the core quest still remains unresolved: it is not the velocity of the fiscal correction which is at issue, but its depth (in terms of structural character), and the fact that it should be associated with a substantial economic correction, capable of putting economic growth back on a sound footing.

Too Much To Do And Too Little Time To Do It In

Let's look now at why what is being proposed is likely to be quite hard. In the first place the Greek economy - before entering a direct body slam with the global economic crisis - had been growing at an average rate of something like one percent a quarter (or around four percent a year). Which looks like a pretty good performance, until you start to think about how they did it.



As can be seen in the following chart, the steady rise in Greek output was being fuelled by a surge in government spending (see chart below) and this gave the impression that the impact of the global crisis was slight, which it was initially, due to the massive support the government was providing, unsustainable support if you look at Greece's overal growth and debt dynamics.



In addition this extra demand being provided by the Greek government was doing nothing to resolve the underlying problem - which is the lack of competitiveness of Greek industry -and was simply sucking in imports to fuel the country's large current account deficit.


But the other part of the equation here is that Greek private consumption has also been losing momentum in recent years - a not infrequent phenomenon in countries with ageing populations, and thus it is unlikely that the Greek economy is going to see any strong internal impetus from this source in the years to come.




In fact bank lending to households, after growing at an rate of around 20% per annum over an extended period, is now down to an annual increase of only 3.9% (in October) and is still falling (see chart).



This is not due to s shortage of liquidity, since liquidity is now abundant in the Eurozone, but due to a lack of demand and unwillingness on the part of banks to risk lending to people with the kind of employment and income profile to be found among those asking for credit at this point in time (ie people with debts, or unemployment, business problems etc). On the other hand, since Greek government bonds are, at least at this point, effectively guaranteed by the Eurosystem, lending to government has naturally boomed.


So here is the problem. The Greek government is going to rein-back some 20 billion euros plus in spending over the next three years in a way which will only fuel the existing contraction. Consumer demand is unlikely to revive, and capital spending and foreign investment are likely to continue to remain weak (see chart below). So everything will depend on exports, and on how long it takes to return competitiveness to the Greek economy. If other countries who have embarked on this path in the last couple of years are anything to go by, results will not be quick in coming, which means the economy will contract, and prices will deflate, while at the same time debt to GDP will surge. This is why the Greek economy will need to be wrapped in cotton wool in the coming years, and why the name of the IMF continues to be mentioned.


Mixed-Signal Mix-up

The big issue in the whole current Greek melodrama, is the one highlighted in the quote by Belka at the start of this post - the EU still lacks clear mechanisms to handle a situation like the present one, and this only leads to more and more confusion, as the name of the IMF gets constantly being invoked.

Obviously the excess deficit process is clear enough. Greece is currently up to the point outlines Art. 126(8) of the Excessive Deficit Procedure (most other countries still being in the Art.126(7) antechamber - for once Greece could be described as being in the vanguard). For Greece to avoid sanctions, it must present a set of credible measures aiming at correcting the deficit, early in 2010, which in theory are as outlined in the draft programme that should have been submitted today and then discussed before the 15th of January. Should an agreement fail to be reached, Greece would then move on to Art.126(9), which is the last injunction before sanctions are triggered. In the hypothetical eventuality that agreement is not reached the sanctions could be things like a) the publication of additional information before issuance of bonds and securities, b) a revision of the ECB policy regarding its loans to the country, c) the requirement of a deposit to be placed with the European Community, and c) ultimately, fines. But really, not of these are either appropriate or desireable in the present situation, although (b) is obviously a possibility, even if it would need to be used as a form of pressure to achieve some other kind of outcome - like Greece voluntarily going and asking for help from the IMF.

But basically this is a measure of last resort, since I am sure all parties want - at this point - to keep this as an "in house" affair. But we in the EU still lack mechanisms, which is why the IMF route cannot be totally discounted.

But it is this uncertainty about just how much the EU has in the way of teeth, and how far it is willing to go in using those teeth that causes part of the problem. It is clear that both the ECB and the EU Commission are convinced that some sort of serious intervention in the Greek economy is essential. The problem is how they convey to Papandreou and Pasok that they are convinced, and how they demonstrate - to Greece, other EU countries and the financial markets - just what their level of conviction is.

On the other hand, even though the ECB is currently talking tough, no one really knows how far they are prepared to go. The ECB is currently accepting bonds which at least one agency rates at BBB- or above, but this is a crisis measure set to expire at the end of 2010 when the previous threshold of A- will be reinstated. ECB Vice-President Lucas Papademos has insisted that the ECB will not hold back on the decision to return to the old collateral standards for the sake of just one country, but at this point few analysts seem convinced, and indeed the only think that really will convince them is if they do eventually implement their threat.

Another way of thinking about the situation is to work back from the end point to the present. If Greece is going to have a really hard time keeping that last A- rating (or A2 in the case of Moody's), and if the ECB really is serious about reintroducing the old collateral standards, then a rubicon is going to have to be crossed in 2010, since while the Eurosystem could undoubtedly cope with a situation where Greek bonds were not acceptable as collateral, this would not be a situation to be welcomed with open arms. So why not take decisions now which will avoid it. That is to say, I find it hard to believe that the Greek government is in any position to refuse the final offer the EU authorities will make to them, so why not include in the list of requirements that the Greek government go to the IMF to seek help. This would give a much tighter handle to the EU on what the Greek government actually gets up to, as well as getting them off the hook about the ratings issue - since Greece would effectively be guaranteed by the Fund, and hence an exception could be made. This is not a perfect solution, but it may be the best we have currently available. What we need to do is put that mechanism together, and do it fast, but in the meantime, let the words of Marek Belka not be lost: "Yes, we are ready. But it depends on whether the EU or Greece will request it."

Other background posts to this situation are:

That "Staggering" Greek Deficit Continues To Stagger Onwards and Upwards

Why The Ratings Agencies Are Right And George Papaconstantinou Is Wrong

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

That "Staggering" Greek Deficit Continues To Stagger Onwards and Upwards

Only a few short weeks ago the financial and economic world declared itself staggered to learn that the 2009 Greek fiscal deficit was going to come in at 12.7% (mind you, as the conservative Dutch newspaper NRC Handelsblad pointed out, there was plenty of evidence of what was coming available long before for those who really wanted to look into the matter). Well, now get ready to be staggered again, since according to a spate of articles that have started appearing in the Greek press, the number which only so very recently had us all reeling in shock may be on its way up again, if only by "a few tenths of a percentage point". How many "tenths of a percentage point?" Well at this stage this isn't exactly clear. On 28 December the web portal Capital.gr reported (in Greek, but try Google translator):

“Temporary (cash) data from the flow of government revenues have fallen quite substantially when compared to those of the last quarter of 2008,... not only data for October-November, but the first indications for December show that the delay in the flow of public tax income (mainly) is important. The Treasury has also begun to "mumble" about the possibility that the deficit in 2009 is going "to close a few decimals above the anticipated 12.7 %...". How many decimals? This is unknown at present, although the General Accounting Office (YPOIK) displayed some optimism that the gap will not exceed 0.1% - 0.2% of GDP (ie the deficit will remain below 13%) even if some do not hesitate to speak of a deficit of over 13% of GDP.”

So it definitely looks like the deficit is likely to be signed off at something over 13%, but according to this article (Greek again, I'm afraid) from "Ta Nea online" on 2 January, speculation is still rife that the breach in the 13% mark could be substantial, and that the final figure may even be as high as 14.5%. If it fear was confirmed, it should not really catch is completely by surprise, since it could well be that now that spending is not accelerating as it was before revenue may be contracting very fast (for a simple illustration of how diminishing stimulus - let alone negative stimulus - works, see this post by Paul Krugman), and with both GDP and prices falling (systematic deflation), the deficit as a % of GDP can easily shoot up. Then again, there are reasons why it might be politically convenient to "book-in" a larger deficit in 2009, in order to make next years cuts look a lot bigger than they actually are (you start from a higher base), so who really knows. Will the true Greek 2009 fiscal deficit please stand up!

The more interesting dimension in the Ta Nea article is all the potential for intrigue it goes into. Evidently, nothing here is ever what it seems to be, and the article speculates that there are those in Pasok (the Greek socialist party) who are wheeling out and using the threat of declaring a 14.5% deficit as a bludgeon with which to try and moral-blackmail Brussels. The thinking seems to go that Brussels cannot afford to let Athens go to the wall at this point, so they would not want to see the kind of pandemonium which might break out if the markets cottoned on to a deficit of this magnitude. On the other hand key people in the governing party don't want to accept the kind of deep reforms the Commission is talking about in the Greek case, so they want to trade a smaller budget deficit for a bigger proportion of one-off measures. But then there are even more wheels within wheels, since it seems Brussels is adamant that it wants to present the reform package as a largely "made in Greece" affair, while those in Greece want to sell the package to their voters as being imposed by Brussels, so there are those who think the 14.5% deficit menace is being cooked up simply to make the Commission furious and get it to read the trems of the riot act out in public. Naturally, protagonists of this viewpoint should remember that old Greek saying, "whom the gods would destroy they first drive mad", so they need to be careful. And as the other old English saying goes, playing around with primed bombs is a decidedly dangerous thing to do. Definitely not recommened.

Structural Reforms AND Internal Devaluation

The Greek parliament passed a 2010 austerity budget just before Christmas aimed at reining in the country's soaring deficit by cutting public spending by 10 percent and cracking down on tax evasion. The budget is the government's response to growing pressure after the three main credit ratings agencies all downgraded Greece’s debt. Prime Minister Papandreou has vowed to bring the deficit to below 9.4 percent next year, but doubts remain as to whether the need for fundamental reform has been accepted, or whether Greek politicians are simply looking to apply some cosmetics and ride out the storm. In theory the 2010 budget aims to cut the 2009 deficit to 9.1% of GDP in 2010 through a combination of spending cuts (€8 billion are currently planned) ) and tax increases.

However, the budget has already been criticized by both the EU and the ratings agencies for relying too much on one-off measures, and too little on permanent reforms like cutting the public sector wage bill or stamping out widespread tax evasion. Moody's decision to cut its sovereign debt rating for Greece to A2 from A1 was widely interpreted as a mini victory for the Greek administration, but it could easily turn into a Pyrrhic one if the measures taken fail to convince. As Moody's stressed

"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."

Finance Minister George Papaconstantinou stressed the government's commitment to far-reaching changes: "With this budget we begin our program of restructuring the economy...and cleaning up public finances," he said. But with Greece already under heightened EU budget supervision, what is needed at this point is something more than mere words, and the government will have to move quickly to convince both Europe's leaders and the financial markets that it is serious about reform.

A key moment is bound to come in mid-January when the government is due to present the EU Commission with its three-year stability and growth timetable outlining the government's medium-term plan to bring the deficit below an EU-mandated ceiling of 3% of GDP by 2013. The government has already pledged itself to introduce sweeping tax reform to boost government revenues, overhaul Greece's deficit-ridden pension system and outline plans for some €2.5 billion in privatizations, and it is presumeably the sum total of all these that is leading to those tensions in the governing party Pasok.

Aside from the fact that these measures are all very unpopular with the party's traditional electors, another problem arises. Most of the measures so far referred to are what could be referred to as "structural reforms", and these are very badly needed to lift Greece's long run growth rate slightly, and ensure fiscal sustainability in the face of a rapidly ageing population. But Greece has another problem - it's enormous current account deficit.




This deficit is largely a product of the large goods trade deficit, itself a reflection of the substantial loss of competitiveness that has characterised Greek industry during the years of the Euro-driven boom. Now the imbalances that this has all produced need to be corrected, and this correction needs to happen simultaneously with the fiscal correction. What this means is that in addition to the structural reforms Greece also needs to carry out what is known as an "internal devaluation", in order to make domestic industry more competitive in both the import and export sectors. And here comes the catch, since this devaluation will mean that GDP will fall even faster than otherwise, as prices also fall. Which means that the fiscal deficit will tend to be higher, and the debt to GDP level will rise even more rapidly than envisaged in the EU Commission forecasts - a process we have seen only to clearly in Latvia lately. And as many people continually point out, such processes are inherently difficult to carry through due to the political and social tensions they engender.

Just how serious this kind of problem this can become was highlighted in a Bloomberg article only today, where they point out that Japanese gross domestic product shrank to an annualized 471 trillion yen (or $5 trillion) in the third quarter of 2009. If you don't correct for changes in prices this takes Japan GDP back to levels not seen since 1991. As Paul Sheard, global chief economist at Nomura Securities International, points out, this tumble is unprecedented among developed economies since the 1930s. What's more, as a result of the ongoing economic contraction, the Finance Ministry now projects tax revenue in 2010 will drop to a quarter-century low.

More than a fifth of Japanese are over 65, according to the National Institute of Population and Social Security Research. The nation’s population began shrinking in 2006 from 127.8 million, and will drop by 3.2 percent in the coming decade, the Tokyo-based, state-sponsored institute estimates.

Japan faces the biggest fiscal gap among the Group of 20 advanced and emerging nations during the coming five years, according to a Nov. 3 report by the International Monetary Fund in Washington. Its deficit will remain as high as 8 percent of gross domestic product in 2014, compared with 6.7 percent in the U.S. and a balanced budget in Germany. Japan’s debt is projected to be 246 percent of GDP that year, compared with 108 percent for the U.S. and 89 percent for Germany, according to the IMF report.

Now Greece can't have exactly the same problem as Japan for a number of reasons. In the first place Japan currently runs a massive current account surplus, while Greece has an equally huge deficit. Further, Greece has no equivalent of the Bank of Japan, since it has no direct channel of influence over the ECB in Frankfurt (which evidently is responsible to a whole group of countries). But even more to the point, as part of a currency union there is an obvious limit to the deflation process, as the fall in prices would eventually restore competitiveness with the other euro area countries (which is where the root of the problem lies). But in the meantime the level of debt to GDP could be lead to rise even more sharply than currently anticipated, and even if the ECB should prove willing to support such a high debt to GDP level, it would still pose serious taxation and growth issues for Greek society.

So the bottom line here is that nothing is going to be easy. Greece now has a hard road to travel, and will need all the institutional support she can muster. Which is why it is high time Greek political leaders realised that this time there really is nowhere to hide, and that all the old games and tricks simply won't work now. They are playing with the future of others, would that they were capable of realising this.

Ten New Year Questions For Paul Krugman

I have an interview with Paul Krugman in today's edition of La Vanguardia (in Spanish). Below I reproduce the English original. As will be evident, there are many topics about which Paul and I are far from being in complete agreement. But on one topic we are in complete harmony: the diffficult situation which now faces Spain, the need for internal devaluation, and the threat which continuing inaction on the part of Spain's current leaders represents for the future of the entire Eurozone.

One

Edward Hugh: In your NYT article "How Did Economists Get It All So Wrong", you state what I imagine for many is the obvious, that few economists saw our current crisis coming. The Spanish economist Luis Garicano even made himself famous for a day because he was asked by the Queen of England the very question I would now like to put to you: could you briefly explain to a Spanish public why you think this was?

Paul Krugman: I think that what happened was a combination of two things. First, the academic side of economics fell too much in love with beautiful mathematical models, which created a bias toward assuming perfect markets. (Perfect markets lead to nice math; imperfect markets are a lot messier). Second, the same forces that lead to financial bubbles – prolonged good news tends to silence the skeptics – also applied to economists. Those who rationalized the way things were going gained credibility until the day things fell apart.


Two

E.H. : The late Sir Karl Popper used to contrast what he regarded as science with ideologies like Marxism and Psychoanalysis, because there seemed to be no way whatever of consenually agreeing with their practitioners a series of simple tests which would enable their theories to be falsified. Some critics of neoclassical economics - including Popper's heir Imre Lakatos - have expressed similar frustrations. Do you think we economists are, as a profession, up to the challenge of formulating testable hypotheses in such a way that the public at large might come to have more confidence in what we are up to, or are we a lost cause?

P.K.: I really don’t think that’s a helpful way to pose this question. Economics is about modeling complex systems, and as such the models are always less than fully accurate. What economists do need, however, is some demonstrated ability to get big things right. They had that after the Great Depression, when Keynesian economics clearly made sense of both the depression and the wartime recovery. But now the profession needs to get back on track.


Three

E.H.: Comparing the types and levels of indebtedness in the United States as between 1929 and 2007 one factor immediately stands out, the importance in modern times of the financial sector. You have repeatedly drawn attention to this phenomenon, and to how the unbridled growth of the institutions associated with it inevitably sowed the seeds of the problem which eventually came. Is there a road back? Can we reduce the strategic importance of this sector in developed economies and still generate meaningful economic growth?

P.K.: We grew fine for 30 years after World War II with a much smaller financial sector. I think if we tax and regulate the sector, we can replace it with other, more productive uses of resources – everything from manufacturing to health care.

Four

E.H.: Another of the distinguishing characteristics of the global economy over the last decade has been the development of large and sustained imbalances, with the US-China one being only the most publicly visible. Here in Europe we also have strong and notable differences between export driven economies like the German and the Swedish ones and many of those in the South and East which have evolved models based on consumer and corporate indebtedness and import dependence. Do you think we have the policy tools available to address such issues, and if so, where do we start?

P.K.: On the domestic side in advanced countries, financial reform should help reduce debt reliance. As for the developing country capital surpluses, that’s heading for a big confrontation. In the end, either China in particular increases domestic spending, or there will be some kind of at least threatened trade war.

Five

E.H.: One of the standard pieces of economic observation about countries recovering from financial crises is that their recoveries are export driven. This has now almost attained the status of a stylised fact. But as you starkly ask, at a time when the financial crisis is generalised across all developed economies - whether because those who borrowed the money now have difficulty paying back, or those who leant it now struggle to recover the money owed them - to which new planet are we all going to export? Maybe we don't need to look so far afield. Many developing economies badly need cheap and responsible credit lines, and access to state-of-the-art technologies. Do you think there is room for some sort of New Marshall Plan initiative, to generate a win-win dynamic for all of us?

P.K.: Um, no. Not realistically as a political matter. We’ll be lucky if we can get the surplus developing countries to spend on themselves. My guess is that our best hope for recovery lies in environmental investment: taking on climate change could, in terms of the macroeconomic impact, be the functional equivalent of a major new technology.

Six

E.H.: Last December you publicly warned of a burgeoning economic crisis on Europe's outer frontiers. Indeed you even went so far as to state that the center of the present crisis had "moved from the U.S. housing market to the European periphery" - and by periphery here I take it you mean countries like Ireland, Spain, Greece, Romania, Bulgaria, Hungary and the Baltics. With hindsight, and looking at how Europe sovereign debt, with Greece in the forefront, has suddenly become the "plat du jour" for the financial markets, this seems to have been extraordinarily perceptive. What was it about the situation on Europe's periphery that attracted your attention at such an early stage?

P.K.: Numbers, numbers, numbers. Those huge current account deficits practically screamed “bubble”. In general, it’s been amazing how useful even very rough measures of imbalance have been at predicting crisis, in everything from U.S. housing to Latvia. And that makes it even more amazing how few people recognized the warning signs.

Seven

E.H.: One of the most significant recent monetary initiatives - the Euro - is now nearly ten years old. On its fifth birthday Ben Bernanke described it as a "great experiment", do you think this description still fits the case, or is it now possible to start to draw some tentative conclusions?

P.K.: It’s still very much an experiment. We’re only seeing the real downside now, as the eurozone tries to cope with the unwinding of large internal imbalances. Until we see how that goes, the judgment on the euro will remain in doubt.

Eight

E.H.: A number of Eurozone economies are currently in some difficulty due to their high general level of indebtedness and a loss of price competitiveness which makes exporting their way out of their problems quite hard. This issue becomes even larger given that these economies no longer have a currency to devalue, In a speech earlier this year in Argentina you said that Spain now had no alternative but to carry out a systematic reduction of prices and wages in order to restore competitiveness. For a Spanish public which is far from convinced that this is the case, could you briefly explain why this is so?

P.K.: Put it this way: for a number of years Spain could pay its way within the eurozone by selling assets, mainly real estate, as the inflow of capital financed a huge housing boom. That allowed Spanish wages to rise relative to those in other European countries. But now the housing boom has gone bust, and the big inflows of money are over. So Spain needs to compete in producing real stuff, such as manufactured goods. And it won’t be able to do that unless it has a major gain in productivity through wage reductions.

Nine

E.H.: In the Latvian context the expression "internal devaluation" has been advanced to describe this kind of wage and price correction process. The expression has a very attractive feel about it, but as you recently pointed out in your NYT blog (The Pain In Spain) the changes involved are far from easy to implement, with consequences which are normally none too pleasant for those on the receiving end. Indeed they bear a striking resemblance to what used to be called wage and price deflation in the 1930s. Have we really advanced so little in all these years, or are there now more sophistocated policy instruments available to public authorities to implement such changes in a way that parallels the monetary policy improvements which we have seen in action during the present crisis?

P.K.: I wish I had some clever suggestions. But the essentials of economics change much less than the façade. The truth is that Spain is very much in the same situation as gold-standard countries in the 1930s; in some ways worse, because it lacks the option of using trade policy as a substitute for devaluation. So deflation it must be.

Ten

E.H.: Finally, as one decade draws to a close, and another opens, are there any grounds for optimism? You often speak of the return of depression economics, is what we once called the "modern growth era" now decidedly over, or are we simply passing through an interlude, with a new dawn out there waiting for us, somewhere just over the horizon?


P.K.: We will recover eventually. And we have learned some things since the Depression, which was why this hasn’t been nearly as bad. Overall, leadership is better – I’m especially relieved that we have smart, well-intentioned people running my own country, which is a major improvement. So sure, things will improve. But it’s going to be a hard slog.