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Wed 3 Mar 2010 09:28 AM

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Greece, debt and the next crisis

DIFC chief economist Dr Nasser Al Saidi argues that Greece's woes are just the beginning for the EU.

Europe’s smaller and more profligate economies are bearing the brunt of the Great Recession and financial crisis. Last week the rating agencies downgraded the debt of Greece’s largest banks and threatened further downgrading of its sovereign debt. Why?

Along with a high current account deficit, Greece is running a deficit of about 13 percent of GDP (four times higher than Eurozone rule of three percent), with public debt running at some 170 percent of GDP and interest on debt at 11.6 percent of GDP. Greece could be heading for a default on its debt.

It is proposing a painful (if implemented) austerity package and fiscal adjustment - including a hike in taxes and the VAT rate, a hiring freeze and wage cut in the public sector - to bring the deficit down to 8.7 percent in 2010.

The markets doubt that Greece (which has been in a state of default 50 percent of the time since the 1830s) has the political will and capacity to withstand the social pain of such an adjustment, as evidenced by strikes and demonstrations by the country’s powerful trade unions.

Indeed fiscal tightening will likely lead to a reduction in economic growth and increased unemployment, leading to a further loss of tax revenues (with the proposed four percent budget deficit reduction likely to lead to a similar decline in growth).

Greece needs more than fiscal adjustment; it requires structural reforms to deal with past and unsustainable spending excesses. It was not ready to enter the Eurozone.

What is to be done? Greece cannot devalue its currency to ease adjustment to the crisis and increase its competitiveness, since it is part of the Eurozone. The Maastricht Treaty has a no-bailout clause which rules out intervention and lending by the ECB or national central banks.

To compound the problem faced by EU policy makers, Greece is not the only country with twin budget and current account deficits. So do Portugal, Ireland, Italy and Spain. If Greece defaults, the spillover effects will engulf these countries and others globally with similar vulnerabilities.

And it is not only the Southern Mediterranean countries. The UK's budget deficit was 11.8% of GDP last year and is forecast to climb further in 2010 to levels similar to that of beleaguered Greece. The EU is facing its first system-wide crisis.

The deficits in advanced economies - but not in emerging economies - are the highest peacetime deficits since World War II. The IMF calculates that, so far, financial rescue programmes and upfront government financing, amount to 13.2 percent of GDP in advanced economies.

The evidence from severe financial crises (C Reinhart & K Rogoff) is that the real value of government debt tends to explode, rising an average of 86 percent in the major post–WWII episodes.

The main cause of debt explosions is not the costs of bailing out the economy; the big drivers of debt increases are the collapse in tax revenues as a result of recession. The US, UK, EU and other advanced economies are heading for a public debt crisis. Already risk premiums on long-term government debt are rising: sovereign debt is no longer low risk. Higher interest rates will aggravate the problem.

Countries with difficulties like Greece would typically turn to the IMF for adjustment assistance. However, the EU has ruled out IMF intervention, since it would signal political weakness and threaten the main achievement of European economic integration, namely monetary union and the Euro.

The fatal weakness is the lack of a unified fiscal policy. It is clear that the two bulwarks of European Union, Germany and France will have to intervene. Joschka Fischer clearly defined the policy dilemma: “Pay for the southern European countries or resign oneself to the end of the euro?”

Quick fixes may avert an immediate financial crisis and default. But the deficit problems of the advanced economies are deeper, structural problems. The growing structural deficits are due to unfunded liabilities arising from rising spending related to entitlements, health and social security associated with the aging populations of the advanced economies such as Japan, Spain, and Italy.

Where do we go from here? The public debt situation in the advanced economies is on an unsustainable path threatening to trigger a new financial crisis. To the structural budget deficits have been added counter-cyclical and financial crisis combating deficits.

The IMF projects that debt to GDP ratios in the advanced economies will average more than 120 percent by 2013-14 and between 300 to 400 percent of fiscal revenues. But an early exit from fiscal stimulus will threaten the anaemic recovery.

The EU will need to impose strict fiscal rules beyond Maastricht and move towards an EU government structure with a unified fiscal policy. Retirement ages should be raised to 70 or 75 and new institutions will be required such as a European Monetary Fund able to intervene and provide adjustment financing for countries facing financial difficulties, verging on insolvency. The current crisis will lead to social and political crises in the advanced economies.

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SR 10 years ago

What one person receives without working for, another person must work for without receiving. The government cannot give to anybody anything that the government does not first take from somebody else. When half of the people get the idea that they do not have to work because the other half is going to take care of them, and when the other half gets the idea that it does no good to work because somebody else is going to get what they work for, that is about the end of any nation. You cannot multiply wealth by dividing it. Poeple in he EU will have to go without expansive social wellfare nets that makes young poeple lazy and old poeple less prone to save. Its as simple as that.

Veracity 10 years ago

SR , you are absolutely right , the glutonous PIGS ( portugal , Ireland , Greece, spain ) will have to tighten the belts .

chiamanhing 10 years ago

I can't agree more with Dr. Nasser that his story is good and Greece is facing into a serious and dangerous policies such were surrounded by hidden risks for a long period of time. It may rapidly spread to others countries worldwide which could cause great recession; more and more people are without job.

SS 10 years ago

V. Good Conclusion

chiamanhing 10 years ago

It is a time to change that Greece should call for a fall ballot measure to impose higher income tax on wealthy residents (there are million of rich families living in Athens) and to drop the sales tax for everyone by a penny; to prevent downturn economic spiral(!)

Chiamanhing 10 years ago

Are you sure that they don’t have to work because the other half’s going to take care of them, and when the other half get the idea it does no good to work because somebody’s going to get what I work for? Dear friend, is about the end of any nation. I think it is all an honest works for an honest pay.