Greek Tragedy:
Beginning of the End or End of the Beginning
A remarkable feature of the financial markets is their recurring problem of selective amnesia. The past decade has seen short-term volatility jump exponentially and reach record levels that were often considered the realm of theoretical possibility. A flabbergasting feature of the markets over the past decade seems to be at odds with the conventional logic that fundamentals always catch up over the long-term. The point is: what is our long-term should perspective and what metrics should we use? This question is not simply a point for academic debate, it is probably the most important riddle that we need to solve in the era of rapid financialisation that is vastly aided by technological changes just at a time when the world is at the cusp of a major structural change. This paper attempts to grapple with changes in the sphere of political economy of global finance
One is forced to wonder whether the structural changes that are taking place in a number of the more advanced economies are being missed by a number of market participants.
A few months ago (in February 2010) a
former Chief Economist of IMF (Simon Johnson) described the G-7 economies as ‘fundamentally useless’. We could extend that analogy could probably be extended to describe the emerging markets as ‘technically useless’. We attempt to grapple with the major issues facing some of the economies of the world. This could be a particularly good time to take up such a study as we are bound to witness increased euphoria that the ‘Greek tragedy’ has come to an end and the world economy could roar back into growth – just like old times. I really hope so. But I would probably be a bit more circumspect and would probably keep the age old adage: buy the rumour and sell the fact. It is likely that this time is no different. Nothing has changed structurally over the weekend – not even with the US$61 billion bailout of Greece. At most it is just the end of one chapter. We are bound to witness a short interregnum period (at the most 2-3 months) before another country take the markets take pot shots at the next most vulnerable country. The list is quite exhaustive, to put it mildly.
BIS, one of the most authoritative voice, in global finance has pointed that public sector debt is now expected to exceed 100% of GDP of OECD countries in 2011 – something that has never happened before in peacetime.
Major Structural Issues:
* The world may be ending the policy that drew largely on Keyanisian policy of counter cyclical spending by governments because of their public debt has almost in every country reached its sustainable level. Any increased debt is likely to lead to a sharp deterioration of public finances.
* Concurrently, we have consumers wilting under heavy debt caused by a culture based on debt induced consumption. The process of debt deleveraging has probably just begun – as implied by the demand for loans in different parts of the world.
* A large number of European countries have no competitive advantage in their economies that will enable them to recover from the blows of the recent credit crunch. In most of the countries the boom was based on spending that accrued in the form of increased revenues originating from over priced assets, especially in the housing sector.
* With the likely end of government largesse turning into an era of enforced fiscal tightening, would the world economy return to economic boom conditions? The short answer once again is negative because of the simple reason that if the governments were to tighten liquidity then we are likely to witness a deflationary spiral at which point the burden of debt only grows due to the declining incomes. If the governments’ donot withdraw the money that they have pumped into the world economy as stimulus then the best case scenario is likely to be stagflation: none of which are good for the return of a consumption oriented economic boom conditions that two generations have come to rely on for any growth.
* The era of low long-term interest rates (over the next decade) is likely to have come to an end, implying that everybody from the governments to the consumers will have to pay a lot more for their debt.
* OECD countries are rapidly ageing and this will open up the Pandora’s Box of problems in their pension systems.
Questioning the Unknown:
* An interesting question that investors would need to grapple with is: why is gold rising, especially if what was supposed to be a Greek tragedy has come to a happy ending? A lazy answer would be that the US Dollar is falling after the announcement of the bailout package. But gold rose from about 1044 in February 2010 and is now near the technically critical resistance of 1170.
* Bond markets seem to thinking that they will not be asked to forego their principle. This seems to quite an oxymoron. Never in the history of capitalism have lenders been not forced to take a haircut (especially large ones) when sovereigns or countries default.
* The countries in trouble profess extreme confidence that they will be willing to reduce their deficit from levels that exceed 11-15% to about 3% (as required by EU) in 2-3 years.
The Never ending Greek Tragedy:
Unfortunately, the ‘Greek Tragedy’ is not about to end so easily, at least not because of the package that the EU has announced. Interestingly, they have not announced as to who will pay the US$61 billion. It has been estimated that the financing requirements of Greece over the next three years is about US$150 billion. The EU has committed to less than half the Greek requirement. Invariably we can be sure that the issue will come back to the centrestage, sooner rather than later. The next time it comes back to the centre stage we may rest assured that it will be accompanied by similar predicaments for other countries. Unless the problem is solved permanently (through drastic structural change) we are bound to witness the game of who is next? The list is quite large and in each country the political instability (or perceptions about such instability) are enough to send ‘hot money’ rushing for the exit. Thailand is the latest example. Geo-political tensions in the middle east could provide another source of problem. More troubling such stop gap bailouts will only provide an opportunity for speculators. The next issue that Greece and its banks have to face is how to overcome the flight of capital, which is already growing at an alarming pace. It has been estimated that nearly 4.5 percent of the GDP has already been transferred out of the Greek banks. Unlike some of the emerging markets, Greece is helpless against such capital flight.
The first important question that any person willing to go beyond the financial media headlines would like to ask is how is Greece going to move from at least 4% GDP primary budget deficit to a 9% GDP Primary surplus – needing a total of 13% GDP further fiscal adjustment. Not an easy task, especially in countries that have been so used to a welfare state model. By the end of 2011 Greece’s debt will be 150% of the GDP (as per IMF estimate) with nearly 80 percent of the debt being owned by foreigners. Therefore even if Greece were to withdraw from the Euro and devalue its currency, the huge increase in the nominal value of the debt is quite high for consumers and government. It has been pointed out that every 1 percentage point rise in interest rates means that Greece needs spend an additional 1.2 percent of its GDP to it bond holders.
The only viable solution for Greece: Default on its debt and write down the principle by about 60-65% and that would bring down the debt to about 50-60% of its debt. Unfortunately, the bond market is not discounting such a big haircut but unfortunately that is the write down that Argentina offered after its default in 2001. Interestingly, there are a number of similarities between Argentina and Greece, if anything Argentina seemed better (at least on paper). In 2001, Argentina’s public debt was 62% of GDP, while in the case of Greece it is 114%. Argentina’s fiscal deficit was 6.4% of GDP in 2001, while in the case of Greece it is 12.7% of GDP in 2009. The current account deficit of Greece is about 11.2% of GDP, while in the case of Argentina it was 1.7% of GDP (in 2002).
Grappling with the unknown:
The BIS has pointed out that there will be substantial pressure on the balance sheets of various OECD countries in 2010-2011 (
See Chart Below). This would need deep fiscal tightening in order to reduce their debt from current levels, but their debt would remain far above the levels that existed before the start of the crisis. We could therefore extrapolate that the next few years will lead to less government spending and with it a collapse in domestic demand in most of the various OECD countries. Unfortunately, the Purchasing power of the populace of the emerging markets is far below that of the OECD and therefore they are unlikely to replace the lost demand. Importantly most of the governments’ in the emerging markets too have increased since the beginning of the crisis, thereby capping the upside growth potential for the world economy.
Can Governments’ Cut Debt so quickly:
The Quick answer is theoretically plausible, but practically speaking probability of a democratic government cutting debt so quickly successfully will probably be less than 10 percent. Take the case of Greece. Simon Johnson the former Chief Economist of IMF, has pointed out the country which had a deficit of about 12.7 percent of GDP in 2009 will have to cut it down to 3 percent by 2012 (two years from now). He estimates that every One Euro cut in government spending (or fiscal tightening) will lead to a decline of about 1.5-2 Euro in lost domestic demand. Greece is not like China, where the rulers need not face a direct election. The government will have to face an election, though not in the near future. The only way Greece can meet that target will be if their policy makers decide to risk political oblivion. Let us accept it: that is unfair or more like asking for too much from a party that has just been elected, after 8 years out of power. Unfortunately, Greece has no industry that can lead to its revival. Their important foreign exchange earner is tourism and that is stuck in the quick sand as Greece has no currency of its own which it can simply devalue to the extent of say 35-50 percent so that their goods become competitive in the global market place. They are stuck with the Euro. Therefore over the next year or two it will become increasingly clear that the only way Greece can come of out of this quagmire is to either to default or exit the Euro.
Ultimately, every $1 of fiscal tightening may generate $1.50-2.00 in lost domestic demand. Fiscal tightening only works if the new unemployment leads to wages and prices falling, so making a nation more competitive.
Counter Point:
There is always a contrarian opinion to any view. It may be pointed out that most of the bull markets will probably start this manner. That may be true to a certain extent but there are two important differences, this time. Unlike in the past (the post World War II era) we have never had so many countries (especially the richer countries) facing such crisis. In most of the cases, they are staring at solvency issues and not liquidity issues. More importantly, unlike the last time this time the policy makers have run out of ammunition thereby limiting their ability to continuously indulge in trillion dollar bail out.
