Importantly, the initial collapse and following standstill in economic activity and nominal levels of GDP is also extremely bad news for the strategy of fiscal consolidation itself. On the one hand, to keep on servicing interest payments (see above), nominal debt will continue to go up. On the other hand, nominal GDP goes down and tends to stay down. This interaction between a rising numerator (nominal debt) and a stagnating denominator (nominal GDP) will result, according to the IMF itself, in a sovereign debt ratio of 145% of GDP by 2014, compared to a ratio of 115% in 2009. . . . The second line in Figure 2 shows what happens to debt dynamics if the primary surplus does not increase to 6.0 percent of GDP as the IMF assumes, but remains at 3%. The long-term debt dynamics become even more dismal: debt climbs up to over 148% of GDP and remains over 140% even at the horizon of 2020. . . .
[From 2014 on] Greece will have to return to the markets and find the financial means to pay back the 110 billion euro loan rescue package, representing some 40% of Greece’s GDP. On top of this, Greece will also need to repay those debts that are set to come due in the rest of this decade. With debt having exploded to a level of 145% of GDP, it is likely that financial markets would continue their refusal to roll over Greek debt, thereby reviving the specter of exceptionally high interest rate charges bankrupting the state and the economy.
The fact that financial markets already seem skeptical does not bode well. Immediately after the announcement of the loan rescue package, interest rate spreads on Greek sovereign debt came down from extremely high levels. However, the interest rate on 10-year Greek bonds has since moved up again. By mid-June, it stood at 9.5%, almost four times the interest rate on German bunds. On top of this, and according to newspaper accounts, savers continue to take funds out of the banking system and out of the country, placing deposits mainly in Cyprus and the UK. . . .
If market confidence is not being restored while the Greek economy is at the same time being pushed into recession, double digit unemployment and rising poverty, then what is the point? Who or what exactly is being saved?
In the end, the purpose of the rescue package may boil down to a huge shift of debt from (mostly) private banks into public hands. The 110 billion euros now being lent to Greece by the IMF and European governments will be mainly used to pay back the banks and institutional investors who are now holding Greek debt. Banks, insurance companies and pension funds are the real beneficiaries. The possibility of Greece defaulting on the payment of interest and principal that is due should now be excluded for the next three years.
There is a clear European dimension to this, given the fact that the major part (almost 80%) of Greek sovereign debt is not in the hands of the Greek financial system but rather is in the balance sheets of German, French and UK banks (see Table 4). Europe and the IMF are not so much providing Greece with fresh finance but, most of all, shielding the European financial system from up to 200 billion euros of losses that could result from a Greek default. Curiously, almost one quarter of Greek debt is located in the UK (and Irish) financial sector. The obvious beneficiaries of the Euro Area governments’ package are not Greek workers and citizens who will suffer from severe budget cuts and recession, but financial centers such as the City of London. . . .
However, since Greece is a member of the Euro Area, there is a risk that the stagnation and deflation imposed on Greece may spread through the rest of the currency union. Financial speculation has spilled over into the rest of the Southern periphery of the Euro Area in the aftermath of the Greek crisis. Euro Area governments together with the European Central Bank decided over the weekend of May 10 to set up a European Financial Stability initiative. Its logic is identical to the Greek adjustment policy exercise: In return for financial support (possibility of 750 billion euro bilateral loans, ECB directly buying sovereign debt) to financially distressed governments, Euro Area member states pledged to turn around their fiscal policy stance and introduce austerity measures.
A string of governments, including Spain, Portugal, Italy, France, and Germany, have announced ambitious cuts in deficit spending with public sector jobs and wages being a prime target. Meanwhile, the IMF is increasing verbal pressure on the issue of more wage and labor market flexibility (see for example the conclusions from the article 4 IMF mission Euro Area). The biggest cuts announced so far have been in Spain, where the government already decided to cut public sector wages by 5% and to raise the age of retirement. If Spain would indeed be forced to apply to the European Financial Stability Initiative to get access to European money, the IMF and DG Ecfin would get an opportunity to deliver a powerful blow to those labor market institutions (public services, social benefits, collective bargaining, minimum wages) on which the European Social Model rests. As is the case with Greece, this policy is also unlikely to get Spain’s finances in order, nor will it succeed elsewhere in the Euro Area. Extreme fiscal austerity is only likely to lead to prolong economic stagnation coupled with possible Japanese-style deflation.
Ronald Janssen is a Research Associate of the Center for Economic and Policy Research in Washington, D.C. This article was first published by CEPR in July 2010 under a Creative Commons license.