A Lesson From Greece

Over 50% of Greek GDP comes from the government sector. Tax raises have already been implemented, but higher taxes won't solve the deficit and debt problem. How much more, as a % of GDP, can higher taxes realistically generate? A couple of percentage points would be record breaking, Greece's deficit stands at around -12% GDP, clearly the problem is with spending.

Why are the bond vigilantes out in force? They've done the math and it doesn't work out. The austerity measures are not enough! Greece has dug itself such a big hole that the planned bailout just is not credible. That's why there is such a massive selloff, the current situation is unsustainable and will come to a head very fast. Here is some analysis on the math:

http://ftalphaville.ft.com/blog/2010/05/05/219811/grim-greek-austerity-arithmetic/

"Greece is attempting to adjust its primary balance by a magnitude that has seldom been achieved historically in western Europe.

While the details of the planned primary balance path under the EPP have not yet been published, we estimate the ratio is likely to be projected to be about 4-6% of GDP by 2014. In turn, this implies an improvement in the primary balance/GDP ratio of 13.5pp. Such an episode of fiscal tightening, if achieved, would constitute a near-record.

Yet such fiscal tightening would be different from other episodes because in the most of the other examples listed, nominal GDP expansion had been boosted by substantial declines in short-term interest rates, while in many cases the real trade weighted exchange rate had depreciated significantly as well. In all cases shown in Figure 7, nominal GDP grew strongly, which helped the deficit itself (via stronger receipts) as well as the denominator. However, it is hard for us to envisage that Greece will be able to generate much expansion in nominal GDP in the current circumstances, given that it is within the monetary union and is also faced with the need for significant competitive adjustment against Germany, which could prove deflationary."


What should we take from Greece's problems? That when doomsday comes, it will come quickly and be very nasty. There won't be many signs of ill health until the crisis hits, and when it hits, it might be too late to do anything. For those who advocate more entitlements and endless government spending in the US, be warned. No the US cannot default, but a stagflation would be just as devastating. We have to clean our own house before we become another Greece.