Chris Watling: Debt and its dynamics may yet leave Greece's economy in ruins

Economic View

Is Greece a liquidity problem or a solvency problem? If that question sounds familiar, it should – the same questions were asked of Western banks in the summer of 2007 and into early 2008 when, initially, policy makers diagnosed the problems of the Western banking system as a liquidity not a solvency issue – now we know that many of those banks were bust.

Policymakers are now making similar noises and suggesting that the next looming crisis – that of Greece's fiscal deficit and government indebtedness – is liquidity not solvency. Last weekend, in response to heightened concerns in the market over the debt (as highlighted by a further widening of Greece's 10-year government bond yields relative to Germany's – that is the risk premium over German debt. Chart 2) the EU, in conjunction with the IMF, announced more details on its lending programme for Greece. EU member states have offered to lend the country €30bn (£26bn) in the first year, at around 5 per cent interest rate, and more money in later years. The IMF has offered a further€€15bn. Given that Greece's funding needs are approximately €45bn to€€50bn in 2010 (and similar in the following four years), this provides it with the near-term liquidity it needs. So far, Greece is yet to take the EU and the IMF up on the offer – but comments from EU finance ministers last week suggest that is likely to change soon.

Perhaps surprisingly, the market reception to this deal has been pretty muted. The premium on Greek 10-year debt over Germany's initially tightened on Monday by 0.5 per cent (suggesting market confidence in the deal, or perhaps just short covering). By the end of Thursday, though, those spreads had given back almost all of Monday's tightening. So despite the EU-IMF backstopping all Greece's financing needs for 2010, and implying that they are likely to do the same for the coming years, bond investors still seem to have little interest in the sovereign debt. The question we have to ask ourselves is, why? And who's right: policymakers or the market?

On one level, given such unprecedented levels of Western government debt issuance in 2010 to 2011 and beyond, it's little wonder that appetite for Greek debt seems severely curtailed. On our calculations, OECD economies are looking to raise $2.6trn (£1.7trn) from investors this year to fund government deficits (that is, 9 per cent of OECD GDP), and a similar amount next year, with that slowly falling in following years. As a share of GDP this is meaningfully higher than at any other time in recent history – the previous record peak (since the end of Bretton Woods in 1971) was just below 5 per cent of GDP in 1983.

Since last September, as central banks have slowed and then stopped their quantitative-easing programmes (and as we have therefore lost the biggest buyers in the market), spreads have started to widen – investors have started to demand higher compensation (interest) for buying so much government paper.

On one level, this is a classic problem of oversupply. On another, though, and more importantly, it also reflects the real risk (probably greater than 50 per cent) that Greece will default.

Under market pressure, Greece is attempting to cut its fiscal deficit quickly. Greek plans incorporate a fiscal tightening from 12.7 per cent deficit in 2009 to 8.7 per cent in 2010, 5.6 per cent in 2011 and 2.8 per cent in 2012. That equates to a fiscal tightening of 3-4 per cent of GDP in each of the next three years. Yet, despite that tightening, the Greek Finance Ministry expects its economy to contract by only 0.3 per cent of GDP in 2010 and then return to a reasonable growth path of 1.5 per cent and 1.9 per cent in 2011 and 2012.

If correct, Greece will stabilise and start bringing down its debt-to-GDP ratio, thereby creating long-term sustainable debt dynamics.

The growth (and inflation) assumption within that calculation, though, is critical. Ireland's economy, the only recent example of a country within the eurozone which has undertaken a draconian fiscal austerity plan, has contracted by 17 per cent in real terms since the beginning of 2008. In nominal terms, that contraction is 22 per cent, as the economy has also suffered deflation. Given that government debt is nominal, not real, the 22 per cent contraction is the relevant one when thinking about debt dynamics. If Greece were to suffer a similar contraction, its debt dynamics would worsen considerably.

While that degree of economic contraction is unlikely (especially as the world economy is growing again), even a more modest contraction would be likely to lead to a vicious circle – whereby refinancing rates rise as debt dynamics deteriorate. Any economy with debt over 100 per cent of nominal GDP (Greece's debt is 115 per cent, says the IMF) faces deteriorating debt dynamics if the interest rate on its debt is greater than nominal GDP growth and it runs a primary fiscal deficit of any size. In 2009, Greece's primary deficit was 8 per cent of GDP.

A loan from the EU and the IMF is essential in order to halt the deterioration of debt dynamics due to rising interest rates. But it doesn't ensure that nominal GDP growth is greater than the weighted interest rate.

With the government contracting by 3 to 4 per cent of GDP each year, a huge question mark exists over the Finance Ministry's growth assumptions. Greece, like Ireland, does not have currency weakness as an option to boost growth (and inflation). In most fiscal crises, the exchange rate serves as a release valve – falling sharply, so boosting exports and supporting growth (or offsetting weakness). As Greece has the euro, this is not an option.

And Greece, with its low productivity levels, is not competitive within the eurozone, while its growth model of the past 10 years has been heavily dependent on house-price appreciation and rapid household credit growth. House prices in Athens and the rest of the country have risen over three-fold since eurozone entry, pumped up by rapid credit growth. Household credit has increased by almost 50 per cent of GDP this past decade. With Greece's cost of borrowing from the rest of the world rising, and unemployment set to rise further as a result of this austerity plan, there's a risk that debt deflation will take hold. This has also been the experience of Ireland these past two to three years. Irish house prices have fallen by 30 per cent from their peak. Private-sector credit has contracted.

So while an EU-IMF loan will help tide Greece over, it doesn't disguise the reality that the levels of debt in Greece, because of its debt dynamics, are probably too high for the economy to handle. So, even if the money is forthcoming from the EU, this farce is likely to turn into a Greek tragedy.

It's the dawning of the age of austerity as populations shrink and get older

Greece's problems are the tip of the iceberg. Many European countries, including Portugal, Spain, Italy and the UK, also have marked fiscal challenges. The IMF estimates that Britain, for example, needs a structural fiscal tightening of 11 per cent of GDP over the next decade to put its government debt to GDP ratio back on to a sustainable path by 2030.

But Europe has demographic problems which dramatically increase the fiscal challenges. Most of its populations are expected to shrink by 10 to 15 per cent over coming decades (starting about now), while all its major countries have ageing populations which means an increasingly expensive welfare state. Old-age dependency ratios (Chart 2) are rising sharply. There are, for example, 27 over-65-year-olds for every 100 working-age adults in Greece. By 2050 it will be 57. Trends are similar in Spain, Portugal, Italy and other countries.

Retirees not only incur greater health costs but also need pensions (out of the taxes of the working-age population). The National Center for Policy Analysis published a study last year which concluded that in order to fund all future, mostly age-related, policy commitments, EU governments, on average, needed to save an extra 8.3 per cent of GDP a year (increasing for every year its implementation is delayed). In the UK, the savings required are 6.5 per cent of GDP, while Greece is at 10.9 per cent. Last month, the Bank for International Settlements published The Future of Public Debt. The paper highlights how even after addressing short-term fiscal deficits, government debt to GDP will stay on an upward trajectory to 2050 for most Western economies. In Britain, government debt to GDP is set to rise from current levels, just below 100 per cent, to almost 400 per cent by 2040.

These problems are easily fixed, by upping retirement age, but that requires political will and public understanding. Without it, today's Greek problem seems destined to be a European one.