The Greek economy is in a vicious cycle: the tax increases to close the budget deficit are worsening a sharp economic contraction. That contraction, in turn, is leading budget revenues to come in below targets, which prompts outsiders to call on the government to introduce additional fiscal measures. Those measures further depress economic output and the cycle goes on. In official forecasts, the Greek government assumes that economic growth will somehow emerge by 2012 or – that assumption looks more and more implausible. The problem is that Greece does not have infinite time - Europe has been very patient but its patience is being exhausted. Faced with such reality, the Greek government can either try more of the same or it can try to double down. What it really needs is a bigger plan.
Greek economic policy has two aims: fiscal consolidation and structural reforms. The former reduces output in the short term, while the latter will increase output in the long term. The question is, how long between the “short term” and the “long term” and what will trigger the inflection point? Right now, there is very little going well for the Greek economy: consumption is down due to higher taxes, lower wages and higher unemployment; investment is down, as it has been over several years; and state spending is down due to the need to lower the budget deficit. Only trade is making a positive contribution to GDP, chiefly because Greece is importing less, which is hardly case for celebration.
Based on the government’s medium-term strategy, the budget deficit should shrink from 10.4% of GDP in 2010 to 1.1% in 2015. But the consolidation would mostly come from a reduction in spending – in fact, revenues would remain flat as a share of GDP. So the Greek consumer cannot really expect a tax break any time soon. And since reduced private spending is driven by higher taxes, lower wages and lower employment, there is little reason to think that private consumption will rise. This is a vicious cycle with no exit and no obvious inflection point.
The fiscal calculus assumes a steady but orderly reduction in spending. But that reduction is too slow and perpetuates the vicious cycle in private consumption. The Greek government has thus two options. First, it can place its hope on investment. In theory, structural reforms will yield additional investment. But how soon will this come? Remember that investment peaked in 2007 as a share of GDP so the country faces some deep-seated problems that will not be wiped out overnight. And at just 15% of GDP, it may too small to be a short-term economic driver.
Its second option is to accelerate fiscal consolidation. The medium term strategy forecasted spending to go from 50% of GDP in 2011 to 44.8% in 2015, while revenues were expected to grow marginally from 42.6% of GDP to 43.2% of GDP in 2015. What is clear is that this “equilibrium” is increasingly implausible – it stabilizes revenues at too high a share of GDP and offers no clear path to a consumption-supported economic recovery. To resolve this problem, the government needs to slash spending faster paired with a fiscal stimulus in the form of a tax break. What this means is a sharp reduction in “less essential” government services that would allow for the government to meet its budget target without having to squeeze consumers so fully. That seems the best way out at the moment.