• Forecast. It is now consensus that the global economic recovery after the “Great Recession“ will be bumpy and should tend to be uneven. In addition, we remain convinced that the medium-term growth path will fall short of that seen in earlier decades – even though Emerging Asia, especially China, is now posting strong growth again.

  • Deleveraging. The reason for this is the inevitable deleveraging of the private sector, not least consumers, in industrialized countries. In the US, this process seems to be already under way. Consumer borrowing is down, and debt falling, most recently also in relation to disposable income (pages 4-5 & chart below).

  • Transfers. This is, however, no contradiction if private consumption is rather resilient and substantially contributed to the presumably strong growth at the turn of the year. The reason for this are massively higher federal transfers, which for the first time in 63 years exceeded taxes and social security contributions of households (cf. chart).

  • (Hi)Story. Private deleveraging at the expense of ballooning government debt is, however, no lasting solution. The record-high overall debt must be reduced! And that will weigh on medium-term growth prospects. This explains why recoveries after recessions associated with financial market crises do not follow the usual V pattern – as the IMF recently noted.

  • Further topics:

    – Weekly Comment: A Greek tragedy (page 2)?

    – Germany: Government sticking to tax reform (page 6).

    – Commodities: A good year for investors (page 8)?

    – Data outlook: Business climate continues to improve; US economy posts strong growth in 4Q09 (page 13).

    – Market outlook: USD continues to be well supported (page 26).


A Greek tragedy?

The Greek situation is worrisome, but what is even more worrisome is that it is not clear at all to what extent it is a Greek problem, and to what extent it is a European problem – European policymakers have uttered a depressingly familiar cacophony of discordant messages over the last two months. Let us try to summarize the situation in as simple terms as possible:

Greece has announced that its budget deficit for 2009 was close to 13% of GDP. Many countries have been running large deficits last year, but the one announced by Greece is problematic for two reasons: First, Greece last year experienced the mildest recession within the eurozone, with a contraction in real GDP of only 1%, and therefore the large deficit reflects excessively lax fiscal management rather than the impact of the crisis; second, the figure announced late last year was much, much larger than previous estimates, undermining confidence in the official statistics. At the same time, late last year, a leaked memo from the National Bank of Greece to domestic banks highlighted the fact the latter have been borrowing heavily at the ECB’s liquidity operations, using a significant share of the liquidity to purchase Greek government bonds. Greek debt has risen significantly, and is projected to reach 130% of GDP in the next few years. And to round off a rather difficult outlook: downgrades by rating agencies have led to a situation where, if Moody’s downgrades Greece by two notches, by the end of 2010 when the rating requirements for paper acceptable as collateral by the ECB go back to their normal pre-crisis standards, Greek bonds would no longer be eligible.

As a consequence, some investors have started to fear that Greece might not be able to repay its debt, and spreads between Greek government bonds and German Bunds have risen to about 300bp (at the 10-year maturity), the highest level reached early last year when similar market concerns about all “peripheral” EU countries had peaked in the wake of Lehman’s bankruptcy. Let’s be clear: markets are not pricing in a default: if that were the case, spreads would be well above 1000bp. However, markets are clearly assigning a non-negligible and rising probability to such an event. Moreover, some of the market dynamics are reminiscent of emerging markets situations, with the sell-off especially sharp at the front end of the curve – the bonds that would have the lowest recovery rate in the event of default. Greece faces about EUR 17bn in redemptions this year, and they come due in two tranches in early April and early May, which is providing an obvious focus point for the market.

To reassure investors, Greece needs to launch a serious fiscal adjustment, and it has been taking steps in that direction, but so far with limited effect. The fact that Greece is perceived as having a volatile political and social situation puts the government in a catch-22 situation: if the fiscal measures it announces are modest, markets fear they cannot redress the situation, but if they are aggressive, markets may fear they cannot be implemented. Next to this catch-22, there is yet another reincarnation of the moral hazard problem – but to get into this, we have to discuss the inter-relation between Greece and the eurozone.

What would happen if Greece defaulted? In our view, the contagion would be devastating. Since inception of the eurozone, spreads between German bunds and the government bonds of countries with larger public debt have been too narrow to properly reflect the difference in fundamentals. That means investors have been pricing in the assumption that if one country got in trouble, it would be helped by its fellow members – the so-called implicit bailout clause. A Greek default would disintegrate this assumption, and lead to a substantial widening of spreads on other countries such as Spain, Portugal, Ireland (in spite of its valiant fiscal adjustment effort), and possibly Italy. The result would be another round of extreme financial instability and almost certainly plunge Europe back into recession. In other words, a default by a eurozone member would be uncharted territory. It may not be as bad as Lehman, but we probably would not want to find out. Could a Greek default be “ring-fenced” by ensuring support for all other countries? I do not see how this could be done credibly.

I believe European policymakers largely understand this, but so does Greece, and here is the moral hazard. Knowing it will be rescued if needed, Greece might feel less urgency to adopt painful fiscal measures. On the other side, EU policymakers do not want to send the signal that fiscal laxitude carries no penalty, as this might lead to even less fiscal discipline within the area. This, I believe, explains the conflicting signals coming out of Europe. EU policymakers try to tell Greece, “it is your problem”, or “nobody will take out his/her wallet to save Greece” (ECB’s Juergen Starck) but as soon as that makes markets nervous and triggers the first signs of contagion, they turn around and say “The fate of one is the fate of all” (Almunia; German Chancellor Merkel made a similar remark in December). Greece, on its part, proudly says it does not expect to be helped and does not need help, but on the other hand it has so far failed to announce decisive enough measures to convince markets. It would be a painful task, no doubt, but certainly not an impossible one: Look at Latvia, or to a lesser extent Ireland.

What is the exit strategy here? We all hope Greece will manage to win back investors’ confidence on its own. But suppose it does not. Default, as I argued above, is too ugly for everyone to contemplate. Financial help would be needed, and it would have to be contingent on policy conditionality. The IMF could easily do it, it has plenty of experience – but that would be seen as a humiliation by the eurozone. The eurozone might therefore try to deal with it on its own, most likely with an emergency loan for balance of payments assistance (although that would be awkward, as eurozone institutions, the ECB first of all, have repeatedly argued that external imbalances at country level within the eurozone are not an issue). But it is not clear that the EU has the technical expertise, or for that matter the political strength to impose serious conditions.

We might come to face an uncomfortable truth: that indeed monetary union is not sustainable without greater political integration. We might then be approaching the greatest test the eurozone has faced so far since its inception.