• Appearance. The Great Recession is over, the global economy regained traction at the turn of the year, and the financial crisis appears to have been overcome – thanks to the billions in bailout and stimulus packages. But the aftermath of the crisis is by no means over yet!

  • Reality. The flipside of the coin is namely ballooning public-sector debt. In the US, the federal deficit has already surged to 10% of GDP. European countries are also spiraling deeper and deeper into red ink. The real source of concern is, however, the long-term prospects (pages 3-6).

  • Government debt. According to the CBO, even strong growth over the medium term would still see US federal debt rise to 100% of GDP by 2020. If the tax cuts of recent years were to be made permanent, the number would even jump to 130%. That would be the highest ratio in times of peace. Our calculations for Germany also show that government finances will spin out of control without corrective action.

  • Dilemma. There is, therefore, no further scope for new spending programs or tax cuts, such as those currently being debated in Italy (pages 9-10). Drastic spending cuts are, however, poison for the still fragile global economic recovery. What would be required are structural reforms that push the growth path to a higher level. But they take time!

  • Danger. Greece is a prime example of what can happen when investors lose confidence in a government's ability and willingness to address serious public deficits. Risk premiums there have skyrocketed recently.

  • Further topics:

    – Weekly Comment: Closed wallets, deep pockets (page 2).

    – ECB: Waiting for March (page 7).

    – Date outlook: Winter weather to hurt production in Europe; US purchasing managers become more cautious (page 11).

    – Market outlook: EUR slide below 1.40 to continue (page 19).


Closed wallets, deep pockets

The remarkable success of Greece’s latest bond issue remarkably short-lived, and recent developments confirm that the eurozone’s fiscal problems will continue to flash red on the markets’ radar screen: fiscal positions are precarious in a number of countries, the government’s response is too often hesitant and timid, and the lack of effective mechanisms to enforce fiscal discipline is exacerbating tensions between fiscal “hawks” and “doves”. These political and market tensions will be with us for a while as markets decide how to re-price different macro and fiscal fundamentals. Portugal’s 2010 budget plan disappointed, while the European Commission presses on with its excessive deficit procedure against Greece. Press reports that Greece might have approached China for an EUR 25bn bond sale, quickly denied by the Greek finance ministry, cast some doubts on whether the strong investor demand at Monday’s syndicated issue can be expected to last. Volatility on sovereign spreads is likely to remain high in the coming weeks. Greece should take more decisive steps to win back investor confidence in a more durable way – a rapid widening in spreads at the pace seen this week could quickly push us to a digital situation were confidence does need to be recovered without delay. But if outside help is needed, it would be especially disappointing if faced with the “closed wallets” of its EU partners, Greece had to turn to the deep pockets of China.

Following the remarkable success of Greece’s latest bond issue, spreads on 10Y Greek government bonds vs. Bunds and 5Y CDS widened sharply to new record levels, and Monday’s success is beginning to look like a big missed opportunity. The high demand at Monday’s 5Y issuance appeared as a sign that markets did in fact have confidence in Greece’s prospects, offering important reassurance that Greece would continue to be able to access markets to secure funding. That signal, in my view, should have been followed up and compounded by a further and stronger sign of commitment to fiscal discipline on the part of the Greek authorities. I realize that with a 13% of GDP fiscal deficit and the economy in recession, Greece is in a catch-22 situation: a moderate fiscal adjustment plan is insufficient to reassure markets, while a draconian plan could either be socially unacceptable or plunge the economy deeper into recession—which would partly negate the benefits of the debt to GDP ratio. But a way out, in my view, would be to announce a combination of structural reforms with long-lasting benefits, for example, to reduce future aging-related costs which cast a frighteningly large shadow on the horizon, combined with a sufficient but not extreme dose of up-front sacrifice in terms of cuts in public sector employment and wages. This would have reassured the rating agencies and the EU, and consolidated market confidence.

The follow-up to Monday’s issuance, instead, has been disappointing. Mr. Juncker called Greece’s plan “an important step in the right direction”, but at the same time the European Commission announced that it is stepping up its excessive deficit procedures against Greece as “…the country has not taken effective action to correct the deficit by the 2010 deadline agreed at the beginning of 2009”. In contrast, statements by Greek Finance Minister Papaconstantinou that Greece “… will do what is necessary to reduce its budget deficit” were too generic to provide convincing comfort. Mr. Papaconstantinou added that Greece has no “Plan B”, probably intending this as a sign of commitment to fight on, akin to burning your ships ashore. But as “Plan A” seems still unconvincing, the absence of a Plan B becomes more a source of concern than reassurance. News reports that Greece had approached China for a possible sale of as much as EUR 25bn were especially unhelpful. The Greek finance ministry categorically denied the reports, but the damage had been done. Approaching a foreign government or a Sovereign Wealth Fund would suggest that Greece does not feel confident that demand by buy-and-hold private investors remains solid – in open contradiction to the signal coming from Monday’s issuance. Moreover, relying on China for about one half of this year’s funding needs would raise concerns about potential geopolitical implications, similar to the worst days of the financial crisis, when SWFs were expected to come to the rescue of financial institutions. Incidentally, such a development would also represent a major blow for the eurozone and the EU, as it might be seen as a “rescue operation” by China, far worse in terms of image than an IMF intervention, and similarly proof that the EU is unable to manage its own problems. Greece also suffered from Portugal’s unimpressive 2010 budget plan, which targets a reduction of just 1pp in the deficit from last year’s 9.3%. Given that Portugal is committed to reducing the deficit below 3% of GDP by 2013, the 2010 plan makes it clear that the fiscal consolidation effort will be heavily back loaded. This could be a sensible strategy, as Portugal will experience a very weak recovery in 2010 with growth barely above zero, and with downside risks coming from its close relationship with Spain, which is projected to remain in recession. However, postponing the bulk of the adjustment to future years of stronger growth requires credibility, and markets appear very unwilling to give countries the benefit of the doubt without some up-front evidence that countries are willing to bear the pain, as in the case of Ireland. In the case of Portugal, the lackluster growth performance of past years also suggests that GDP growth will not bring a major contribution towards an improvement in public accounts. Fitch maintained its negative outlook on Portugal following the release of the plan, which seems to have raised the risk of a downgrade.