Renewed Optimism About Greece Is Well Overdone
Judging by the renewed optimism in the Greek sovereign debt market, one could be forgiven for thinking that the worst of the Greek economic crisis was behind us. After all, Greek sovereign bond yields have now declined toward levels last seen immediately before the onset of the European sovereign crisis some five years ago. However, it would be a grave mistake for Greek policymakers to allow currently buoyant market sentiment to blind them to Greece's still very large economic and political challenges. If left untreated, the country's poor fundamentals threaten to undermine Greece's prospects for digging itself out of its present depressed economic situation when global liquidity conditions become less favorable than they are today.
A popular adage on Wall Street is that when the winds are strong even turkeys fly. By this it is meant that when liquidity is ample, investors do not discriminate between different credits but rather invest blindly in anything that offers an attractive yield. If ever global liquidity conditions have been highly favorable, it has to have been in the past year and a half. For not only was the Federal Reserve expanding its balance sheet at an unprecedented rate but so too was the Bank of Japan in an effort to rid Japan of deflation.
In the context of ample global liquidity, Europe has now regained the market's favor despite the threat that a move to deflation poses towards the European economy and despite dismal European parliamentary election results, which suggested a crumbling of the European political center. As a result, the Italian government today can borrow at rates as low as those paid by the U.S. government despite the fact that Italy's debt to GDP ratio now exceeds 135 percent. Similarly, the French government now borrows at rates very similar to those of the German government despite the clearest of signs of domestic political fragmentation and despite the country's many structural economic difficulties. Meanwhile, countries like Cyprus and Portugal, which were not too long ago viewed as countries with unsustainable debt dynamics, have now been able to re-access the global capital market.
Against this background, the recent dramatic decline in Greek yields over the past year should be seen more as part of a generalized reduction in global interest rates, rather than as the result of any major improvement in Greek economic and economic fundamentals. For despite encouraging signs of an incipient economic recovery, Greece remains mired in the deepest of economic depressions and it is now burdened by a mountain of debt. And despite considerable progress in reducing the budget deficit, Greece now shows the clearest of signs of austerity fatigue and political fragmentation.
In the economic sphere, it is of particular concern that Greece has now moved decisively into deflation in response to the very high gaps that currently characterize its labor and product markets. Greek consumer prices are now declining by 2 percent, or at the fastest rate in the Eurozone, while the persistence of very high unemployment levels make it more than likely that deflation will not be a passing phenomenon. The problem with deflation is that it increases the real burden of Greece's public debt which has already risen to around 175 percent of GDP. Deflation is also likely to constitute a headwind to any economic recovery as consumers might hold off consuming in the expectation of lower future prices. This would be especially unfortunate at a time that the economic recovery is very feeble and that further budget adjustment within the straitjacket of the Euro will also be weighing on aggregate demand.
In the political sphere, it has to be of great concern that Greece is losing the political willingness to persevere with much needed structural economic reform to get the Greek economy moving again. It is perhaps understandable that today the government might not want to make difficult economic decisions in the wake of Syriza's recent strong showing at the polls and with the very real prospect of parliamentary elections early next year. However, any stalling in budget adjustment and economic reform is likely to undermine the prospects for a favorable reception of Greece's request for major official debt relief. It is also likely to reduce the prospects for Greece to successfully negotiate a third international support package.
Especially at a time when the Federal Reserve has already started tapering its bond buying program, Greek policymakers would be making a grave mistake to premise their policies on the assumption that today's highly favorable global liquidity conditions will persist indefinitely. Rather, they should now be preparing for a return to more normal liquidity conditions by redoubling their efforts at structural economic reform to make the Greek economy very much more competitive. For by so doing, they will put Greece in a better position to weather the more difficult global financial environment that almost certainly lies ahead.