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The Greek Non-Plan

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Historically, records show that spending cuts, tax increases during a recession are a recipe for disaster.

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The Greek government announced additional "austerity" measures today in order to reduce its deficit to 8.7% of GDP by the end of 2010. The measures include 2.4 billion euros of spending cuts and 2.4 billion in tax increases. The plan is far from impressive. Will the Germans hold their nose and foot the bill for a bailout?

An Unimpressive Plan

To begin with, as I pointed out in my articles To Greeks, Germans: Don't Repeat the Folly of "Shock Therapy" and Will Greece Repeat Argentina's 2001 Fiasco? the historical record is quite clear that spending cuts and tax increases during a recession are a recipe for disaster. It's like a dog chasing its tail; tax increases and spending cuts decrease economic activity, and decreased economic activity reduces tax revenue.

Furthermore, the baseline GDP estimate for 2010 of -1.5% used to estimate the Greek budget deficit seems far from reliable. Because of the austerity plan, government spending will be a drag on GDP of between 2-3 times that magnitude -- and this doesn't incorporate the negative effects of any Keynesian multipliers.

It follows that private-sector activity would have to grow very significantly in order to compensate for the large contraction in the public sector. How realistic is that? Greece's private-sector economy is highly dependent on tourism and other sources of demand essentially emanating from northern Europe. With the European economy having almost completely stalled out in the fourth quarter of 2009 and showing signs of contraction in the first quarter of 2010, a GDP forecast for Greece that assumes robust private-sector growth seems ambitious, to put it mildly.

Thus, it seems that Greece is quite unlikely to be able to meet its target deficit of 8.7% of GDP. Failure to meet this objective would jeopardize any international assistance.

The German Dilemma and the Prospects for International Assistance

Regarding the likelihood of generous international assistance for Greece, it's clear that Germany holds the key. In this respect, there are two conflicting forces impinging on the Germans.

On the one hand, the average German worker feels that he has made very significant concessions -- including the renunciation of "historic labor conquests" -- in recent years in terms of wages and benefits in order for the country to get its fiscal house in order. They're in no mood to be footing the bill for a plan in which Greek workers -- who Germans don't have a particularly high opinion of anyway -- are making relatively small sacrifices. Furthermore, Germans widely perceive the Greek political leaders that are currently asking for aid as frauds that have many times "swindled" the euro system. This general attitude of the German populous makes it politically very difficult for German political leaders to support a bailout of Greece.

On the other hand, the fact is that Germany is by far the largest beneficiary of the euro scheme. Germany's economy thrives on the basis of its huge export industry. Germany has a massive current account surplus that it's run up due to the relative undervaluation of the euro in German PPP terms that's currently embedded in the EU economy.

For example, Germany has a massive trade surplus vis-a-vis Greece precisely due the fact that the euro is undervalued in German PPP terms and is overvalued in Greek PPP terms. The euro system essentially freezes this competitive advantage for Germany, that because of the fixed-exchange rate, can only slowly be corrected through painful deflation, unemployment, and real wage decreases on the part of Greece. The same advantages Germany has vis-a-vis Greece, it has versus Italy, Spain, and the majority of countries in the Union. Thus, to the extent that a Greek default threatens the euro system, it's clearly in Germany's economic interest to come to Greece's aid.

This is what makes the German calculus so difficult. German economists and other technocrats mostly understand that bailing Greece out is probably in the German national interest as it helps preserve a system which greatly benefits Germany. On the other hand, politicians ultimately are accountable to Jürgen Sixpack, and he wants nothing to do with a Greek bailout.

Due to the above configuration of economic and political forces, I suspect that various economists and technocrats in Germany are busy working on a plan that would pave the way for a Greek default and an exit of Greece from the euro. Such a plan would require placing a "firewall" around the Greek catastrophe including a bailout of European banks with exposure in Greece as well as multilateral assistance for other countries such as Spain and Italy that could come under speculative attack. However, upon examining various scenarios involving such a firewall, I don't believe that such a plan will work.

The only way any plan will work -- Greek bailout, or firewall around Greek default -- is if the European economy is growing vigorously. With growth in Europe, coupled with financial assistance, the highly dependent Greek economy can get by. Alternatively, if Spain, Italy, and the rest of Europe are growing, a firewall could be successfully put around Greece. Without growth in Europe there are little prospects of any plan succeeding.

As things currently stand, with the European economy stalling as I reported in Europe is the Weak Link In the Global Economy, both Germany and Greece are backed up against a corner. There are few incentives for radical action given that almost any bold plan would be either politically and/or economically nonviable. Thus, I suspect that rather than expect a climactic positive or negative resolution, we'll probably get a long and drawn out agony such as that experienced by Argentina between 1999 and 2002.

Investors may want to take a look at currency ETFs such as UUP or country equity ETFs such EWG, EWI, EWP, ESR,and GUR as means of expressing a view on the issues discussed in this article. I am currently 100% cash.

For more on ETFs, take a FREE 14 day trial to the Grail ETF & Equity Investor newsletter by Ron Coby & Denny Lamson as they find ETFs poised for big moves. Learn more.
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