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February 22, 2012

More Challenges for Greece
By Eric Przybylinski, CAIA, Senior Research Analyst

Another round of bailouts, totaling €130 billion, was approved for Greece on Tuesday. As with other Greek bailouts, the receipt of the money was contingent on further budget cuts and austerity. Going forward, Greece faces two main concerns, one short-term, and one long-term. In the short-term, Greece will likely continue to experience solvency/liquidity pressures, as large debt and deficits require continued aid and debt write-downs. The approved bailouts help relieve these pressures.

However, continued austerity in the face of negative GDP growth and large deficits may exacerbate Greece’s financing problems. Austerity has improved Greece’s finances less than expected, as budget cuts result in lower GDP and thus lower tax revenues. As recently as March 2011, the IMF expected Greece’s contraction to bottom in 2010, and resume growth by 2012. New estimates from the Eurogroup expect the GDP contraction in Greece to bottom in 2012, and resume growth by 2014. It is difficult to see how this goal is achievable utilizing similar policy prescriptions that have failed to work in the past. Forecasts may still be overly optimistic.

Regardless, short-term solvency issues can continue to be relieved by further bailouts as long as there is political will. Longer-term competitiveness problems may be more difficult to solve. EU officials hope that Greece can transform into a competitive, export-driven economy. Currently Greece, along with other PIIGS countries, runs a large current account deficit. Simultaneously, Germany runs a large current account surplus. One of the main drivers in the competitiveness gap between Greece and Germany are differences in unit labor costs. Unit labor costs measure the average costs per unit of output, and are calculated as the ratio of total labor costs to real output.

The chart above shows the change in unit labor costs for select Eurozone countries since 2002. Greece’s labor costs over this period have risen significantly, while Germany’s have barely budged. The two main solutions to this gap are relative inflation in Germany (unlikely given its history), or years of wage deflation in Greece. This suggests that the adjustment period for Greece as long as it remains in the Eurozone could be quite long indeed.

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