Greece Falls Into 'Death Spiral': Rising Debt, No Growth

Drowning in red ink, Greece has nowhere to turn to revive the economic growth that might put its debt on a sustainable trajectory, reassure angry foreign creditors and offer hope to its recession-weary citizens.

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Instead, the country finds itself in a vicious circle—a death spiral, some would say—in which it is borrowing ever more to keep up on its existing debts, crushing growth in the process and thereby worsening its all-important ratio of debt-to-gross domestic product.

Springing the debt trap would not be a miracle cure either: a manageable level of borrowing is a necessary but not a sufficient condition for Greece to start restoring competitiveness and resume growth after three years of economic contraction.

"If there was a deus ex machina tomorrow and you halved Greece's debt-to-GDP ratio overnight, there'd obviously be a huge benefit in terms of cash flow," said George Magnus, senior economic adviser to UBS in London.

"So you can alleviate the financial stress on Greece quite quickly and effectively, but I don't think that in and of itself means the economy is going to grow," he said.

New figures dramatize Athens's bind. As recently as July, the International Monetary Fund was forecasting that Greece would eke out 0.6 percent growth next year. Just 10 weeks later, it reckons the economy will in fact shrink 2.5 percent in 2012 after a 5.5 percent slump this year.

With tax revenues shrinking as the economy shrivels, debt is likely to rise to an eye-watering 173 percent of GDP in 2012 from 162 percent this year.

To illustrate the speed of the deterioration, the IMF based its May 2010 bailout of Greece on forecasts that gross debt would peak in 2012 at 149 percent of GDP.

Dimitris Drakopoulos, an economist at Nomura in London, agreed that it was an illusion to think that the economy was sinking solely under the burden of debt.

"Greece has large structural bottlenecks to growth, and the sustainability of the public finances is only one of the bottlenecks," he said.

Nitty-gritty reforms

Greece has accepted a raft of conditions set by the IMF, European Union and European Central Bank in return for a financial lifeline. These include slashing the public payroll, raising the retirement age and opening up protected sectors of the economy, including trucking and the law, to more competition.

Economists estimate such deep-seated changes could raise total output by 10 percent over 20 years. That is not to be sneezed at. The problem is that measures such as cutting civil service numbers and wages initially take a big bite out of demand.

"All these structural reforms are making things worse in the short term," Drakopoulos said. "Liberalizing the economy, at the start, under this sort of conditions is going to make things more tough for the first few years."

With a low labor force participation rate, thickets of red tape tying business in knots and productivity 30 percent below the EU average, Athens has little chance of battling back to growth by tightening its belt, markets believe.

Under scenarios prepared after a second 109 billion euro bailout-in-principle agreed on July 21, Nomura reckoned Greece would have to run a primary budget surplus—before interest payments—of 5 percent of GDP to stabilize its debt by 2014 and a 9 percent surplus to reduce it to 90 percent by 2031.

"Besides Belgium and Denmark, which have both had average primary surpluses of around 5 percent of GDP for almost 10 years, there are few other examples of advanced economics showing a similar performance," Nomura said in a report.

Grand bargain

In a similar exercise, economists Stephen King and Janet Henry at HSBC calculated that Italy, prior to the economic crisis, needed to run a primary budget surplus of 3.5 percent of GDP to shrink its debt to 90 percent of GDP by 2014.

That figure, they reckon, has now risen to a whopping 20 percent of GDP. No wonder bond markets have taken fright.

Austerity alone was highly unlikely to lower the borrowing costs of the likes of Greece, Italy and Ireland to levels at which they can achieve debt sustainability any time soon.

"Faced with year after year of economic pain, default looks ever-more enticing, particularly if the creditor nations look as though they may otherwise be able to escape with no more than a bloody nose," they said in a report.

Lax lending by euro zone creditor nations, led by Germany, was as much to blame as unbridled borrowing by the currency bloc's periphery, King and Henry argued: "The solution lies in a much greater pooling of sovereignty over bond issuance and fiscal policy."

Holding Germany responsible for the shortcomings of others angers Berlin. But Magnus at UBS agreed that far-reaching changes were needed to address the 'imbalances management problem' between euro zone surplus and deficit countries.

"How do you get growth? It depends partly on micro and structural measures at home to increase supply responsiveness. But it's also down to the external environment and whether the creditor nations of Europe—which is code for Germany really—are willing to change their behavior to allow that growth to happen," he said.

"Germany is a prolific saver and Greece is a prolific borrower. How do you manage that relationship so that the Greeks can borrow less and the Germans don't lend as much? That's ultimately the acid test about whether monetary union will work," Magnus said.