The Guest Blog

Farr: Santa, Greece Has Been Naughty!


A recent Washington Post article discusses the latest report on Greece from the International Monetary Fund, IMF,.

The report, spearheaded by IMF Greece mission chief Poul Thomsen, was apparently quite critical of the Greeks for their lack of follow-through on previous promises. According to the Post, "Thomsen cast the blame squarely on Greek officials' slowness in carrying out their pledges to reform economic policy and government spending. Those politically painful steps involve selling off state enterprises, firing tens of thousands of politically connected state employees and removing jealously guarded protections that limit competition in dozens of professions."

Herein lays the crux of the European problem. Although most of the other troubled European countriesmay not have the same degree of tax evasion and nepotism that Greece has, each of these countries will be forced to implement painful reforms that are likely to endanger the jobs of many European politicians. None of these lessons should be lost in the US either. Greece is the test case for what may eventually happen throughout Southern Europe, including the much larger economies of Italy, Spain and Portugal. And while other countries may not be carrying the same level of debt, relative to GDP , as Greece, these other countries will also not get the same "voluntary" deal for a 50% reduction in privately held bonds outstanding that Greece, at this point, is likely to enjoy.

So the questions remain, how does a government implement painful spending cuts and somehow retain enough support to remain in office long enough to carry out the plans? And perhaps more importantly, what will happen to aggregate economic growth in the event that multiple countries implement sharp spending cuts simultaneously? This is exactly why so many pundits are pessimistic about the European situation. Lots of stuff needs to go right in order to get to the other side of this crisis. First, austerity plans must be implemented and carried out across multiple countries without major governmental disruption and social unrest. And second, nobody knows the impact that simultaneous spending cuts across Europe will have on the aggregate European economy.

The Greek economy is expected to shrink about 6% this year - more than double the amount expected at the inception of the bailout program in May 2010. In addition, the economy will continue contracting next year compared to an original expectation for a return to positive growth. The Post quoted Thomsen as saying "Reforms have fallen short. They are well behind schedule. They are well away from the critical mass that would make people conclude Greece is doing business in a fundamentally different way, and that is the main reason the bottoming out of the recession has not happened." But is it realistic to think that had the reforms (ie, spending cuts) been implemented as planned, the Greek economy would be back on track to grow again in 2012? It does not seem very likely to me, especially when the rest of the continent is shrinking at the same time.

I am all for biting the bullet, ripping off the band-aid, jumping on the grenade, etc, etc. However, in this case, it seems that the IMF and the markets should be careful what they wish for. The famous economist John Maynard Keynes argued that in times of weak economic growth, governments should step in and increase spending in an effort to prime the economic pump. If Keynes were alive today, he would undoubtedly argue that sharp, simultaneous cuts in public spending across large swaths of the European economy could very likely cause bigger problems than many people fully appreciate. A mild downturn could turn into an ugly recession very quickly.

The point is that in Greece, the rest of Europe, and the United States, spending cuts are necessary. If cuts are implemented too aggressively, recessions will result. If cuts are too mild, Reinhart and Rogoff’s study, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” shows that debt will reach levels that stifle growth and can cause equally deep recessions that may last a long time. Striking a proper balance is the key. Errors, in our opinion, should favor the “aggressive” end of the cutting scale. Though potentially more painful, the sooner markets are allowed to clear, the better. 

This post was also written by Keith B. Davis, CFA. Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C.  Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.