Kirkegaard: After $1 Trillion High, Reality and Deflation Dawn

It did not take long for the $1 trillion rescue package in Europe to stir second thoughts in global financial markets.

This is probably not too surprising, since the purpose of the package was to contain the contagion risks in Europe, without addressing the immediate cause of the problem, Greece’s insolvency.

In recent days we have received a number of significant new pieces of information and announcements in Europe, all bearing implications for how this crisis will develop.

First, the International Monetary Fund (IMF) has published its detailed economic analysis of the Greek restructuring program. It makes for truly grim reading.

The analysis highlights substantial risks, even under the IMF’s somewhat optimistic economic assumptions. For instance, the IMF indicates that even with the bailout package from the euro zone and the fund, Greece is expected to cover part of its public financing need through a rollover of short-term debt in the private financial markets as soon as the third quarter of 2010 -- next month. In today’s markets, that will be tricky.

The IMF also envisions that Greece will be able to roll over long-term debt as soon as the first quarter of 2012, at a time when Greece is expected to have a total debt burden of 145 percent of GDP.

Even if everything else goes right for Greece, the IMF’s timetable is just not credible. It would require Greece to reduce its total debt burden before 2012, even under the IMF’s own baseline scenario.

Spain Gets Real

Second, on May 12, a remarkable turnaround came from Madrid, where the government of Prime Minister José Luis Rodríguez Zapatero -- having been in denial throughout this crisis so far -- awakened to the need for action.

Zapatero will now cut public wages by 5 percent in 2010, freeze them in 2011, suspend a pension rise promised during the last election, scrap a €2,500 ($3,100) subsidy for new parents, trim foreign aid assistance and let public investments fall by €6 billion in 2011. In addition, the cabinet members themselves will see their wages cut by 15 percent to achieve a 6 percent deficit by 2011, down from 11.2 in 2009.

For a socialist government, this is true “shock and awe,” not least towards its own supporters. Zapatero may be signing his own political death sentence, as these measures are sure to infuriate his party’s traditional allies among the Spanish labor unions, and lead to massive public protests on the streets of Madrid and elsewhere.

Even so, the Spanish government should go further and act to solve not only the immediate fiscal issue, but also Spain’s underlying problem, its low medium-term growth outlook. Having already antagonized its union allies, it should first implement drastic labor market reform to end the insider-outsider labor market, with its history of unemployment rates of 20 percent or more.

ECB Carries the Big Stick

Spain’s immediate and credible austerity measures so far indicate the kind of political concessions that the European Central Bank (ECB) won in return for its extraordinary policy actions.

The willingness of Spain to fall on its sword so swiftly shows the effectiveness of ECB pressure and greatly adds to the bank’s longer-term credibility.

Spain’s agreement to pursue “legislated wage deflation” follows in the footsteps of both Latvia and Ireland. Together these steps have placed significant additional pressure on other euro-zone governments, not least Portugal (which has already signaled additional measures that will raise “social tension”) but also Italy. The entire euro zone is now feeling the heat to accelerate fiscal austerity efforts and bring down primary deficits.

Indeed, in the wake of the Spanish announcement, it seems more likely that the entire Southern part of the euro-zone will fall into outright deflation in the short to medium term. This should ensure that the ECB keeps interest rates low for the foreseeable future.

But that prospect makes the IMF assumption that Greece will increase its exports of goods and services by 4.5 percent in 2010 and more than 5 percent annually thereafter utterly unrealistic.

Jacob Funk Kirkegaard has been a research fellow at the Institute since 2002. Before joining the Institute, he worked with the Danish Ministry of Defense, the United Nations in Iraq, and in the private financial sector.