In fact, it’s spreading….

There are basically four ways to address an unsustainable public debt and deficit situation:

1. Making large public spending cuts and tax hikes
2. Higher economic growth
3. Higher inflation
4. Increasing productivity, competitiveness and economic growth through structural reforms

In isolation, structural reforms won’t achieve any immediate relief, so we won’t discuss them here. These have more of a long-term support role (albeit an important one), so form a necessary but complementary part of any package, .

Greece now apparently is embarking on the first, in the form of a 24B euro austerity package. The effects of measures like increasing the pension age from 53 now to 67(!), cutting public sector wages by 14% at least, increasing value added tax (again), and the like on economic growth and inflation are entirely predictable.

The Greek economy will fall off a cliff, at least for the near future. This will put the whole package in doubt as:

• Political support for it, already low, will crumble futher if initial results are even worse
• A tanking economy might very well worsen the deficit and debt problems (or at least not provide any improvements, which is what happened in Ireland even after drastic austerity measures). Ergo, Greece will need more money. Will the rest of Europe keep footing the bill?

This is what Krugman had to say on it this morning:

• Greece’s fiscal woes would be serious but probably manageable if the Greek economy’s prospects for the next few years looked even moderately favorable. But they don’t. Earlier this week, when it downgraded Greek debt, Standard & Poor’s suggested that the euro value of Greek G.D.P. may not return to its 2008 level until 2017, meaning that Greece has no hope of growing out of its troubles.

And Greece is far from the only country with large public sector deficit and/or debt problems. There are the other “PIIGS” European countries (Portugal, Ireland, Italy, Spain) which urgently need to address the mess in their public finances. And public finance problems are by no means confined to the euro area. This is what the IMF said:

• The Fund has calculated that almost all advanced economies need to tighten fiscal policy significantly in the coming decade in order to stabilise debt at 60 per cent of national income by 2030 and the tightening needed in the US, Japan and the UK is just as bad as that required in Greece, Spain, Ireland and Portugal.

What will happen to economic growth when many countries will embark on austerity at the same time? This will make the ‘easy way out’ of these problems that much more difficult. Historically, a combination of economic growth and inflation has mitigated many of these problems, but we cannot count on that happening again.

In fact, having stretched the possibilities of monetary policy already to the full, we might very well end up with deflation, rather than inflation. Deflation  increases the real value of the outstanding debt, thereby making the problem that much more intractable (ask the Japanese, whose debt/GDP ratio is approaching 200%, almost twice that of Greece. Their situation is still somewhat less dramatic as they can rely on domestic, rather than foreign savings to finance the deficit and maturing debt).

The euro is now hindering, not helping a solution as the countries with the biggest trouble cannot devalue or embark on their own monetary policy (although the latter disadvantage is moot in the present environment of super accommodating monetary policy). Krugman called this the ‘Euro Trap’, this morning:

• But that’s a much harder thing to do now than it was when each European nation had its own currency. Back then, costs could be brought in line by adjusting exchange rates — e.g., Greece could cut its wages relative to German wages simply by reducing the value of the drachma in terms of Deutsche marks. Now that Greece and Germany share the same currency, however, the only way to reduce Greek relative costs is through some combination of German inflation and Greek deflation. And since Germany won’t accept inflation, deflation it is.

So, in conclusion:

• As the Irish experience has shown already, even outrageous austerity measures are not going to improve the budgetary and debt situation initially.
• They will slash economic growth and inflation, any reducing deficit and debt program’s best friends.
• This is especially true if many countries are embarking on austerity at the same time, this could very well lead to deflation
• More bail-out money will be needed
• The euro makes adjustment that much more difficult

Sooner or later, something has to give…