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Thursday, June 27, 2013

The Czech Economy That Didn't Bounce?

The Czech republic has been making the news recently. On the one hand the country has been on the receiving end of massive, devastating floods, while on the other the country's government was brought to the brink of collapse (and beyond)  by the resignation  of Prime Minister Petr Necas following the arrest of one of his most trusted aides on corruption charges. After the deluge I suppose.

Curiously both these events serve to highlight one important underlying reality - Czech voters are deeply dissatisfied and in a highly skeptical mood, since following seven quarters without growth the country's economy is evidently stuck in the doldrums. The worst part is things look highly unlikely to improve anytime soon.

Naturally the flood damage has resurected an old and somewhat tiresome debate about whether or not destruction is actually good for an economy. The last time this surfaced in any significant way was in the aftermath of the Japanese tsunami (see my piece of the time here), and as we can now see all that reconstruction spending totally failed to get the economy back on track, although it did leave the ailing country with just a bit more debt.

As I think everyone agrees, flood damage is a form of wealth destruction. If you have a house on one day, and the next you don't then somehow you feel poorer. It isn't really surprising that you feel poorer because in actual fact  you are poorer. Naturally, if your home gets rebuilt, and you find yourself with an even better one as a result, then  you may even feel you have benefited (although what about all those valued personal belongings you lost), but that will be because someone else, either a government or an insurance company, has made good your loss, so they are poorer instead of you. As Reuter's reporter Michael Winfrey puts it: "Governments and insurers from Germany to Romania will have to pick up the costs of helping families and business recover from the floods, which have killed at least a dozen people and driven hundreds of thousands from their homes since the start of June".

Now clearly in the short term GDP may benefit, since spending money will generate economic activity. As the country's Finance Minister Miroslav Kalosuek told Czech Television at the time: "If we take just the normal households, and how many brooms, bleach and rubber gloves they must suddenly buy, that is demand. There will also be demand in construction, demand in renewing roads, higher demand for certain goods and services. And higher demand is pro-growth."

But will the extra demand really generate extra growth in the longer run, rather than simply advancing spending from the future to now (or as the Spanish expression so evocatively puts it "give us bread for today and hunger for tomorrow") ?  The evidence we have seems to suggest that it will if the problem the economy was suffering from was a lack of stimulus - which brings us nicely round in a circle to the stimulus versus austerity debate. But if lack of stimulus wasn't the problem, as we have seen in the Japan case, an extra reconstruction programme won't make a blind bit of difference at the end of the day. It will simply shift demand around a bit in time.

So which is it? Is the Czech Republic suffering from a normal common or garden recession, one in which a bit more stimulus might help, or is something deeper going on?

The Demographic Spanner Stuck In The Works

The Baltics, Hungary, Romania and Bulgaria are all recognized - each in their own way - to have encountered serious economic problems and generated sizable imbalances during the run in to the global financial crisis. These problems - at the time - were seen as placing serious question marks over the underlying soundness of a group of economies which in the pre-2008 world were often lauded for their growth prowess and fiscal abstemience when compared with their West European neighbors. The fact that these countries started, one after another, to go off the rails could be explained by viewing them as examples of  the "weaker economic cases"in the group.

But when, in a way which curiously parallels what is now happening in purportedly "core Europe" countries like Finland and the Netherlands in the West,  what were previously regarded as best-case-scenarios, like the Czech Republic and Slovenia, start to struggle and then continue to flounder, well perhaps we should be raising more than an eyebrow or two - indeed,  maybe we should really be asking ourselves some serious, thought-provoking questions not only about the structural depth of the problems being faced by the whole group of Eastern Accession countries, but also even about the very soundness and adequacy of the received theories the main multilateral policy institutions are working with.

In the current case, the Czech Republic is now in all probability in its eighth quarter of  recession - and the last time the economy actually grew was in the three months up to June 2011. This is quite a preoccupying outcome for a country which was not perceived to be suffering from any special problems - like outsize credit booms, or government fiscal largesse - in the pre-crisis world. The economy is now moving sideways, and, more importantly, substantial question marks hover over what the country's real future growth potential actually is. Certainly, and in any event, it is well below that which was considered a norm pre 2008.

In the past the country was characterised by and renowned for the soundness of its industrial base and  its strong export performance, but the continuing crisis in the Euro Area (the principal source of external demand for the country's products) has meant overseas sales have been largely stagnant for some quarters now. And with countries in Southern Europe striving to make a substantial competitiveness correction and claw back some of their lost ground, it is in the East of Europe where the impact of these efforts is likely to be most acutely felt. It was precisely during the time that the Southern economies were shifting over to credit-driven service ones that their Eastern counterparts were busy building their industrial foothold in the EU. Now those in the East face the risk that a sizeable chunk of this coupling and integration process may simply unwind. A rising tide may lift all boats, but what does a flat sea do?

Czech industrial activity has become virtually stagnant when it isn't actually falling.

And construction is steadily sliding downhill.

In addition to the loss of export leverage household consumption has remained very weak. As the IMF put it in their latest country report, "the export-led recovery observed in 2010-11 subsided as euro area import demand slowed, and growth has noticeably underperformed trade partners and peers since the middle of 2011 mainly because of weaker domestic consumption and investment."

Naturally, both the IMF and EU Commission assume that what is happening to the country does not go far beyond a short term blip, and both institutions take it as a given that "recovery" will set in somtime soon. As the IMF puts it, "The Czech Republic's economic fundamentals are strong." The EU Commission broadly agrees: "Due to a strong downturn in consumer confidence, a drop in public investment and a weaker external environment, real GDP is estimated to have decreased by 1.3% in 2012. As these factors ease off in 2013, economic activity is forecast to bottom out in the middle of the year. The recovery is expected to consolidate in 2014, supported by growth of real household income".

That being said a nuanced but interesting divergence has emerged between the two Troika partners over the immediate outlook for the country. While EU Commission see "domestic risks to the outlook" as "fairly balanced", the IMF feels general risks lie  "mainly to the downside" highlighting the risks of  "further deterioration of euro area growth" and the danger of "permanent scars to potential growth".

The Fund explain their concerns as follows:  "With recent disappointing export performance, the economy is at the risk of being dragged deeper into recession. Also, the current poor growth performance, if protracted, runs the risk of translating itself into a long-term decline in potential growth due to lower investment." I.E. the slowdown could eventually become self perpetuating if the recession becomes an even more dragged out affair. Unfortunately this possibility is far from being excluded.

Given the existence of such risks it is worth asking ourselves whether growth in the Czech economy really will bounce back to an average of around 2.8% a year between 2015 and 2018? What is there in the works which really could make such a growth spurt - from the current near zero level - possible? Or could the IMF forecast numbers not be just another example of what Christine Lagarde once called “wishful thinking” of the kind that has been habitually practiced in, say, the Greek case.

But let's put the question another way. What might impede the country from  reverting to a pattern of strong growth rather than simply continuing to bounce along the flatline?  Well, you've got it - it's the demography stupid!  The Czech Republics population and workforce just turned the historic corner pointing towards long term decline. To some this piece of information may seem surprising, but CEE demographics in general really are quite unique, since while fertility fell and life expectancy started to rise as it did in the West, due to the development delay produced by nearly half a century of communist government most of these countries are now in the process of getting old before they get rich, creating a very special set of economic growth and sustainability issues.

Czech fertility has long been below replacement level, and has been below the 1.5tfr level since the early 1990s.    

The Czech population has been virtually stationary over the last few years, but is now finally starting to contract.

As in many countries on the European periphery the decline is an indirect by-product of the economic crisis. Population levels which were previously precariously balanced around the zero growth line are suddenly being destabilised by the drop in births associated with the recession and the sudden disappearance of the positive net number of migrants arriving which helped keep the balance in the pre-crisis world.

"In the first three months of 2013.... net international migration was equal to minus 4 people – the number of emigrants was 9 998 people and number of immigrants was 9 994 people. The highest net migration was reached with the citizens of Slovakia (1 213 people) and Germany (334 people), followed by United States (290 people) and Romania (213 people). The considerable decrease was registered in the number of citizens of Ukraine (by 2 201 persons), Czech Republic (by 505 persons) and the number of Vietnamese citizens (by 427 persons)".

But even more important (in terms of GDP growth potential) than the overall population decline (which is still tiny) is the fall in working age population (WAP).  Following a pattern seen in country after country along the periphery, the start of the decline in this population group has also  coincided in time with the onset of the European debt crisis.

This means that employment growth will have the wind blowing against it, rather than behind it, and that it will become harder and harder to get GDP growth from adding extra labour (indeed at some point the number of those employed may well become negative) and the only major impetus towards headline GDP growth will have to come from productivity improvements. For an examination of this issue from the Portuguese point of view see this post here.

Is There Deflation Risk?

One of the lesser known details about the Czech economy is that - since it has retained its own currency, the Koruna - it has its own independent monetary policy and the central bank therehave now been holding interest rates about as near zero to zero as you can get  (0.05%) for  the past 8 months. This puts the country's bank in more or less the same situation as most of its better known peers across the globe - namely it is now up against the "zero bound" which makes it difficult to lower nominal interest rates any further.

With inflation weakening the debate at the central bank is now moving towards whether it will be necessary to use exceptional measures of the kind which would elsewhere be called QE. One option which is under consideration is a local version of "Abenomics" whereby the bank actively intervenes in the currency markets to provoke Koruna weakening - not so much to generate more export competitivness (banned by the G20) but rather in order to to try and raise the price level and avoid deflation risk (see these comments from central bank board member Lubomir Lizal). Such interventions, which (as in the Japan case) target the price level and not the currency value are for the time being accepted by the international community.

At the present time the Czech Republic is experiencing strong disinflation rather than outright deflation, but the IMF clearly see a danger if domestic demand remains weak and the economy continues to drift that this could become outright deflation.
The policy interest rate has reached the zero bound, but risks to inflation are to the downside. The Czech National Bank (CNB) was swift to cut its policy rate by 70 basis points to 0.05 percent between June and November 2012. Inflation declined below the 2 percent target level starting from January 2013, as the effects of 2012 VAT hike subsided and contributions from food and fuel fell. Inflation is projected to remain at around 1¾ percent through 2014, but risks are to the downside in line with the risks to the growth outlook.
"If a persistent and large undershooting of the inflation target is in prospect, the CNB should employ additional tools. The CNB’s statement that additional monetary easing within the context of inflation targeting framework would come from foreign exchange (FX) interventions is welcome and has been clearly communicated. The mission agrees that FX interventions would be an effective and appropriate tool to address deflationary risks."
The risk of outright deflation is thus intrinsically linked by the Fund to the downside risks to headline GDP growth. If the economy under-performs, and investment does not bounce back then not only will there be damage to the country's long term growth potential, movements in prices might turn negative.

Japan With A Current Account Deficit And Negative Net External Investment Position?

Few, I suppose, would have thought there would be any good reason to make a comparison between the Czech Republic and Japan. Naturally it is noticeable that both countries have strong industrial bases and are very dependent on exports for growth. But beyond that it would seem the two countries have little in common.

Except, except.....  what about the decline in working age population (WAP)? Isn't that the factor that many feel is behind the ongoing battle that Japan is fighting with deflation? (See, for example, this post). The Bank of Japan has long recognised that there is some sort of correlation between the rate of workforce growth and the rate of inflation (see chart below), with price inflation turning negative at more or less the same time as labour force growth did. The causality behind the correlation would be connected with the rate of rise (or decline) in domestic demand (initially consumption and then investment). Movements in WAP could be considered to be a good proxy for movements in employment and incomes, and hence consumer demand. As a country's WAP enters decline then domestic demand tends to weaken and following this the investment which goes with such demand does not occur. This is why failure to adequately resolve the present malaise into which the Czech Republic has fallen could produce a long term negative consequence for trend growth, as the IMF have highlighted.

Thus it isn't just a coincidence that the Czech Republic is starting to notice a fall in domestic demand and a fall in investment at just the time when the working age population starts to decline. This is a development which needs to be closely watched.

But, beyond any loose similarities, there is one important sense in which the country differs from Japan - the state of its Net External Investment Position

The Czech Republic has, as I have repeatedly stressed, a strong export sector. So much so that the goods trade balance tends to be positive and large. What's more, it has been growing rapidly since the crisis. In fact, in Japan as the population has aged this balance has weakened.

But while in Japan the current account balance remains strongly positive, in the CR it is constantly negative.

The reason for this apparent paradox  lieswith the large negative income component in the current account.

This income component is largely made up of interest payments on external loans (for example in the banking sector between West European parent bank and Czech subsidiary) and dividends on equities owned by non residents (for instance non-Czech parent companies which bought into Czech utilities during the privatisation wave).

The income item is large and negative due to the country's strong negative Net International Investment Position. Simply put non Czech nationals have more investments in the Czech Republic than Czech citizens have abroad to the tune of some 50% of GDP. In an ageing society, with a shrinking workforce this situation is simply not sustainable. Czech companies and citizens need to save more, even though this will weaken domestic demand further and make the country even more dependent on exports, and more of these savings then need to be invested abroad to generate an income flow which will help the country support its rapidly ageing population from 2020 onwards. This situation is widespread across Eastern Europe (see Hungary here and Bulgaria here).

Summing up: In recent years Czech exports have performed remarkably well, and the country has a strong goods trade surplus. The problem is that most of the country’s exports have been geared to the European market, and consumption in this area is now stagnant with a tendency to decline. In addition the country is heavily indebted abroad. With each passing day the CR looks more and more like Germany and Japan, without the strong overseas investment stock which gives the economies of those countries some sort of stability. The country cannot gain enough export momentum and as a result the economy languishes in recession.

The thing about elderly economies is that they no longer stand on two pillars, domestic consumption steadily runs out of steam, and the economy becomes export dependent. This is what can be observed in the Czech Republic, and the country’s demographics make it unlikely we will ever see strong growth in private consumption again.

On the other hand the country has a low sovereign debt level – around 45% of GDP – and before the onset of the latest recession it did maintain a reasonably strict fiscal discipline, despite the fact that with an ageing population the costs of health care and pensions continue rising annually.

One of the reasons for the low sovereign debt level is the fact the country privatized a number of its state owned companies at the start of the century - and herein lies the problem on the income side of the current account. Privatising to overseas (rather than domestic) investors means the even though the sovereign itself is less indebted, the level of indebtedness of the country as a whole doesn't change much. Ultimately the sovereign supports the nation, and the nation the sovereign, so apart from the political debate about larger or smaller government the rest is more akin to moving the deckchairs around. This kind of privatisation does not guarantee long run sustainability for the country, and if not backed by a rise in domestic saving it can become "bread for today and hunger for tomorrow" as the Spanish expression goes.

So despite being out of the Euro, and having the ability to devalue, it is not clear to what  extent the Czech government will be able to withstand popular pressure to increase spending in the face of a stagnant economy. Without some plan for handling the ageing population problem calls for continuing austerity will likely fall on increasingly deaf ears as they do in country after country along the EU periphery. Despite talk of a constitutional change limiting public debt to 50% of GDP, as we are now seeing in the Polish case such laws are easier to enact than they are to implement. So it is likely that the current wave of austerity policies will increasingly come into question if, as seems probable, the economy continues to stagnate.  In which case watch out for credit rating downgrades, and future surges in yield spreads on the one hand and growing deficit and debt levels on the other. As Paul Krugman once put it, some countries have low growth because they have high debt, and others accumulate high debt because they have low growth. The latter is in dabger of becoming the Czech case.

Wednesday, June 19, 2013

The Second Battle Of Thermopylae

According to legend and some historians, by making a stand in the Thermopylae pass 300 brave Spartans valiantly saved the day for the entire Greek army in the face of a Persian force of overwhelming strength and manpower. More than 2,000 years later some 11 million Greeks might be considered to have carried out a rather similar operation by single handedly facing-off a massed horde of frantic global speculators on behalf of the entire Euro Area population - at no mean cost to themselves in terms of wealth, employment and general well-being. Or at least that is the conclusion which could be drawn from reading through the latest self-critical review issued by the IMF dedicated to the lessons which can be learned from the to-date handling of  the country’s deep economic and social crisis.

The document, entitled Ex Post Evaluation of Exceptional Access Under the 2010 Stand-By Arrangement (henceforth referred to as the Evaluation Document), does not mince its words, and suggests that Greece suffered a worse than necessary recession due to the reluctance of Europe's leaders to agree on debt restructuring from the outset. The reason for this reluctance is obvious with hindsight, the Euro Area was institutionally ill-prepared for the kind of crisis which was unfolding while the interconnection of the European capital markets and the banking sectors meant the financial systems of a number of other European countries were at risk.
Contagion from Greece was a major concern for euro area members given the considerable exposure of their banks to the sovereign debt of the euro area periphery. 

 Earlier debt restructuring could have eased the burden of adjustment on Greece and contributed to a less dramatic contraction in output. The delay provided a window for private creditors to reduce exposures and shift debt into official hands. This shift occurred on a significant scale and left the official sector on the hook.
An upfront debt restructuring would have been better for Greece although this was not acceptable to the euro partners. A delayed debt restructuring also provided a window for private creditors to reduce exposures and shift debt into official hands. As seen earlier, this shift occurred on a significant scale and limited the bail-in of creditors when PSI eventually took place, leaving taxpayers and the official sector on the hook. - IMF Evaluation Document

The contents of the Evaluation Document were widely reported on in the press (see for example here), and produced a swift response from EU Commission representatives, including an "I don't think it's fair and just that (the IMF) is trying to wash its hands and throw dirty water on European shoulders," from Economic and Monetary Affairs Commissioner Olli Rehn. The little phrase that caused all the problems was the report's assertion that "An upfront debt restructuring would have been better for Greece although this was not acceptable to the euro partners."  Obviously, when a dispute becomes as public as this, something, somewhere is going on. Trying to fathom what it was I couldn't help noticing that the publication of the  Evaluation Document coincided almost exactly in timing with the issuing of the Fund's latest report on the current (rather than the initial) Greek programme - The Third Review Under the Extended Arrangement Under the Extended Fund Facility (what a mouthful that is, henceforth the Third Review) - where curiously the international lenders let slip the significant little detail that next year Greece is expected to have a funding shortfall of some 4 billion Euros. Almost immediately denials that any kind of talks were ongoing about any kind of  forthcoming debt pardoning for the country started to surface in Germany, (or see here).

In my case the light dawned when reading more thoroughly through the Third Review document I came across the following paragraph:

The macroeconomic outlook, debt service to the Fund, and peak access remain broadly unchanged and euro area member states remain committed to an official support package that will help keep debt on the programmed path as long as Greece adheres to program policies. Capacity to repay the Fund thus depends on the authorities’ ability to fully implement an ambitious program. It continues to be the case that if the program went irretrievably off-track and euro area member states did not continue to support Greece, capacity to repay the Fund would likely be insufficient.
Now all of this may sound - at least to the uninitiated - like a load of old bureaucratic mumbo-jumbo, but actually there are a number of key statements here which may help to put the recent internal Troika tiff in some sort of broader and more intelligible perspective.

Sometimes in order to get to grips with a highly complicated argument thread it helps to go to the endpoint and then work your way back. It also helps to bear in mind that the recent Evaluation Document is as much about the future as it is about the past - and in particular the scenario which will come into play in 2020 and 2022 when the current programme's debt to GDP targets are expected to be achieved.

The cited paragraph talks about three issues: the macroeconomic outlook, the commitment of euro area member states to support Greece and keep the debt on the programmed path as long as Greece adheres to the programme's requirements, and the danger that should the programme go "irretrievably off track", and euro area member states not give the necessary support then the country's capacity to repay the Fund would clearly be insufficient - ie the IMF would be left holding the can, and Fund employees would be faced with the complicated task of explaining to its non-European members why losses had been incurred.

So now I understand the nervousness a bit better. Crudely put the position is this - as long as the IMF continue to write reviews stating the Greek programme is on track then the euro area member states are on the hook to make up any shortfall in Greek debt performance. This is a commitment they undertook during negotiations on the second bailout agreement.

On the other hand, if the IMF were to start producing reports stating that the programme was off-track because of Greek non-compliance, rather than for example arguing that the numbers were out of whack due to faulty macroeconomic forecasts (some of them from the EU Commission itself), then the euro area member states would be off the hook from additional stepping up to the plate with the result that the IMF would end-up taking a loss.

Complicated isn't it? That is why the rule of starting out from the assumption that nothing is ever exactly what it seems to be is normally a good one to work by.

What is obvious from reading through the documentation is that the IMF is keen to highlight the guarantees given by Greece's euro area peers at the time of setting up the Extended Fund Facility (2012) that "adequate support" would be provided to bring Greece's debt down below 110% of GDP in 2022 (ie that there would be some form of debt pardoning) should the country comply with the terms of its programme and the debt dynamics still not turn out right. Since we now have a track record on all this, and since staff economists at the Fund have also recently conducted a debt sensitivity analysis which came up with the finding that given slight under-performance on GDP and inflation outcomes the debt could still be as high as 147% of GDP come 2022 , the issue is no mere trifle.

This is, in my opinion, why so much emphasis is now being placed in Washington on the fact that Greece's short term interests were to some extent sacrificed for the greater good of the eurozone, a justification which may make the bitter pill of Euro-partner losses on their loans to Greece easier to sell to their respective electorates.

Well, since nothing is really valid in this world until it is tested (like the June 2012 commitment to mutualise some of Spain's bank losses), and since 2020 is still a relatively long way away, it isn't hard to understand why the good folks in Washington might want to see the commitment in Europe tested a good deal sooner, which is where, I think, next year's 4 billion euro funding shortfall comes in. I cite the latest review document (my emphasis):
The program is fully financed through the first half of 2014, but a projected financing gap of €4 billion will open up in the second half of 2014. Thus, under staff’s current projections, additional financing will need to be identified by the time of the next review, to keep the program fully financed on a 12-month forward basis, and the Eurogroup has initiated discussions already on how to eliminate the projected 2014 gap. In this regard, the Eurogroup commitment made in both February and November 2012 to provide adequate support to Greece during the life of the program and beyond, provided that Greece fully complies with the program, is particularly important.
Again the essentials are hard to-get-through-to for all the bureaucrat-speak, but the last sentence says it all - "The Eurogroup Commitment...to provide support to Greece....is particularly important."

A Deeper Than Necessary Recession?

Greece's recession has been one of the deepest peacetime recessions ever experienced in industrialized economies, and bears comparison with the great depressions of the 1930s in the US and Germany (see chart prepared by the IMF below). Overall, the economy contracted by 22 percent between 2008 and 2012 and unemployment rose to 27 percent; youth unemployment now exceeds 60 percent. As domestic demand shrank across all areas, net exports provided support largely through shrinking imports. Indeed as opposed to other countries on Europe's periphery exports actually shrank in Greece in both 2011 and 2012.  The issue this raises is was such devastation really necessary in a country participating in a currency union which could have expected support from other participants?

Naturally the country "cheated" on its partners, and sacrifices were inevitable but surely a more pragmatic and equitable solution could have been found. Simply punishing a country for what is perceived to have been "wrong doing" accomplishes little and may put a great deal at risk, including amongst those not directly involved.

As the IMF points out in the Third Review, Greece was forced into one of the largest fiscal adjustments seen anywhere  to date (see chart below).The primary adjustment in 2010–12 amounted to 9 percent of GDP, and was much higher (15 percent of GDP) in cyclically-adjusted terms. The same outcome could have been achieved over a slightly longer period of time had a more constructive attitude been taken. On the other hand the IMF take the view that some sort of rapid fiscal adjustment was unavoidable (but how rapid?) given that the Greece had lost market access and official financing could be considered to have been  as large as politically feasible. They conclude:
It is difficult to argue that adjustment should have been attempted more slowly. The required adjustment in the primary balance, 14½ percentage points of GDP, was an enormous adjustment with relatively few precedents, but was the minimum needed to bring debt down to 120 percent by 2020. Moreover, despite the starting point being slightly worse than thought to be the case when the 2010 Stability Program was drawn up, the SBA-supported program had already extended the period over which the Maastricht deficit target would be achieved from 3 to 5 years. Since the program only ran through mid-2013, the last part of this adjustment would occur after the program and the conditionality had ended. Moreover, debt would still be increasing when the program ended.

One of the key points to note here is the observation that the program only ran through mid-2013. This is a knock-on consequence of the type of program originally set up (the so-called Standby Arrangement - or SBA). SBA's are by their very nature designed and intended for short term liquidity support prior to a reasonably rapid return to market access. But Greece's needs, as is now obvious, were longer term and involved solvency issues. Had a decision been taken at the outset to set up an Extended Funding Facility (the 2012 program is of precisely this type) then the time horizon could have been longer, but part of the reason an EFF was not chosen was because the solvency issue was not recognised and debt restructuring was not on the table, so the argument at this point becomes somewhat circular. That is to say, had the will been there at the outset to use an Extended Funding Facility and had the realistic view (recognized with hindsight) that debt restructuring was inevitable been taken, then the Greek fiscal correction would still have been significant, but more extended in time, and with less overall damage to the economy's private sector.

And the damage was severe. The employment loss was dramatic (see chart) and as in other countries who have suffered a similar, if more benign, fate (Spain, Portugal) it is hard to see how earlier levels are ever going to be recovered given anticipated future growth rates.

The social and economic consequences of the over ambitious fiscal correction  have gone well beyond the downsizing of the country's bloated public sector, and no part of Greek society has been spared. Among Greek households the fall in disposable income between 2009 and 2011 nearly doubled the previous debt-to-disposable-income ratio (which rose to 96 percent - higher than the peak observed in Latvia). Falling property prices have raised mortgage loan-to-value ratios from around 70 percent on average before the crisis (lower than in European peers) to close to 90 percent in 2012 (currently higher than even in Spain). House prices fell by 11.8% in the year to the end of March, according to the residential price index published by realtors Knight Frank following a 9.8% drop a year earlier. For a country which didn't really have a property boom before the crisis this is very striking.

In the non-financial corporate sector the decline in profits has affected firms’ ability to service debt, with the interest coverage ratio dropping from 24 percent in 2001 (one of the highest in Europe) to 2.4 percent in 2012 (higher only than Portugal). As a result Non-performing loans in both the household and corporate sectors have risen sharply (see chart below for the corporate case) and in 2013 are expected to pass the 30% of total loans mark.

All this distress and impairment naturally creates problems where previously few existed. The Euro firewall building process meant that most of Greece's sovereign debt risk was transferred from other European banks to Greek ones, with the consequence that when the debt restructuring finally did come these banks all needed recapitalizing by the state leading the country to have to borrow yet more money to pay for this. Now that the only external imbalance correction process is what the IMF calls the "recessionary path" (rather than a more comprehensive internal devaluation - see below) these same banks are being faced with substantially more losses on their general loan books, possibly leading to the need for yet more recapitalization, and so on.

Divergences Within The Troika On Deflation?
"Deflation is a protracted fall in prices across different commodities, sectors and countries. In other words, it is a generalised protracted fall in prices, with self-fulfilling expectations. Therefore, it has explosive downward dynamics. We do not see anything like that in any country". Mario Draghi answering the question "do you see any risk of deflation in some countries in the euro area?" at this months ECB press conference
"Macroeconomic developments are broadly as expected. The economy is rebalancing apace: the current account deficit is now shrinking fast, by 6½ percent of GDP in 2012; the competitiveness gap has been reduced by about half as last year’s labor market reforms are facilitating significant wage adjustment; and deflation is finally setting in". - IMF Third Programme Review (my emphasis).

Leaving aside a small quibble about the definition of deflation Mario Draghi selects for himself - for self-fulfilling expectations about an ongoing fall in prices to set in prices first need to start falling - there is no doubt that in the case of Greece prices are now falling, and the arrival of this crude kind of deflation (rather than what we could call the Draghi variety) in any country is surely an issue which most of the world's central bankers beyond the confines of the ECBs governing council are certainly not blasé about, if only because unless it is handled properly it can transform itself into the kind Mr Draghi so rightly fears . According to the IMF Third Review
In response to Greece’s now high output gap, headline HIPC inflation fell to 0.3 percent at end-2012 (from over 2 percent at end-2011) and turned negative in March (-0.2 percent) and April (-0.6 percent). Core inflation (excluding energy and unprocessed food), which has been negative for some time, fell further to -1¼ percent in March. The GDP deflator also turned negative in 2012 (-¾ percent).
The striking thing, leaving aside the issue of definition,  is that the IMF actually seem to welcome the fact deflation is finally arriving in Greece - due to the competitiveness impact it will have on the Greek price level. But it is here I think that one can discern some sort of difference of opinion within the Troika itself. It seems likely that the IMF would actually agree with Mario Draghi that Japanese-style deflation is probably not on the cards in Greece at the moment (although given the depth of the country's problems and the fact that the countries workforce has now started shrinking - due to demographic shifts and emigration - who the hell really knows, I certainly wouldn't put my hand in the fire one way or the other on this one).

But the IMF are concerned about an ongoing fall in wages and incomes in the context of continuing increases in the price level, and hence welcome the drop in prices as part of an internal devaluation which is seen as essential to restore international competitiveness.
The far-reaching labor market reforms put in place in early 2012 have contributed to deeper wage corrections than in other recent crisis cases and substantial adjustment in the ULC-based REER. Less encouraging has been the weak and delayed response of prices to wage reductions, owing largely to product market rigidities. This asymmetry in price adjustment has led to a substantial erosion in real incomes and demand, and placed a disproportionate burden on wage earners relative to the self employed and the corporate sector. It has also left the CPI-based REER overvalued in 2012 by about 9 percent (Box 2). With the headline inflation now in negative territory and a widening inflation differential with the euro area, the extent of overvaluation is gradually reducing and relative prices between the tradable and nontradable sectors are adjusting. - IMF 2013 Article IV Consultation

So why might the other parts of the Troika - the EU Commission and the ECB - be more nervous about the consequences of this drop in the price level? They are concerned about the impact on Greek debt dynamics is the obvious answer. This drop in prices is now seen as essential and inevitable by the Fund, but is still to some extent being resisted in  Brussels and Berlin. Again, the reason for the reticence is obvious, "we're on the hook" - remember, if Greek debt is above the 110% of GDP target in 2022, or reaches levels in the intervening years that make this level obviously unattainable, for reasons of lower than anticipated GDP or price growth then the Euro Area peer countries are committed to making up the difference.

The chart below shows the results of a Debt Sustainability Analysis carried out by Fund economists during the period of the first bailout. What is clear is that the two main risk items for debt snowballing are lower than anticipated GDP growth and deflation. As the IMF itself observes in the Evaluation Document: Since the shocks considered were fairly mild, this sensitivity analysis demonstrated the precariousness of the debt trajectory. For example, the deflation shock considered in the DSA (3 percent more) would not have made much difference to the internal devaluation, but would have caused debt to jump to 175 percent of GDP.

In the Third Review the Fund goes even further on the basis of a new Debt Sustainability analysis - "If nominal growth averages 1 percent lower than the 4 percent baseline projection, debt will be 134 percent in 2020 with an only modest declining path thereafter". That is to say, if the sum of GDP growth and inflation is 1% less than forecast in the baseline scenario debt will rise substantially.

So Whither Greece? Is Grexit About To Become An Option Again?

According to Citi's Chief Economist Willem Buiter, the man who coined the term Grexit, the possibility of Greece exiting the euro zone has receded "markedly" in recent months. "We still believe that there is a fairly high risk of Grexit in coming years, but no longer put it in our base case at any particular date," Citi said in a research note co-authored by Buiter published in May. Reading this assessment at the time of its publication the argument seemed reasonable to me. But after 48 hours of poring over IMF documentation on the country I am no longer so sure that this conclusion is as solid as it seems.

My feeling now is that, despite Buiter's recent pronouncements, Grexit may well come rapidly back on the agenda after the German elections. I think markets are soothing themselves with an overoptimistic expectation of how committed German politicians are to moving towards banking and fiscal union - Draghi bond buying at the ECB is another issue, but the Greeks by and large don't have bonds to sell, they just have debt obligations to the official sector. Put another way, as Wolfgang Munchau argues in this week's Financial Times, “The OMT is not designed to address the solvency problems of various private and public entities in the eurozone”, and Greece's coming problems are surely of the solvency and not the liquidity kind.

 The key issue really hangs around the obligations the Euro partners entered into with the IMF last December to fund any shortfall in Greek funding and debt-reduction needs as long as the IMF continues to give the country a pass mark during the ongoing reviews.

 Looking over and over again through the numbers the IMF put forward it is clear to me that there is really very little wiggle room left on Greek debt dynamics, and that the IMF are fully aware of this as their Debt Sustainability exercises demonstrate, hence initial attempts to distance themselves from EU institutions in the Evaluation Document. The move reminds me of one of Leo Messi's attempts to lose his markers while languishing near the edge of the penalty box. One swift lunge and its in the net.

Now one possibility which lies before us is obviously that the IMF gives the country a red flag in a review. That wouldn't be so difficult given the way Greece works. Yet actually, for reasons discussed in the introductory section to this piece, the Fund has precious little interest in doing this, since the country's Euro peers could then simply walk away from their funding obligations and the IMF would be last man standing on the debt, a situation they repeatedly stress they are anxious to avoid. Nonetheless, let us assume they do throw up a red flag, what would be the consequences?

Well, not another EU backed aid programme surely. The red flag would mean the issue of possible Grexit would be directly back on the table, since core Europe would surely be extremely reluctant to accept politically unpopular losses for a country that wasn't complying, and it is hard to see what the solution to ongoing funding shortfalls coupled with non-compliance would be if it wasn't euro exit.

So now let's assume that the country gets a series of continuing green flags, but that nominal GDP performance is less than projected in the programme's baseline scenario - it may not be politically correct to say this, but it is hard not to get the impression that the inflation and growth numbers for 2015 to 2018 (showing nominal GDP growth of around 4.7%) have been devised explicitly to bring Greek debt into the region of 120% by 2020, at least on paper. The probability of under-performance is thus high.

Cognizant of this looming difficulty the Fund seem to be already attempting to force the issue by looking for a 4 billion Euro down-payment on their commitment from the Euro partners in 2014. Then, supposing they wanted to accelerate the Euro partners Greek bail-in process they would only have to revise down their post 2014 inflation and GDP forecasts to make even more money needed quite quickly. But, if we think about it a bit,  the political logic for ongoing debt pardoning in Greece by other EU member states isn't especially clear given that Italy, Portugal, Ireland and Spain could all easily have debt levels over 110% of GDP come 2022. So how can you justify making Greece a special case in the positive sense? I think the more likely outcome is that core Europe will try to wriggle out of its obligations following the German elections, and that this move will lead to a surge in uncertainty about Greece's future, with Grexit once more becoming an openly discussed option.