Macro View: Complacency over Greece is dangerous illusion

A POSSIBLE Greek default is again a major topic of interest. But market concerns are mostly superficial. The risks are understood in theory, but the endless negotiations are no longer generating a sense of real suspense. There is widespread belief that, in spite of the difficulties, things will not be allowed to get out of control and another temporary compromise will be agreed before we step over the brink.

While this will not resolve the fundamental problems, it will avoid an immediate crisis and buy a brief respite. When the next deadline arrives, the chances are that we will repeat the same exercise. Having gone through this routine on many previous occasions, it is not surprising that the markets have become smug. This complacency is neither surprising nor illogical, but is nonetheless a dangerous illusion.

A Greek crisis may abort the slow eurozone recovery and damage the world economy, at a time when the US and China are slowing and growth forecasts are being downgraded. Global confidence is still too dependent on abnormally low official interest rates and on huge quantitative easing (QE) programmes. The consequences of allowing Greece to default and to leave the euro (Grexit) are highly unpredictable. Though contingency plans are now in place to protect Europe’s banks in the event of default, there is still a serious risk that Grexit would be much more costly for everyone, including the creditors, than bailing out Greece. Since the sums required are relatively modest, helping Greece, albeit grudgingly, is a rational choice for Germany and other eurozone members.

However, this assessment ignores the fact that the crisis is becoming increasingly toxic. Both in Greece and among its main creditors, the political dynamics are increasingly volatile, and are evolving in a way that would make it difficult to contain tensions and avert a new crisis.

An unusual poker game

The Greek negotiations are an unusual poker game where all the players could be big losers. Everyone is using bluff and guile to test how far they can go. But the risks of a miscalculation are escalating. The gaps between the opposing positions are essentially irreconcilable, in spite of good will and efforts to reach a compromise. Greece is claiming the democratic legitimacy of a government elected on a promise to end austerity, or at least scale it back significantly. For the IMF, Germany and other creditors, the overriding need is to enforce the basic principle that debts have to be repaid on time. In a sign of defiance, Greece delayed for a few weeks a payment of €300m (£215m) due to the IMF.

The brief postponement did not trigger a default because, although highly unusual, it was legal. However, it came in response to growing internal political pressures on Prime Minister Tsipras to take a harder line and not to give way. Greece may be able to make its next payment on time, but the hard reality is that the country will be effectively broke within months without further support. In the short term, Greece will be given again more latitude, but a moment of truth cannot be put off indefinitely. If the creditors continue to insist that Greece must meet its obligations, and must adopt though policies in order to become solvent, a new stalemate is unavoidable before long.

With eurozone prospects improving, the markets are only too ready to ignore Greece. Deflation fears have eased further, as annual consumer price inflation moved back into positive territory in May, rising to 0.3%. Eurozone GDP quarterly growth was 0.4% in Q1 2015, marginally less than expected, but better than in recent quarters, and stronger than in the US & the UK. The jobless rate fell to 11.1% in April, the lowest in three years.

The markets reacted positively to the eurozone’s progress, and the euro is well above its recent low point against the US dollar. But longer term comparisons still show a relative weak economy. Eurozone year-on-year growth in Q1 2015 was much lower than in the US and the UK, and the jobless rate remains persistently higher. The European Central Bank (ECB) will not take any chances, and president Mario Draghi will not consider an early relaxation in his aggressive QE plan, which on present plans will run until September 2016. The Bank of Japan (BoJ) will also remain very cautious. In spite of the 2.4% annualised GDP growth in Q1 2015, the strongest in a year, the BoJ is determined to persevere with its own aggressive QE programme for the time being.

Recent US trends have been mixed, with disappointing growth but an improving jobs situation. Revised data shows that US GDP fell by an annualised 0.7% in Q1 2015, worse than expected and down from an initial estimate of 0.2% annualised growth, which was already disappointingly low. Very bad weather conditions and a worsening trade balance, due to the strong dollar, were the main factors accounting for the poor Q1 performance. But US growth has probably rebounded in Q2 2015.

Persevere with ‘wait and see’

This is similar to the 2014 experience, when a GDP fall in Q1 due to poor weather was followed by positive growth in subsequent quarters, Even so, the fall in output earlier this year will reduce full-year GDP growth in 2015, and our US forecast is revised down from 2.5 to 2.2%. Hopes that activity recovered in Q2 are supported by the strong May jobs report. The US economy created 280,000 jobs in May, more than expected; the March and April job figures were revised up. Though the unemployment rate, which is derived from a different survey, edged up to 5.5% in May, this was due to more people looking for work. Given the conflicting signals over the strength of the US economy, the Federal Reserve will persevere with its “wait and see” stance. With core inflation rising, the most likely date for the first increase in official rates remains September 2015. But, if there are renewed signs of US weakness, the Fed will not hesitate to postpone any tightening.

After the brief post-election euphoria, the UK is facing again the hard economic problems that it has to deal with. The huge fiscal deficit has only been cut by half since 2010, and further painful cuts in public spending will be needed. The official aim of moving into budgetary surplus by 2018/19 may prove to be too ambitious, and the job may take at least a year longer. The UK external deficit remains unacceptably large. Prime Minister Cameron is asserting his political authority after his election victory. The timetable of negotiating a new agreement with the EU is being accelerated, and the prospect that the UK will stay in the EU are now much higher, even though there will be some opposition among eurosceptic Conservative MPs. With UK consume price inflation now marginally negative, at -0.1%, the MPC is likely to persevere with its current stance. Although the labour market remains strong, with employment rising and unemployment falling, official interest are likely to stay at 0.5% until the middle of 2016.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist