The Houdini question

Greek bonds: Greece has come to the market again. It has successfully sold 5 billion euros ($6.7 billion) of seven-year paper at a yield of 6 per cent, about 3.5 percentage points more than comparable German government debt. If politics were all that mattered, the new bonds would be a steal. Greece clearly has political leverage over the European Union. Even Angela Merkel, the German chancellor who has been taking a hard line on helping Athens, does not want to countenance a default by a euro zone government. The International Monetary Fund is also interested in helping.

But ultimately, Greece has to make good on its existing 270 billion euros of government debt, not to mention the roughly 25 billion euros of new debt it is expected to raise in 2010. For that, the politicians need not merely a financial, but an economic, work-out.

The constraints are daunting. On one side is the mountain of debt, set to rise to 125 percent of GDP this year. Yields on new paper are 3 percentage points higher than at the 2005 trough. What's more, about 70 per cent of interest payments leave the country - so it's not even as though Greece can tax the recipients. On the other side is the precipice of falling GDP.

The government’s austerity plan involves cuts in spending and wages. The result is likely to be a steep recession, which would normally reduce tax revenue. The most direct ways to get the debt level down - default and inflation - are all currently closed to Greece. That leaves putting up taxes, further swingeing spending cuts and rapid growth as the main options. The snag is that an even hairier fiscal shirt would militate against growth. And the easiest way of getting growth - a devaluation - isn’t an option.

For a country to stabilise its debt/GDP ratio, broadly speaking two things are needed. First, it has to stop running a so-called “primary deficit” - that is, the deficit before interest payments. Second, its average interest rate needs to be less than its nominal growth in GDP. Both of these will be a challenge for Greece. Its primary deficit, 7.7 percent last year, is forecast to be not much under 5 percent despite the belt-tightening. Meanwhile, the average interest rate, currently 4.4 percent, will rise in the immediate future as the country issues bonds with 6 percent coupons. What that means is that the economy really needs a period of sustained nominal growth of 5 percent.

Greece has enjoyed rapid growth in the past. Between 2000 and 2008 nominal GDP grew at a 7.3 percent compound rate. But the current yield reflects justified scepticism that it can get back on the growth track.