As most readers of this blog already know, there's a big election in Greece on Sunday. The perception is that if Syriza wins, financial markets will panic, causing a flight to safety (lower bond yields in the US, Germany, and other safe havens combined with a large decline in stock prices). At the same time, many think that if things get out of control, central banks around the world will inject liquidity to stabilize the global financial system. Does that mean if New Democracy wins instead (the center-right party), the Greek situation will improve? Unfortunately not. As discussed in previous posts, there's no easy solution to the Greek problem. To reassure financial markets, it must get its deficit under control, primarily through budget cuts. However, budget cuts hurt the economy in the short run (and Greek unemployment already exceeds 22%) and the weaker economy that results could actually increase the deficit. Does that mean it should engage in stimulus (whether through tax cuts or spending increases)? Unfortunately, it's hands are tied since markets are already unwilling to purchase Greek bonds and finance deficit spending.
On a related note, what role does transparency play in crises? Though some question the transparency of many governments, two countries stand out in recent years in terms of not being upfront about their financial conditions. Many are aware that Greece "misrepresented" the size of its 2009 budget deficit (for example, click here). That devastated its credibility and set it on the road to its current crisis. What other country "misrepresented" its financial condition (for the answer, click here)? Back in 2009, this country had just experienced a collapse in housing prices, but maintained that its banks were unaffected. Which country am I talking about? Spain. This week, Spanish banks received a promise of a 100 billion euro bailout (I guess they really weren't in good shape after all). Thus, the two countries currently bringing the most fear to global financial markets and policymakers are those that didn't face up to reality and instead tried to cover up the severity of their problems. Lack of credibility gets punished in the form of higher interest rates (to compensate for higher perceived risk).
Unfortunately, we're not close to the end of this story.
