A whiff of panic has descended on world stock markets. But if the Greek politicians hold their nerve, it could be a great buying opportunity.
By now you'll probably know something about Greece's €110 billion rescue package, courtesy of the EU and IMF. Although this money will see the country through its short-term obligations, the bond market remains sceptical of Greece's long-term solvency.
And rather than solve the market's worries, the package seems to have actually exacerbated them. That's because investors, due to the tightened ties between Greece and Europe, now fear contagion -- a series of sovereign defaults in countries such as Portugal and Spain that would threaten the economic stability of the entire region.
This is why shares are being whacked across the globe, with a degree of panic setting in overnight in the US. But is it so bad that an indiscriminate sell-off is warranted?
The plan! The plan!
Standing between the present and that looming financial apocalypse is Greece's austerity plan -- the measures it needs to put in place to get its debt and deficit under control and remain eligible for EU and IMF loans -- and it is aggressive.
Here, however, is the good news. Unlike most government plans (including the UK and US), Greece's plan is front-loaded and based in realistic assumptions. This isn't to say Greece won't encounter resistance or even that it will ultimately be able to pull it off, but rather that the plan, at the very least, is not doomed from the outset.
What's expected of the Greeks
Greek austerity efforts are forecast to be a whopping 9% of GDP in fiscal 2010 and aim both to cut spending and raise revenue. On the revenue-raising side, Greeks can expect an increased VAT tax, increased booze and fag taxes, a widened tax base on property and luxury items, windfall taxes on profitable businesses, and a major crackdown on tax evasion.
It's this last effort that has the potential to move the needle most for the Greek budget. The Greek government at present collects just 4.7% of GDP in personal income tax -- a little more than half of other European countries despite comparable tax rates.
In terms of spending cuts, the country is staring down freezes and cuts in public sector salaries, allowances, and pensions as well as restrictions on procurements. For a country that sacrifices up to 8% of its GDP annually to nepotism, cronyism, and bribery, according to Daniel Kaufmann of the Brookings Institution, this could also make a real difference.
Here's what we mean
In most cases, of course, these plans and projections would be just about worthless. That's because most governments build their financial models from ridiculous assumptions. Take, for example, the U.S. government budget for fiscal 2011. Its 10-year deficit reduction goal is a relatively modest $1.2 trillion, which would cut the annual deficit from 5% to 4% of GDP annually.
Yet even this forecast is based on a real GDP growth forecast of 4.3% in 2011, 4.3% in 2012, and 4.2% in 2013. To put this in context, the U.S. has not sustained better than 4% GDP growth for three years since the three-year period ending 1999. You may remember that as the top of the dot-com bubble -- a temporary boom that ended as a ridiculous bust. Prior to that, it was the three years ending 1985.
In other words, maybe the U.S. is due for some robust growth. More likely, the federal budget is far too optimistic. As Christina Romer, head of the White House Council of Economic Advisors, said in a live chat at the time of the budget release, "all forecasts have to be understood to be subject to substantial margins of error."
And yet!
Despite this acknowledgment of substantial potential margins of error, the U.S. is staring down serious financial consequences should it not sustain 3.3% annual GDP growth between now and 2020. In fact, according to the sensitivity analysis included in the White House's own budget, it will add more than $3.1 trillion to the national debt should annual GDP growth through 2020 check in at 2.3% -- just one percentage point lower.
How likely is this to happen? After all, 3.3% real annual GDP growth is roughly the historical U.S. average.
According to a recent paper from the Bank of International Settlements, GDP growth falls one percentage point annually when a country's debt reaches more than 90% of GDP. The U.S. is currently at 87.3%. That number will be over 90% by the end of this year or next, making 2.3% GDP growth over the next decade much more likely than 3.3% GDP growth given that 3.3% was the average when the country was not weighed down by debt.
This fact, if you're concerned about fiscal responsibility, should have you headed to the toilet. And it just goes to show how so many well-intentioned government plans are doomed by optimistic, unrealistic assumptions.
Why Greece's plan could work
With that as background, let's take a look at the assumptions underlying Greece's plan. Thanks in all likelihood to IMF assistance, Greece's key macroecomic assumptions are realistic. It assumes a 4% decline in GDP in 2010, a 2.6% decline in 2011, and mere 1.1%, 2.1%, and 2.1% increases, respectively, in 2012, 2013, and 2014.
This is not outrageous. If Greece's plan is to fail, the culprit will not be unforeseen deteriorating macroeconomic circumstances that conveniently for politicians cannot be blamed on them. Rather, it will be because the government lacked the political will to see through its efforts.
At least Greece has admitted its problems and, though it will be difficult, is attempting to solve them within a realistic framework. Such a radical approach has yet to dawn on other governments and we can only hope that it does so sooner rather than later.
But leaving other countries aside for the moment, we're inclined to give the Greek plan the benefit of the doubt for the time being. This makes blue chips such as Vodafone (LSE: VOD), GlaxoSmithKline (LSE: GSK) and Shell (LSE: RDSB) – all trading on prospective P/E's of less than 10 -- a fertile hunting ground for potentially oversold shares.
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> This article was originally written by Tim Hanson, and published on Fool.com. It has been updated by Bruce Jackson, who has a position in Vodafone and GlaxoSmithKline.
