Greek Budget Realities: No Easy Option

This paper uses a quantitative dynamic open economy macroeconomic model to examine alternative strategies that the Greek government could implement to increase its primary balance on a flow basis by 1 percent of GDP, representing roughly one quarter of Greece’s total annual liability. We examine the impact of increases in distortionary taxes and reductions in government expenditures on the macroeconomy in both the short and long run. The necessary fiscal adjustments are large and entail substantial macroeconomic costs. These costs are even greater when one takes into account realistic elasticities of the tax base and the fact that Greece is a small open economy. Delaying fiscal adjustment could yield short-term benefits, but ultimately such delays come at a high price unless Greece’s creditors are willing to provide additional finance at below-market rates. The basic framework holds the growth rate of the Greek economy fixed. Naturally, fiscal adjustments become less painful under a scenario in which the Greek economy returns to a positive growth path. Whether structural reforms or other policies can generate such growth remains an open question.