Political Economy Complicates Greece

NEW YORK (BBH FX Strategy) -- Greece's economic mess has understandably dominated investors' concerns. News from the European Central Bank earlier Wednesday that Greek bank deposits fell 2.7% in February and now stand at the lowest level since October 2006 reflects the ongoing bank run. The fact that Greece's new 10-year bond is yielding around 20% reflects ongoing concerns that the Private Sector Initiative has not put closure on this chapter of Greece's tragedy.

The International Monetary Fund's mission to Greece warns that the pace of reforms remains insufficient and it highlighted the efforts to fight tax evasion to underscore its conclusion that "the rescue has a high risk of going awry."

Note that the Troika is in Athens Monday and is pressing Greece for another 11.6 billion euros in savings for the 2013-to-2014 period. This will give the new government little breathing room.

Although there has been no official announcement, the local press appears to be thinking that a May 6 election date is most likely. Polls suggest that a terribly fragmented parliament will result. The largest party is the New Democracy is polling around 20% presently -- that may translate into 60 seats in the 300-seat parliament. The lack of a strong government does not bode well for decisive action or painful structural reforms.

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One area that we have pointed to previously that offers scope for savings yet to be fully explored and that does not further squeeze employees and pensioners is defense spending. Even though Greece has trimmed its military spending, it is still highest in the region.

If, over the past decade Greece would have spent only the eurozone average of 1.7% of GDP on defense, rather than 4%, it would have saved a little more than 50% of GDP or roughly 150 billion euros -- more than the second aid package.

Greece argues that its needs to strong defense spending for two threats. The first is from Turkey. Yet relations have improved and a military confrontation between these two NATO members seems quite remote. The other threat Greece is thought to face is refugees from Northern Africa and Middle East. Yet the kind of weapons Greece buys, like submarines and fighter jets, do not seem suitable for border protection.

Perhaps it is more comprehensible if we looked at it from another angle. Consider that Greece is the world's third largest arms importer after the behemoths of China and India. The arms imports contribute to the trade and current account deficits.

This leads us to look at where Greece is buying its weapons from. In the five years to 2010, Greece was Germany's number one customer for munitions, accounting for 15% of Germany's arms sales. Greece is also France's third largest customer, though the largest in Europe.

Incidentally, but not unrelated, Portugal is Germany's second largest arms purchaser.

This may help understand why the creditor nations have been less insistent on Greece cutting back more on arms spending. In 2010, the last year data is available, Greece actually increased defense spending by about 900 million euros as it cut social spending by 1.8 billion euros.

It also reinforces the sense, which we suggested before, that the creditor nations were essentially engaged in producer financing. Loans from countries such as Germany and France were used to buy a significant part to buy their goods.

While we are all aware of how the debtor countries, like Greece, need to make more adjustments, there continues to be a reluctance to consider the implications for creditor countries. Germany appears to have redirected some of its exports away from the periphery in Europe toward Asia, including China. Other creditors like France and the Netherlands seems somewhat less successful.

Defense

At the same time, one cannot help but wonder if one of the casualties of the crisis is the export-oriented models. One of the significant challenges countries face is where will aggregate demand come from during this protracted de-leveraging (household and government sectors). Export-oriented models borrow from other countries' demand. The foreign direct-investment strategy, used by many U.S. companies and Japanese auto and parts producers, for example, of building and selling locally may prove superior under these conditions.

We have also emphasized another reason in addition to cost-benefit, behind the need for Greece to remain in the eurozone. Greece is a NATO member and has a number of geostrategic assets. If it were to unceremoniously leave, the animosity toward its creditors and need for financing could see it do things that would be against the interests of Europe and the U.S.

Among the strategic assets Greece has are its ports and infrastructure. China has recently secured a 35-year concession to operate the Greek port of Piraeus. Ian Bremmer, the head of the Eurasia Group, recently noted that down the road, Russia might be interested in securing basing rights there, especially if its current access or ability to project power in the Mediterranean through Syria, is at risk. Separately, Gazprom is reportedly interested in the privatization of Greece's gas company Depa and electric grid operator Desfa.

By simply looking at the ongoing run on Greek banks in the form of falling deposits, or its slow pace of structural reforms, or Target 2 imbalances, one misses some of the more important linkages between Greece and the eurozone creditor nations as well as its significant geostrategic assets.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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