Greece still in danger zone

ATHENS may have been in flames late on Sunday but there was much rejoicing on financial markets after Greek politicians ratified another round of austerity measures guaranteed to keep the birthplace of democracy in recession for years. The jubilation yesterday helped drive Australian and regional markets higher, which only serves to highlight just how short sighted and illogical financial markets can be.

For the past five weeks, the tension on global markets has been gradually easing with financial stocks among the big beneficiaries. A growing sense that European policymakers may be able to muddle through the debt minefields - and hence avoid a global banking crisis - has helped restore calm even though logic and basic mathematics tell you that Greece, and possibly several other euro-zone members, cannot avoid default.

Getting Greece even to this point seemed nigh on impossible late last year. That euro-zone leaders at last have recognised the extraordinary dangers they face, and the potential repercussions for the global economy, is underscored by their newfound determination to throw everything at avoiding meltdown. But there are two fundamental issues that shatter the fragile illusion of normality, or ''recovery'', as many pundits are calling it.

As important as last week's debt restructure for Greece was, with private investors being strong-armed into taking a crewcut on outstanding loans to the nation, it is not enough to lift the country out of the debt danger zone. Even after private sector debt holders write down the value of their loans, Greece will still be saddled with a debt to gross domestic product ratio in excess of 120 per cent, a wildly dangerous level. Before the private debt deal, it was hovering around 150 per cent and growing each year. So, clearly, it is in relatively safer territory after the write-off. Unfortunately, it is still unsustainable. And the deal cut over the weekend only ensures it will remain so.

While Greece needs fundamental economic restructuring, the ever harsher austerity packages foisted upon it (in exchange for bailout funds) will only serve to deepen the country's recession. And simple mathematics dictate that if the economy is going backwards, if GDP is shrinking, then the debt to GDP ratio will continue to deteriorate.

Add into the equation penalty interest rates and a budget deficit and there is no avoiding that with a shrinking economy, the debt ratio is likely to again blow out above 130 per cent this year and continue to accelerate thereafter. Greece has been in recession for five years. Youth unemployment has topped 50 per cent. Without a flexible exchange rate to help it adapt to the economic crisis, it would be reasonable to expect young Greeks to look for work elsewhere, which would entrench the nation's economic decline.

Even more alarming, as was witnessed over the weekend, such hurried and harsh austerity measures imposed on an already troubled economy have the potential to awaken social unrest on a massive scale, unleashing deep-seated fears and prejudices that pander to the interests of those at political extremes. That has the potential to further damage the economy and cause a potential flight of capital.

Putting aside the havoc a default would unleash on European banking, if Greece were allowed to default, and then exit the European Union, its economy would benefit by a deeply devalued drachma. But despite recent rhetoric from German leaders that it wouldn't be overly concerned about a Greek exit, that isn't an option. For it suits euro-zone leaders to maintain the attention on Greece, which is on the fringes of the European Union.

Without that distraction, it is possible bond market investors would focus on Italy, Portugal and Spain, at the heart of the union. But financial markets are seduced by short-term events only for a short time. Within the next few months, attention again will be directed towards the European debt problems. And that is bound to again unsettle equity and bond markets.

The Europeans, however, have embarked on a more aggressive campaign to alleviate their problems. Like the Americans and the British, the European Central Bank has busted out the printing press, pumping new money through the financial system while keeping interest rates low.

The new man at the helm of the European Central Bank, Mario Draghi, has managed to convince the Germans to cast aside their opposition. It didn't work in Germany during the post-World War I Weimar Republic, leading to skyrocketing inflation and social upheaval that led to the rise of nationalist socialism and Adolf Hitler. Robert Mugabe found it had some nasty side-effects in Zimbabwe as well. He's since reverted to using the US dollar.

The US has undertaken two massive stages of ''quantitative easing'', with a third being contemplated. Britain again has begun printing cash and the Europeans are gearing up for a second round, reportedly worth ?1 trillion. The idea is to depress the currency, to boost spending and to inflate the economy out of the doldrums. It certainly has boosted financial markets since late last year. As an economic strategy, it is akin to cardiac shock treatment. It can be effective in short, sharp doses. But it isn't recommended as a long-term fix.