It is Really about Political Economy in Greece

Greece's economic mess has understandably dominated investors' concerns. News from the ECB earlier today that Greek bank deposits fell 2.7% in February and now stand at the lowest level since Oct 2006, reflects the ongoing bank run. The fact that Greece's new 10-year bond is yielding around 20% reflects ongoing concerns that the PSI is not put closure on this chapter of Greece's tragedy.

The IMF's mission to Greece warns that the pace of reforms remain insufficient, and it highlighted the efforts to fight tax evasion underscore its conclusion, which the market fully embraces that "the rescue has a high risk of going awry."

Note that the Troika is in Athens on Monday and is pressing Greece for another 11.6 bln euro in savings for the 2013/2014 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 6th election date is most likely. Polls suggest that a terribly fragmented parliament will result. The largest party is the New Democracy which 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.

One area that we have pointed to previously that offers scope for savings that has yet to be fully explored and does not further squeeze of 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 euro zone 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 bln euros--more than the second aid package.

Greece argues that it needs strong defense spending to address two threats. The first is from Turkey. Yet relations have improved and a military confrontation between these two NATO members seem 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. Arms imports contribute to Greece's 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 explain 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 mln euros as it cut social spending by 1.8 bln 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.

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, like many US companies and Japanese auto and parts producers, for example, of building and selling locally may prove superior under these conditions.

Returning to Greece, we have also emphasized another reason in addition to cost-benefit analysis, behind the need for it to remain in the euro zone. Greece is a NATO member and has a number of geostrategic assets. If it were to unceremoniously leave, the animosity toward its creditors and its need for financing could see it do things that would be against Europe (and the US) interest.

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 euro zone creditor nations as well as its significant geostrategic assets.